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The Great Inflation/Deflation Debate (Part 2)
Getting real on inflation (continued) Life on a debt rocket Currency Life Cycle A Shakespearian Tragedy Ostrich avoidance Real estate update – The next two shoes? Last month , we looked at some examples where hyperinflation got the better of a nation and whether it’s a possibility that should worry us. With that in mind, we will take a closer look at the differences between the official and the unofficial Consumer Price Index (CPI) and examine the implications for the economy and market if inflation is greater than the official CPI would have us believe it is. What will it mean for the future of markets, our economy and your financial well-being? More importantly, what can you do to protect yourself? 
Figure 1 – Chart comparing the monthly official Consumer Price Index numbers (CPI-U in green) that shows annual inflation was running at 3.84% in 2008 versus the Alternate CPI estimate (CPI-Alt in red) using the calculation before the changes post 1980 which showed inflation at 11.57% in 2008. Notice how the two estimates have diverged since the statistical changes first made in the 1980s. Source – Bureau of Labor Statistics and ShadowStats.com Getting real on inflation (continued) If we take the annual CPI numbers from the chart above, we can calculate how inflation has impacted buying power since 1970. First, we’ll examine what the official CPI is telling us. According to annual CPI data from the Bureau of Labor Statistic (BLS), inflation averaged 4.68% between 1970 and 2008. In 1970, a US dollar purchased 100 cents worth of goods. What is a dollar worth today? More precisely, what percentage of the goods that a dollar bought in 1970 would it purchase today? According to the official BLS CPI, in 2009 a dollar buys about $0.18 worth of goods that it did thirty-nine years ago. Put another way, what cost you one dollar in 1970 now costs $5.56 if you believe official inflation figures. Now let’s perform the same exercise for the CPI (CPI-Alt) calculated the way it was before government statisticians began to modify it in the 1980s. According to CPI-Alt, a dollar in 2009 buys less than $0.06 worth of goods that it did in 1970 which means what cost $1 in 1970 now costs $16.95. In other words, the dollar has just one-third the value that the government would have us believe. Let’s look at another measure of value – what did a cup of coffee cost in 1970? According to Wiki.Answers.com, most restaurants charged $0.10 for a cup of coffee with a meal. Today the cost of an average cup of coffee in the U.S. is $1.38. Our rudimentary coffee index says that it now takes $13.80 to buy what cost $1.00 in 1970. Let’s forget that you usually got a bottomless cup back then so the comparison isn’t perfect. But our coffee index is much closer to the CPI-Alt estimate. Now let’s examine a standard that has been used for thousands of years as a currency, gold. In 1970 while the U.S. was still on the gold standard, an ounce of gold (Englehard gold price) averaged $36.75. In 2009, gold averaged $920.40 which makes the 1970 dollar now worth just $0.04. In other words it now takes $25 dollars to buy what a buck purchased in 1970 using the gold standard. If we use the linear regression of the price of gold today to remove the big ups and downs, which pegs the present day price of gold at $560/oz, the dollar is now worth $0.06. Even using this extremely conservative gold price estimate, the present day value of a dollar is still roughly one-third the $0.18 estimate based on the official CPI and nearly identical to the Alt-CPI estimate. 
