The Houdini Economy

I believe there are many, many parallels in the world economy today, to that of previous economic depressions. We need only to look at past history. However, historian's all have different accounts and points of view. Is historical information based on objective analysis, primary evidence or a biased second hand account?

Is the economic events of today so different to that of the past? We are constantly told we are living through the worst economic downturn since the Great Depression; then we are told Australia has a resilient economy and that we are weathering the storm. Surely it can't happen to us?

"But we live in a modern, innovative, high-tech society today!"

In the 1920s America - the "Roaring Twenties", the sharemarket was booming, the humble car was built for the masses (T-Model Fords), and the population was extremely opportunistic. The population had never felt so wealthy, the horse and buggy were essentially gone from urban areas and the economy had never been more innovative. It seemed the good times would always last.

And today? We live in the so-called "new economy". A modern, innovative, high tech economy. We have never felt wealthier. We expect the good times to always get better. The next 20 years will be better then the last 20 years.

These are two different points in history - but the same human traits of economic complacency are well and truly alive today. There is usually a large economic depression every 75 years - the average life span of a human. Is it a coincidence economic lessons repeat? Is it a coincidence that each generation since the 'silent' generation (of the 1920s and 30s) has progressively had worse money habits than their parents generation? Everything used to be bought within our means, today its on credit, and we have little incentive to save for a raining day.

Houdini economy

** The big difference between 1929 and today, I believe, is the acceptance of mis-information by the general public and an acceptance to think the monetary system will always work. We live in the so called "Information Age", yet our diluted statistics mean we live in a Houdini economy. It's all smoke and mirrors. Government's have an interest to keeping the public unaware about what is really happening in the economy - to maintain political and social stability (in the short run).

However, comparing today to the past has become distorted because economists, Governments, and the media think they are comparing apples to apples. Today, statistics are treated as gospel. We believe that the stats on the nightly news are accurate, objective and unbiased. Why are we not learning from recent events? Many of the economists and bankers who got it wrong, are still in positions of power and influence. Central banks are being given expanded powers (particularly the Fed Reserve), rather than face increased accountability.

More often than not, an economic number today will be grossly diluted to that of 75 years ago. For example, the unemployment rate, or level of inflation are grossly misunderstated today.

For instance why is unemployment so low at the moment? In the 1930s it got to 32 per cent in Australia! Yet it is still around 5 per cent today, despite a recession and economic turmoil worldwide.

Answer: The ABS counts people as been employed if they are working just 1 hour per week.

But as the following chart shows, the number of hours worked has been falling gradually in the last 15 years. For starters there are a lot more part time jobs. It's good for people who want to work less, but its bad for recording what the real unemployment rate should be.

Chart 1:
Source: Kohler, ABC News

Getting back on topic - lets compare further to the last Great Depression:

1929 to 1932- the greatest sharemarket crash in history put the world into a Great Depression. In 3 years the market fell 89 per cent.

Current sharemarket crash? Depends on your measuring stick, namely, the monetary system has changed. 1929 money was backed by gold. Today it is backed by an exponential curve of debt.

If we use the Dow/Gold Ratio (which is what the 1929 sharemarket crash was recorded against), then the current bear market we have today really started in 1999 (not 2007). So far from top to bottom of the bear market the Dow Jones has fallen 84 percent measured against gold (the old monetary unit).

Perhaps we are already in economic depression but we just aren't awake to it?

As the following chart shows, the inflated US Dollars of today have diluted the impact of what is really happening. From 1999 to 2007 the Dow Jones rose in nominal terms, while the old monetary system was showing the economy was sick (and crashing), now both these measuring sticks are showing the US and world economy is continuing to tank.

Chart 2: Dow Jones over last 100 years
Wow - look at the 1929 crash! It's huge. What this chart fails to show is that important change of the monetary rule book in 1971 (when the gold link was removed).

The following chart puts the 1929 crash, and today's sharemarket crash into a better perspective (apples vs apples).

Chart 3: 100 yeas Dow/Gold Ratio.
Source: Steve Hickel, gold-eagle.com

The last dip in Dow/Gold Ratio:

Notice has taken at least 32 years to reach a new peak in the Dow/Gold Ratio in the last two downturns. In the last downturn there was stagflation in the 1970s, a change of the monetary rulebook in 1971, a commodity price peak in 1982, and an increase in social security outlays of Governments among other things. There was no great depression, but inflation was accepted and new bubbles came along to occupy everyone's money. The key last time is that there remained confidence in the new fiat monetary system. I believe this time round will be different.

Clearly there is a huge difference between Chart 2 and Chart 3. Chart 2 is an inflation drive chart. Chart 2 characters a true free market which goes from undervalued to overvalued and back over time. (Change the monetary system (methodology), and you will change the shapes of the charts!)

Steel industry today vs 1920s

Lets compare 1920s and today even further...

In the 1920s, there was a huge boom in the United States steel industry. 15 per cent of steel was used in automotive manufacturing. By 1928 there was over 21 million cars, enough for 1 in every 6 Americans. When the Great Depression hit however, by the mid 1930s over 50 per cent of the United States steel capacity stood idle.

