AGD - Chapter III: Some Alternative Explanations of Depression: A Critique

Whereas the text concedes, that economic downturns and shocks can be caused by many events – famine, plague, seizure of bullion, bank runs, war, heavy taxation to name a few – it holds the Austrian Theory up as the only one explaining the business cycle. Having disputed Keynesian arguments in Chapter II, several others are disregarded at the following pages.

General Overproduction: Given free markets, such a thing should not exist, as prices will fall and shelves will be cleared from stock. There might be a problem of cost-price differentials, but the cluster of errors and the bidding up of factor prices is explained by the Austrian Theory.
Underconsumption: Rothbard states that the desire for goods cannot go away indefinitely and that it is even hard to argument for people not wanting a better standard of living all the time. Conceding the structure of consumption could change from less consumer goods to more capital goods, this would lead to falling prices, but still a higher living standard.
The Acceleration Principle: the principle itself is not very interesting, but the argumentation around it has a point of high value. You cannot come to a general theory of business cycle by explaining the progress on a single firm level on the one side, or by using aggregates for the economy as a whole. Doing so, you put aside the important interrelations between participants in the market – thus putting aside the mechanism that will do all the adoptions to different outlooks and situations.
Dearth of “Investment Opportunities”: Causal factors claimed by the supporters of this theory are insufficient rate of population growth, lack of resources, and inadequate technical innovation. Rohtbard does away with these factors being causal for investment and – as for the acceleration principle – makes us aware that the whole argument lacks any description of a price system.
Schumpeter’s Business Cycle Theory: Rohtbard concedes that Schumpeter’s theory at least is a general economic theory, but with a postulate of zero rate interest, discarding consumer taste, dispensing new resources and ignoring time preferences. The possible element of change remaining is technological innovation.
Qualitative Credit Doctrines: Those are described as having something in common with the Austrian Theory: seeing the negative in the boom, wanting to prevent them before they begin, and evaluation the bust as the necessary corrective action that has to follow. But they differ in the causal analysis.
Overoptimism and Overpessimism: Economic expectations are described as self-correcting, not self-aggravating and thus not causal to the cluster of error in a boom-bust cycle. Optimism and pessimism typically last until after the trend change, thus not being causal.

Taxageddon – 7 Trillion USD Fiscal Cliff heads towards us

While we are all – cautiously – looking at the US, European and Chinese economy, hoping for some improvement or at least not a set-back too big, a 7 Trillion USD Fiscal Cliff is heading towards us. 7 TRILLION – I do not even know how to abbreviate Trillion. 2.3 Trillion USD of spending cuts and 5 Trillion USD tax hikes will hit the US economy by 1st of January, 2013. It’s still not a given fact, but has some probability. And even if Republicans and Democrats can find a way to kick the can down the road, the nitty-gritty discussions leading to that hoped-for outcome will impact markets and economy. But what’s going to happen?

I) 2013 fiscal year starts in October 1st, 2012. By that time the US government should have a budget in place. It will not. Given the timeline for the presidential elections (November, 6th), this will simply not happen. Well- nothing to worry about: there was no US-budget since years. Sarcasm aside: how can the leading industrial nation not have a budget since years? This is no banana-republic. How can this not be a major discussion point in the elections campaigns? How can all this discussions not drag down US economy and markets? Unless thinking about a major diversion (Iran?) I cannot see, how it cannot.

II) By October or November the US debt ceiling is going to be leveled out. Maybe you can remember the discussion in August 2011 about raising the limit. Without such an agreement to raise the limit, US government has either to send employees home, close its national parks, stop payments for retirees or stop payments on its debt. Last time, the discussion went quite unnoticed, as the Europeans have been fighting their debt crisis. This time, presidential elections on November 6th and hitting the tax limit will interfere with each other – and there is maybe no European diversion. How this can-not happen to lead to nasty discussions of politicians, impacting the economy and the markets?

III) By 1st of January, 2013 the Bush tax cuts will no longer apply, the social security tax hikes will hit, and the spending cuts will hammer in. Those are the details:

- Social Security payroll tax will raise from 4.2 to 6.2 percent of income - 124 USD bn effect on tax payers - will cost the average family a 100 USD a month
- Alternative Minimum Tax (AMT) expires -118 USD bn effect: AMT means that you cannot press your tax rate below a certain level (the alternative minimum tax) by different tax deductions. This regulation was not applied since the Bush tax cuts for certain (lower) income groups, but will be effective again.