Figure 2 – Chart showing three different estimates on how the value of a dollar has changed since 1970. By 1980, the buying power of a dollar had been more than cut in half. But then in 1982, a strange thing happened. Government statisticians began making changes to the way inflation was calculated that had the effect of minimizing it. The official CPI (CPI-U) puts the value of a 1970 dollar at $0.18 today compared to $0.059 using the Alt-CPI (original CPI calculation) and $0.04 using gold. Source data – Bureau of Labor Statistics and ShadowStats.com But no matter which way you slice it, it is safe to say that the official CPI estimate has underestimated the true rate of inflation and as we see from figure 1 and from the Fudge Factor chart in figure 2 of our last report , this discrepancy is accelerating at an increasing rate. (At the end of this report we’ll show you how the Dow Jones Industrial Average priced in gold has performed in the last decade.) Why would the government mislead us? As long-time ProfitScore IQ readers know, we believe it’s at least partly because statistics are just one tool that incumbent governments use to get re-elected. It would seem that the temptation to modify economic statistics to woo voters has been just too powerful for governments to resist. Just look at the most powerful short-term cycle in markets – the four-year presidential cycle. For those of you not familiar with it, 93% of Dow Jones Industrial gains were earned in the 26 months leading up to each election versus just 7% in the 22 months after each election between 1902 and 2006. So by being invested 54% of the time, the hypothetical investor would have captured 93% of Dow gains using a simple presidential cycle trading system. But whether or not you agree that official stats paint a biased picture, can we at least agree on the necessity of viewing the financial world as it really is, not as it should be or as someone would like us to see it? Certainly for the investor, that is essential. And no investor is more sensitive to the real rate of inflation than the bond investor. So why focus on the bond investor? Simple, the fate of the western world now lies in her hands. Bond investors finance debt and debt in the U.S. has reached gargantuan proportions. As figure 3 shows, government debt projected to be nearly $13 trillion in 2009 is spiraling out of control. At $53 trillion (Q1-09), total credit market debt (debt at all levels of our economy) is more than four times greater than federal government debt (figure 4). Total debt has grown without a break since the 1981 recession and has doubled in nominal terms since 2000 (see figure 5). Who finances a large chunk of the trillions in government debt? You got it, the bond investor. And as we have observed from this year’s Treasury auctions, roughly one-half of the bidders have been indirect bidders comprised of foreign central banks. As the largest debtor nation in the world, we rely on the kindness of strangers to finance our debt – the total debt of the rest of the world is dwarfed by U.S. debt as we saw in figure 3 of last month's report. 
Figure 3 – Chart showing annual growth in government debt and the year-to-year growth rate. In 2009, the debt was growing at 29% based on the estimate of the 2009 budget deficit. Since 1970 government debt has grown at an average annual rate of 8.89%. As this chart shows, since then it has not declined even for a year. Data – Whitehouse.gov Bloomberg estimated that the U.S. government will be selling as much as $3.25 trillion worth of Treasuries in 2009, from 90-day to 30-year notes to pay the bills for yields (interest rates) that last week ranged from 0.17% at the short end to 4.44% for the 30-Year Treasury. 
Figure 4 – Historic chart showing total credit market debt to GDP through 2009. In the wake of the stock meltdown in 1933, the ratio hit 265% but then dropped into the early 1940s. The last year total credit debt dropped relative to GDP was 1981. Since 2000, TCMD has grown 35% faster than the economy in a time of economic expansion (if you believe the official GDP growth numbers). Data Source – U.S. Federal Reserve and Gabelli Mathers Fund. 
Figure 5 – The function of recessions is supposed to be to remove the excesses that have built up during the good times and reduce debt. But as this chart shows, total credit market debt has continued to grow unabated since 1981 thanks in large part to the Federal Reserve’s accommodative “cheap money” policies. As we see, debt expanded even more rapidly than average in 2008 as the credit crisis took hold thanks to the Fed quantitative easing. Data – U.S. Federal Reserve. This is where the inflation argument gets really interesting. As of July 2009, the official annualized CPI from the Bureau of Labor Statistics was -2.1% showing deflation. This compares to annual inflation of +5.44% according to the CPI-Alt from ShadowStats.com. A bond investor relying on the official CPI, buying a Treasury bond believes that it will shield him (or her) from the deemed real drop in prices with a guaranteed return of anywhere from 0.17 to 4.44%. However, if the CPI-Alt is a better reflection of reality, the bond investor is actually losing money since the rate of return is below the actual inflation rate. From a longer-term perspective, the second scenario has been the more accurate. The value of 10-year Treasuries lost 4.5% in nominal terms during the first half of 2009, which was the worst performance in 30 years according to Bloomberg (see article Treasuries Drop for First Time in Six Weeks below). If we use the CPI-Alt inflation rate of 5.44% it means investors generated a real annual loss of at least 9.94% (the rate of inflation according to the CPI-Alt was much higher at the beginning of the year)! 