Today there is vast amounts of steel capacity standing idle also. Lets compare.

Kingdom of Rust

According to latest research from Macquarie Bank, there is some 362 million tonnes per annum of unutilised steel capacity in the world.

Chart 3: Today, around 25 per cent of the world's steel capacity is sitting idle.
Source: Macarthur Coal Presentation - 17 June 2009

To put this into perspective, this is equivalent to:
- every single steel mill in Europe, Japan and Korea shutting down OR/
- ¾ of China’s steel production closing down.

With all this recent iron ore hype in the Australian sharemarket (in the last couple of months), just stop for one moment and envisage 3 out of every 4 steel mills in China closing down. Only the lowest cost (lowest debt) iron ore, coking coal, steel producers could survive a sustained turn down. Clearly there is too much capacity worldwide. This is not unique to just the steel/iron ore industries. The capacity for most goods today is built on the premise that the current monetary system will continue to work, that the world economy will continue to expand at a rapid rate, and that our tolerance of debt will continue to expand.

All this extra capacity will have to be removed from the system. Many companies will continue to go under. This is only natural. In the boom times too much competition led to cheaper cars and airfares, and even steel was pre-fabricated in China and exported back to Australia! There needs to be a giant shake-out across industry worldwide. Give it a few years..

Baltic Dry Index

Much of the gains on the Australian Securities Exchange (ASX) in recent months have been on the back of a bounce in commodity prices (ie. A fall in the US Dollar), and increased shipping movements out of China for Australian iron ore and coal. This has also lifted the Baltic Dry Index (BDI), which had a major crash in 2008. The BDI is a daily number published by the Baltic Exchange – it tracks world wide international shipping prices for dry bulk cargoes such as iron ore. It shot up in the boom years, and crashed big time last year as the following chart demonstrates.

Chart 4: Baltic Dry Index crashed 94 percent when the resources boom bust, its now rebounded on growing Chinese iron stockpiles.
Source: Bloomberg

The following chart from Alan Kohler pictures an interesting relationship between the BDI and movements in the Australian and US Dollar. Positive movements in commodity prices (particular in US terms) and the BDI - is a positive force for the Australian sharemarket.

Chart 5: Baltic vs AUD
Source: Kohler, ABC News

I believe its now time for the BDI to fall sharply once again. The third quarter of the calendar year is traditionally the worse for commodity prices (from my experience, particularly in base metals). Apparently about 10 per cent of the world Capesize ships (the largest) are sitting of Chinese ports, unable to unload their iron ore. The two largest iron ore terminals in China are said to be close to full capacity. Now that the 2009/10 iron ore benchmark prices have been finalised (with Japan and Korea), my bet is the Chinese have done most of their shopping for this year, and will try to manipulate the market in the short-run to really hammer down prices come next year.

World Trade

Ok, so i've talked about the BDI - what about world trade as a whole?

The following chart from Alan Kohler paints a bleak picture for world trade. It uses a base of 100 for the peak in world trade (some 12 months ago). Already we have gone from a massive boom, and the big bust continues at a greater magnitude than the 1929 trade bust. Just like the 1920s America – there is significant overcapacity in the world. Trade flows are stalling.

Chart 6: World trade has fallen off a cliff much higher then the Great Depression slump.Source: Kohler, ABC News

Covering up debt - back to the suitcase method

We all know what hiding bad debts can do... Subprime mortgage-backed securities, bundled together, given a AAA rating and sold overseas to unknowing investors worldwide. This grand scheme worked for a while... now it appears the humble suitcase is back in vogue to move Government debt around.

Here is a rather amusing article. If this were true... the US/Japanese Governments are running out of places to hide their debt!!

Suitcase With $134 Billion Puts Dollar on Edge

Two Japanese men are detained in Italy after allegedly attempting to take $134 billion worth of U.S. bonds over the border into Switzerland. ..

The trillions of dollars of debt the U.S. will issue in the next couple of years needs buyers. Attracting them will require making sure that existing ones aren’t losing faith in the U.S.’s ability to control the dollar. ..

Think about it: These two guys were carrying the gross domestic product of New Zealand or enough for three Beijing Olympics. If economies were for sale, the men could buy Slovakia and Croatia and have plenty left over for Mongolia or Cambodia. ..

Let’s assume for a moment that these U.S. bonds are real. That would make a mockery of Japanese Finance Minister Kaoru Yosano’s “absolutely unshakable” confidence in the credibility of the U.S. dollar. ..

Bad news can only be covered up for so long. Question everything!

Scott

GM goes, Rio snubs, and the PM shrugs ("technically")

You gotta admire how bad the rhetoric coming out of Canberra is getting these days. We were told in the led up to the last election by the now Prime Minister, that he was an “economic conservative” (18 months later we have over $314 billion in projected debt).

In the recent budget we were told that the Government will go into a “temporary deficit”. Translated, “temporary” works out to be until at least 2021. Twelve years of spiralling deficits is not temporary.

