Agora Financial’s Rude Awakening

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Dubai, UAE

· The Fed’s exploding balance sheet – $1 trillion…$2 trillion…$3 trillion…more!
· Uncovering the counter-intuitive psychology of finance,
· Rare baseball cards, abundant dollar bills and plenty more…

Chris Mayer, explaining inflation to a nine-year old, reports…

Some concepts I can explain to my 9-year old son, Calvin, but economists with advanced degrees can’t seem to get it. Calvin, named after my favorite ballplayer (Cal Ripken, though my wife hates it when I say that. “We didn’t name him after Cal Ripken, we just liked the name!”), wanted to know how the dollar lost value over time. He wanted to know why things got more expensive over time.

I explained it very simply. He likes to play this card game in which the players get different creatures and each of them has certain abilities. I explained to him how he valued certain cards highly because they are rare and hard to get. If the cards were easy to get and common, then they would be less valuable. This he understood.

So I told him that dollars work the same way. As the government prints more of them, they become less special. They buy less. We call this inflation.

Today, the Federal Reserve is laying the groundwork for massive inflation. “Over the past year,” Grant’s Interest Rate Observer notes, “the central bank’s balance sheet has grown by 133%. It was only yesterday when annual growth of 13% seemed aggressive, if not reckless, and certainly inflationary. Ten times that aggressive-if-not-reckless-and-certainly-inflationary rate of expansion is a fact that takes some getting used to.”

Over the last three months, Federal Reserve Bank credit is up 1,560%, reports Grant’s. It was only in September that the Fed’s balance sheet crossed $1 trillion for the first time. On Nov. 5, it scooted past $2 trillion. By year-end, says the president of the Federal Reserve Bank of Dallas, it could slide right on past $3 trillion. Our Federal Reserve seems hellbent on making Argentina look like Switzerland in terms of monetary restraint.

Why is this ballooning balance sheet inflationary? The Federal Reserve increases its assets by buying stuff — financial assets of banks and others. The Federal Reserve pays for these assets by creating money that did not exist before. That’s it. Simple as pie.

Of course, our government is not acting alone. Central banks across the globe are doing the same thing, if with somewhat lesser vigor, at the moment.

In any event, it means paper money will buy less. We may see nominal prices — for oil and gold and metals — continue to fall in the short term, but long term, I think we’re set up for some huge re-flation in 2009.

If I’m right, the overall stock market might continue to struggle for a long time to come. But selected resource stocks could do very well. I’m thinking of the many beaten-up stocks in the energy sector that have become extraordinarily cheap.

Yeah, I know it’s a bear market right now – a brutal bear market – but that means diligent investors can find some excellent values.

More on that in my column below…

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Buy Low…If You Dare
By Chris Mayer

Last month, I spent some time in San Juan, Puerto Rico. One day, we visited Old San Juan, the oldest settlement within the territory of the United States, with a history that begins in 1508. We also visited the old fort known officially as El Castillo San Felipe del Morro, or simply El Morro.

The fort must have sent shivers up the spines of all those who hoped to take it. The walls of El Morro are 18 feet thick and 145 feet high. Built on a headland, the Spanish Empire controlled the flow of goods in and out of the New World from here. El Morro has been tested many times. Even today, you can walk in the oldest tower in the fort, built in 1539, and see shell fragments in the ceiling that date to the 1898 bombardment of San Juan by the U.S. Navy during the Spanish-American War.

El Morro is a testament to the idea that in war, some things have not changed since Joshua gazed upon the walls of Jericho, or since Pericles sent the Athenian fleet against Sparta.

In investing, too, there are some things haven’t changed since those 24 brokers met under a buttonwood tree and started what became the NYSE. Buying low and selling high works in all markets. But this is easier said than done. As James Grant, editor of Grant’s Interest Rate Observer, points out in a recent letter: “We human beings only say we like to buy low and sell high. Our every instinct is to do the opposite. Rock-bottom prices only seem low in retrospect. At the time, they seem frightening because of the very reasons they are cheap.”

Such a time is now. And it is a sign of the kind of panic we are in. The investors who loved stocks one year ago when the Dow was hitting new record highs are the same investors who are now afraid to buy stocks, even though they are half the price they used to be. Successful investors buy when stocks are cheap and falling. Unsuccessful investors merely panic.

Let me tell you a little story that illustrates the point…

In July 1986, John Mendelson, a strategist at the brokerage firm Dean Witter Reynolds, was out fishing with his son. For whatever reasons, he decided the market would drop. And on Monday morning, at the next strategy meeting, Mendelson convinced 60 stockbrokers it was time to sell.

After the meeting, they rushed for the phones. (This was in the old days, before the advent of BlackBerries and the Internet.) Before long, the sell order rippled through some 600 institutional investors. The Dow Jones industrial average fell 62 points. This was back in the days when the Dow was barely 1,900. So it was a significant drop.

Lars Tvede tells this story in his The Psychology of Finance. It’s meant to show how one man could precipitate a meaningful drop in the market. It seems arbitrary, and it is. An investor in 1986 might’ve fretted at seeing his stocks in the red, but he shouldn’t have. The sell-off had nothing to do with his investments as much as it did with the hunch one man got while fishing.

Economist Robert Shiller has done some interesting work on the reasons people sell into declines like that one in 1986. In September, the market had another drop of 87 points. Shiller asked hundreds of institutional investors and large individual investors for reasons why they bought or sold during these times. Out of the 113 replies he received, none sold for any economic news or fundamental reasons that the press pointed out after the fact. Instead, “What was emphasized most,” Tvede writes, “was the market’s drop itself.”

After the big 1987 crash, Shiller sent out thousands of questionnaires. Again, the results were the same. The overwhelming reason investors sold was because the market was down.

This reminds me of that old Chinese saying that one dog barks at something and a hundred bark at the bark. Don’t be just one of the dogs that’s barking at the bark.

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[Rude Endnote: Foreign markets finished down again overnight with Hong Kong’s Hang Seng and Japan’s Nikkei falling 4.5% and 2.3% respectively. The Aussies took a battering too, following up yesterday’s stunning drop with another 3.47% decline.

Over in Europe, U.S. stock futures were down sharply in London, pointing to a lower open in New York. S&P futures slid 1.3% while Nasdaq and Dow futures traded lower by 2.1% and 1.5% respectively.

And on that bitter note, it’s time we were off to grab our afternoon triple espresso.

Until tomorrow…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com