Figure 6 – Chart showing monthly changes Treasury international capital flows (net foreign purchases of U.S. Treasuries) together with the amount required monthly to finance the budget deficit since 2005 (red line). This year’s budget deficit estimated by the White House (www.whitehouse.gov) equates to more than $140 billion per month. Also shown is the trend of foreign net Treasury capital flows (yellow line). Source – U.S. Treasury  Figure 7 – Overview of foreign investments in the U.S. since 1980. Notice the big drop in 2009 indicating net selling of U.S. assets by foreigners. Source – St Louis Federal Reserve. Life on a Debt Rocket Is it any wonder foreigners are losing interest in financing our credit needs? Here is a brief summary of the problems we now face. Problem 1 – Sheer size and growth rate of the debt The total projected 2009 government debt ($12.9 trillion) works out to more than $42,400 for every man, woman and child or $112,000 per household in this country and this debt has been growing at an average annual rate of nearly 9% since 2000. However, this does not include future unfunded Medicare and Social Security liabilities that taken together with total government debt total more than $50 trillion according to former U.S. Comptroller General David M. Walker. Today’s total credit market debt of $53 trillion (not including future liabilities), works out to nearly $175,000 per person or $460,000 per household (assuming 115 million U.S. households) and is approaching 4 times the size of our total annual economic output or GDP. If we take David Walker’s estimate of future unfunded Medicare, Social Security and other liabilities and add them to current total credit market debt, the total is more than $90 trillion which works out to total present and future debt obligations of more than $780,000 per U.S. household! (As I write this I am hoping I made a mistake with the math but I have triple-checked the government and total credit market debt figures. Granted our savings rate has been climbing but it would take far more than total U.S. savings to finance our debt. According to data to March 31, 2009 the 8,246 financial institutions insured by the FDIC had total assets of $13.54 trillion. So even if we used every penny of the assets of all insured U.S. banks, we would still only have roughly enough to finance federal government debt but that is just one-quarter of all U.S. debt. We have been clearly living far above our income levels and debt levels tell us that this habit is growing. With foreign interest in our bonds dropping, who is going to finance our growing financial needs? Problem 2 – Growing cost of financing Over the last thirty years, debt has continued to grow in both booms and recessions but so far it has been manageable enough to finance. But even at current low interest rates, it’s getting more expensive due to its sheer size. This year’s projected government debt of $12.9 trillion will cost us more than $452 billion per year at an interest rate of 3.5% (approximate yield on a 10-year Treasury). That is roughly equal to the entire cost of the total federal budget deficit just last year in 2008 ($455 billion). Problem 3 – Interest rate risk Whenever there is a debt, it is accompanied by an interest-rate risk and the greater the debt, the greater the risk. Historically speaking, current interest rates are near 50-year lows. If rates rise, so will the cost of the debt. At an interest rate of 8%, the annual interest on government debt rises above $1 trillion. Is this a real threat? This is where the real inflation rate becomes crucial. When (not if) bond investors get tired of financing this debt for the current small rate of return, they will demand a higher return. If the real inflation rate is 5.44%, it means we will have to pay bond investors that plus a reasonable return of at least two to three percent which puts the interest on government debt at a minimum of 7.44%. Could it happen? Take another look at figure 3 above. Government debt has increased at an average annual rate of 9% and at no time since 1970 has government debt declined. It did happen in Iceland a couple of years ago. The government was willing to pay 8% to investors to finance the government debt but no one was interested. Within fifteen days, the rate jumped to 14% and the government had not choice but to pay it or face default. The important takeaway for now is to realize how vulnerable we have become due to our high debt levels and just how quickly this habit has spiraled out of control. As we will see next, history has not been kind to nations that have found themselves in a similar position in the past. Currency Life Cycle In last month's report we began with a discussion of Zimbabwe, the latest example of a fiat paper currency that fell prey to the evils of hyperinflation. The overriding question today is could it happen again, here in the U.S.? When I say “again,” it is not a typo. This has happened in our country before and more than just once. In his 2008 book entitled Fiat Paper Money: The History and Evolution of our Currency, bullion and currency specialist Ralph Foster discusses Zimbabwe and other national fiat currencies throughout history. And one important lesson standouts out. Without exception, every fiat paper currency since the beginning of time has suffered a strikingly similar fate. As we mentioned last month, the U.S. dollar became a fiat paper currency backed by nothing more than the faith and good