Now Australia is “technically” not in recession. Technically New South Wales should have won the State of Origin on Wednesday.... Enough of the rhetoric. Actions speak louder than words. And there will be political consequences for ignoring sustainable economics. It’s not just in Australia, expect more political and social disconnect with politicians and the voting constituents in the next few years. For now we get to watch the UK Government tear each other to shreads.

Also in an eventful week:

- General Motors enters Chapter 11 bankruptcy

Well another "officially" it happened moment... but lets be realistic. GM isn't being liquidated - just restructured. Yes, it should have been restructured years ago, but despite the leftist media - its failure to not reinvent itself to produce "green" cars instead of "gas guzzlers" had nothing to do with GM's downfall. GM's balance sheet was choking with unfunded liabilities (indeed it is just a mirror of the greater problems facing the US Government). As I stated (in my first post this year), between 1993 and 2007 GM spent much more paying pensions and retiree health care ($103 bn)than it did in dividends ($13 bn) to its shareholders! The company should have went under years ago. Economics 101 - your balance sheet must be sustainable. Unions once again kicked themselves in the foot - pension/health care plans which were agreed upon as early as the 1950s have come back to bite their children's, children. The Western World must learn to stop over-consuming (on debt) and demanding higher and higher wages (source of inflation). Perhaps with a more stable monetary system, union demands would be reigned in (wishful thinking?)

Now that GM is in Chapter 11, its plan is to cut its liabilities... 150,000 current and future employees will get a cut to their pensions, health benefits and life insurance. That's right - the new majority owner, the US Government will continue to bail GM out. It's only thrown hundreds of billions at the car industry for decades - why stop now?

Restructuring GM will not bring it back to its former glory. The world economy will determine its future. Like GM, the US Economy has been trading insolvent - its liabilities are completely unsustainable (over US$65 trillion). China and India have growing automotive industries, which are innovative, competitive and forward-looking. There is an oversupply of auto makers (Australia alone has around 60 different brands of vehicles to choose from!), and the free market will force mass consolidation in the coming decades, much like what has occured in aerospace and defence in the last couple of decades.


- BHP and RIO announce Pilbra Joint Venture

Great news for Australia, bad news for China and steel mills. BHP is the master at striking great deals, and this looks to be another one. Iron ore prices should be higher now that the producers can maintain their bargaining power over their customers. Bad luck China, expect them to buy some smaller producers. Odds are Murchison Metals (MMX.ax) will be taken very shortly, perhaps Andrew Forrest will sell down more of FMG if China puts a few billion down to expand it’s production in a significant way.

- Australia avoids official recession (for now)

The buzz word for the world economy right now is “green shoots” – economic recovery is in site! Markets do not move in straight lines. The duration and magnitude of economic recessions vary greatly and do not move in straight lines. We are still on par with the 1929 crash (see chart 2 and 3 from this previous post). The fundamental problems of the broken world monetary system remain. The United States is still insolvent. As Kenneth Rogoff discussed on Thursday (Australian Financial Review),

“global trade and current account imbalances needed to be reined in to reduce the chance of a severe financial crisis. The US and China are not solely responsible for these imbalances, but their relationship is certainly at the centre of it”

“The US consumer, whose gluttony helped fuel growth throughout the world for more than a decade, seems finally set to go on a diet. In addition to tighter credit, falling home prices and high unemployment will continue to put a crimp on US consumer spending.”

These two paragraphs sum up the situation quite nicely. The monetary system is broken, the China-US trade imbalance is broken. The musical chairs
has stopped, and for now Australia is lucky to have

Property Researcher slams Rudd Bank

As discussed briefly on my blog, the Commonwealth Government is seeking to proceed with its Australian Business Investment Partnership (ABIP), a $30 billion financing fund (in conjunction with the Big 4 banks) to help the commercial property market stay up right. In other words, an anti asset-deflation device. Rudd thinks he can take on the free market and win.

This is some of what DTZ Research stated in the Australian Financial Review on 1 June 2009:

“the government’s ability to improve market fundamentals is limited”

“it has the potential to affect the feasibility of development projects”

Further “Ruddbank could distort market forces that would eventually cause the property market to recover in any case.”

DTZ warned that providing “funds via ABIP to restart projects that have stalled has the potential to not only flood a failing market, but prolong its recovery.”

Further, (DTZ) argued that falling values were a natural market mechanism for dealing with an oversupplied market and declining demand.

Lastly, “Intervention by providing a funding solution, and not addressing the core problem, can only lead to further issues.”

Two programs worth watching:

Million Dollar Traders – SBS 7:30pm Tuesdays

Eight ordinary people are given a million dollars, a fortnight of intensive training and two months to run their own hedge fund.



The Ascent of Money – ABC 8:30pm Thursdays

Harvard professor Niall Ferguson examines the long history of money, credit, and banking. In it he predicts a financial crisis as a result of the world economy and in particular the United States using too much credit.



Charting exercise - short term resistance/support

The following is a short-term (5 day) chart analysis I drew up during the week on SLR – Silver Lake Resources. The analysis shows how resistance/support lines (as well as candlesticks) can give a good insight into the short-term direction of some stocks.

Chart 1: SLR 5-day

Cheers,
Scott