will of the government following the move by Richard Nixon to take the nation off the gold standard in 1971. Fiat paper money is currency not backed by gold, silver or other semi-precious metal or tangible asset. Its first recorded use provides valuable insight into the challenges nations employing it have faced throughout history. According to Foster, fiat currency for general use first appeared in recorded history in the 11th century AD in Szechwan, China. Following a long period of peace and prosperity, the area around Szechwan suffered a shortage of copper which was used for coinage. Iron was tried but it proved too heavy and impractical. Paper had been used in money shops in the exchange of deposit receipts to transact business so the next logical step was to use it as a currency. In 1024 it made its debut as a national currency for general use by the Sung Empire. Armed with the best of intentions, bureaucrats for the imperial Sung treasury originally intended that the currency be redeemed for coin after three years. However, whenever there is potential for abuse the temptation becomes unbearable and over time, the Sung treasury kept printing an increasing number of notes and redeeming fewer at the allotted time. By 1077, only 29 percent of the issue was backed by coin. But in spite of these abuses, the note called the chiao-tzu held its value for seven decades. As time went on, the treasury gradually and quietly slipped into the practice of issuing series after series of notes with little regard for the regulatory controls. The days of 29 percent backing quietly slipped into oblivion as the state discovered how easy it was to pay its obligations in paper (sound familiar yet?). By the first decade of the 12th century, over 20 times as many notes were circulating as had been originally authorized in 1024 and prices were quickly rising. Then the Sung Empire was attacked and war began, further increasing the need for money by the rulers. Laws were enacted to contain inflation but it was too late. In 1127, the leaders of the Sung Empire were broke, forced to cede the territory in dispute and flee south by which time the chiao-tzu had become worthless. This set of events with different casts played out four more times over the next two centuries in China and then countless times in other parts of the world over the next nine hundred years in just about every civilized nation in the world. And although the characters and locations changed, the plot remained strikingly similar that like a Shakespearian tragedy, could be broken down into five all-too predictable acts including the death of the play’s central character – the currency. Of Fiat Princes and Paupers (in that order) – A Shakespearian Tragedy Act 1 – A form of currency, usually a metal, which had been in use, became impractical as the economy grew causing bureaucrats to adopt a paper replacement due to its light weight, ease of use and versatility. Often but not always, the new note was initially backed either by gold, silver or copper and would often have a redemption date.
Act 2 – As time progressed and prosperity grew, the temptation to create something from nothing was too great to resist and an increasing number of notes would be printed by those in charge of the treasury. This would not be immediately noticeable which led to an increasing number of notes being printed to the benefit of those in charge. At this stage the ruling classes often enjoyed new found prosperity, wealth and status. It was also at this stage of the fiat currency life cycle that Ponzi schemes like Tulip Mania (1637) in the Netherlands or the South Sea Company bubble (1720) took root. Without the availability of large amounts of ready and portable cash, such schemes and bubbles are nearly impossible. Act 3 – Often a war, attack, military action or other crisis erupted that required huge sums of money from the ruling classes. Debt replaced greed as the primary motivator to print more money. Any checks and balances still in place to curtail money supply would be abandoned and the printing presses were kicked into high gear. Debt continued to mount and inflation rapidly accelerated. Act 4 – The result was always the same – hyperinflation ensued after attempts to pay off unmanageable levels of debt failed and the currency plunged in value until it became worthless. Act 5 was the unfortunate and inevitable final step. Act 5 – In the wake of financial collapse which was often but not always the result of a failed expensive military campaign or war (which the subject country usually lost), economic collapse gripped the nation and economic chaos followed. Citizens stripped of their property struggled to feed themselves and their families. Barter became the primary form of currency. Often laws would be passed banning the use of paper currency again. But in a generation these lessons were forgotten laying the foundation for the next fiat currency cycle. Foster’s Fiat Paper Money is an essential read for anyone concerned about their future financial well-being. In the appendix, Foster lists the instances he found in which national notes became worthless, breaking the list into decade-long periods starting from the beginning of the 20th century. In total, there are 431 examples (pages 216 and 217) in which a national note or currency became worthless between 1900 and 2009 which works out to an average of four fiat money collapses per year. And a number of nations have been repeat offenders.
Foster also discusses four interesting examples of fiat paper money in the U.S. since our nation’s beginnings (not including the current dollar) that like every other case of every fiat currency in history, eventually became worthless and had to be taken out of circulation. Resisting the ‘ostrich’ urge Granted, our debt appears to be spiraling out of control which has only been made possible thanks to existence of a fiat paper currency that allows those in control of the treasury to print as much money as they want as the need arises. But burying your head in the sand won’t make the problem go away. History tells us that over time, regulatory controls diminish and out-of-control inflation is the unavoidable end result. I am still optimistic that we are not beyond the point of no return to become a Zimbabwe, at least not yet. But the solution window is closing more quickly than most realize. As a friend of mine used to say, plan for the worst and hope for the best. This means taking some steps to protect your assets from potential inflation which once it has begun could escalate to hyperinflation in relatively short order. More about that at the end of this letter. 
Figure 8 – Chart showing the parabolic move in the Zimbabwe Industrial Index in the dying days of the Zimbabwe dollar. The problem is that by the time you sold the stock and cashed the check, you had virtually nothing left thanks to an inflation rate running in the billions of percent. Real Estate Update – The next two shoes? We have been hearing about the green shoots in the real estate market. Both new and existing home sales have improved and although median prices haven’t responded with much conviction yet, they appear to have stopped falling at least for the time being. Builder sentiment is also on the mend if you believe the most recent National Association of Home Builders sentiment report. But according to the Case-Shiller home price index, while existing home prices are falling more slowly than before, they were still falling at an annualized rate of 17% in May. And there are two more clouds on the real estate recovery horizon. The first is foreclosures as another 1.9 million were registered in the first half of 2009. And while existing home sales are gradually improving, the addition of new foreclosures means inventories will remain stubbornly high for the foreseeable future, further depressing prices. The second cloud is commercial real estate. Based on recent news, the commercial property market may be as much as two years behind its residential counterpart and this is very bad news for the beleagured banks that hold the mortgages. Already reeling from residential defaults and soaring foreclosures the banks are now taking it on the chin as commercial property values and occupancy rates plummet and this has led to a new round of bank defaults which hit 77 for the year on August 14 with the failure of Colonial BancGroup, which is the largest failure of 2009 and the most costly since the failure of IndyMac Bancorp in 2008. Some areas have been harder hit than others. Commercial property sales in Denver dropped 68% in the 12 months ending June 30 according to a report from LoopNet Inc. Property owners have been increasingly squeezed between falling demand amid the economic slowdown and tightening lending standards by banks desperately attempting to stem the hemorrhaging of red ink from their balance sheets. 
Figure 9 – Chart showing delinquency rates at commercial banks for residential and commercial real estate ad credit cards. According to one industry analyst, “The bottom line: defaults are exploding. It’s going to be worse than the early 90’s.” The delinquency rate on commercial property loans pooled together into investments, estimated at around $750 billion, hit nearly 3% in Q2-09 which is about triple from where it was at year-end 208 according to real estate group Reis Inc. In all, there are about $3.5 trillion worth of commercial real estate loans held by banks, tied up in commercial mortgage-backed securities or held by other institutions. More than $2 trillion in commercial mortgages are expected to come due between now and 2013 (see article below Recession and debt drag on commercial real estate). REIT Rally Madness What I find interesting is the how well the majority of Real Estate Investment Trusts (REITs) have performed since March. The First Trust S&P REIT Index ETF (FRI) is up more than 65%, the REIT Diversified Industrial (MG441) is up 69% since March 6 which is representative of how well they have performed since the most recent recovery began. Overall, REITs (both equity and mortgage) are up 68% since March 6 according to the VectorVest composite REIT sector index. According to data from VectorVest.com, per share earnings for the VectorVest REIT Sector Index comprised of 133 equity REITs and 41 mortgage REITs came in at negative $1.08/share according to the latest data which is an improvement from the March 18 low of -$1.35 but a sizable per share loss none-the-less. More importantly, the earnings growth rate is negative 4%. So are gains approaching 70% justified when REITs are still bleeding significant cash? I’ll let you be the judge. For the broad range of stocks, according to the latest earnings data from VectorVest.com per share earnings for the more than 8000 U.S. stocks tracked by the VectorVest Composite Index have risen to an average of $0.17 from an all-time low of $0.13 six weeks ago which hardly justifies the more than 50% gains we have seen in equity prices since March. There is little doubt in our minds that stocks in general have clearly gotten ahead of themselves and REITs are way overvalued given the economic environment. Finally, the chart by dshort.com (above) compares the most recent rally (blue) with the rally in 1930 (grey). We don’t believe that the S&P500 is getting set to drop 83% as happened from 1930 to 1932 (let’s face it there is too much stimulus money being pumped into the system for that to happen), but it does suggest that the correction we saw in the third week of August may be the beginning of more to come in the coming weeks. Suggested Reading: In New Phase of Crisis, Securities Sink Banks http://finance.yahoo.com/news/In-New-Phase-of-Crisis-wallstreet-1020317667.html?x=0&.v=4 The Economy is in Deep, Deep Trouble… http://globalresearch.ca/index.php?context=va&aid=14759 Toxic Loans Topping 5% May Push 150 Banks to Point of No Return http://www.bloomberg.com/apps/news?pid=20601109&sid=aTTT9jivRIWE Recession and debt drag on commercial real estate http://news.yahoo.com/s/ap/20090812/ap_on_bi_ge/us_commercial_real_estate_2 Commercial mortgage failure at 20-year high in U.S.: report http://www.reuters.com/article/ousiv/idUSTRE56J1A120090720 Commercial real estate deals off, prices up http://www.bizjournals.com/denver/stories/2009/08/10/daily88.html?ana=from_rss Underwater Mortgages May Reach 30% by Mid-2010, Zillow Says http://www.bloomberg.com/apps/news?pid=20601110&sid=aL3gWFhKRt_w Treasuries Fall for First Time in Six Weeks as Stocks Advance http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aVIVaL2qqOWY HSBC Says 2010 European Bond Sales to Approach 1 Trillion Euros http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aEId3R3ePT9s Fiat Paper Money: The History and Evolution of our Currency by Ralph Foster http://home.pacbell.net/tfdf/ Money, Bank Credit, and Economic Cycles by Jesus Huerta de Soto http://mises.org/store/Money-Bank-Credit-and-Economic-Cycles-P290.aspx Disclaimer TradeSystemGuru.com obtains information from sources deemed to be reliable; however, TradeSystemGuru.com does not guarantee the accuracy of any of the information provided. TradeSystemGuru.com makes no warranties, expressed or implied, as to the fitness of the information for any purpose, or to results obtained by individuals using the information. We may or may not be invested in any investments cited above. In no event shall TradeSystemGuru.com be held liable for direct, indirect, or incidental damages resulting from the use of the information found on or distributed through this website. TradeSystemGuru.com shall be indemnified and held harmless from any actions, claims, proceedings, or liabilities with respect to the information and its use. TradeSystemGuru.com does not make specific trading recommendations or provide individualized market advice. All information provided is to be construed as opinions and is intended to be used as an educational information service only. We encourage investors to contact a registered securities representative prior to making any investment or related decisions. 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