- Income tax or to be more specific the marginal tax rates will increase. The rate for the first USD 8,700 will increase from 10 to 15 %, the top rates will go from 33 to 36 % and from 35 to 39.6 %
- Itemized deductions (like housing interest, charity donations, …) will no longer be considered at your marginal tax rate, but at a maximum of 28 % (average tax effect of +1.2 % on the US tax payer)

- Assuming Obama’s health care reform makes it through Supreme Court, a +0,9 % Medicare Hospital Insurance tax (HI) will apply for incomes above USD 200.000 (or USD 250.000 filing jointly) (increasing the tax from 2.9 to 3.8 percent)
- The top Capital Gains tax will increase from 15 to 20 % (for long-term capital gains with above one year holding)
- Dividends will no longer be taxed as capital gains (10 – 15 %), but at marginal income tax rate up to a maximum of 39.6 %
- Additional 3.8 % Medicare tax on unearned income (interest, dividends, capital gains, annuities, royalties, rents) will be effective, with the same thresholds applying as for HI-tax. The effect will be USD 20 bn,

- The marriage penalty for joint filers comes back
- Child credit per child drops from USD 1.000 to USD 500 – this will no longer be refundable generally, but on more limited conditions (only with 3 or more childs, … ).

- The estate tax rate goes from 35 % to 55 % (tax on the taxable estate of a deceased person), tax exemption drops from 5 mn USD to 1 mn USD.

Some of these increases will hit every tax payer in the US. Some only if you earn 200.000 USD or more. Currently, 4 % of Americans earn more than 200.000 USD (according to IRS). Fewer than 1% currently pay the 35% income tax rate and fewer than 4% even pay 33%. As for the old 39.6% rate: Adjusted for inflation, you'd only pay that now on any income over $363,000 a year – but the limits are not raised, they are just in effect again. Take a married couple earning a 125.000 USD (less than 100.000 EUR) a year before taxes – their income tax will go from 19.400 to 23.400 USD and taking social security taxes into consideration, they will lose roughly 500 USD a month.

IV) This all still does not address US government spending, having increased 1 Trillion USD over the last year and running deficits every year.

V) In order to raise the deficit limit in 2011, there was agreed on automatic spending cuts in 2013, after all the elections did take place. The Budget Control Act was put into place, cutting the budget by 2.1 trillion USD between 2012 and 2021 (or: a tenth of that sum every year). 900 billion of that have been included, named, itemized or whatever you want to call it in the Act. 50 % or 450 USD mn should come from defense, and another 50 % from non-defense – excluding Medicaid, food stamps, Social Security and other benefit programs. The rest – 1.2 trillion USD – where not even allocated generally to any field of politics, but should come out of the decisions of a so-called Super-Committee, consisting of 6 Republicans and 6 Democrats.

VI) So far we have no decisions from the Super-Committee, nor from Congress, on additional spending cuts. There simply is no sound plan how to stay within the limits, how to go on further.

So now you tell me, how all that should not affect the US economy and thus the world economy!

At the moment, the markets seem to ignore it. A 7 Trillion USD impact is so huge, so insane - even B52 Ben Bernanke seems to be frightened. “And I am concerned that if all the tax increases and all the spending cuts that are associated with the current law which would take place, absent any Congressional action, that would occur on January 1st that that would be a significant risk to the recovery. So I am looking and hoping that Congress will take actions that will address both sides of that ‘uh’ both requirements of good fiscal policy.”

Markets seem to ignore this event, saying: it will not happen. Let us hope, it does not. But even if it does not, there will be blood down the streets before politicians get their act together. I don’t see, how all this cannot effect the next 6 to 12 months.

AGD - Chapter II - Keynesian Critisisms of the Theory

Chapter II discusses the main arguments of Keynesians against the Austrian Theory. It starts with The Liquidity Trap – meaning that the preference for money/liquidity could be so high, that investment cannot be stimulated by a falling interest rate. This means an economy will not find its way out of depression by itself. The following paragraphs focus on how savings, investment and interest rates are interlinked and whether liquidity preferences or time preferences determine the rate of interest. At first this seems to be an academic discussion, but then re-think: are the Keynesian or the Austrian views more relevant in a situation of financial depression. What does really determine our interest rate at the moment? Are we in a liquidity trap? And what if there would be no forces keeping these interest rates so low? 

Carrying on with Wage Rates and Unemployment, the old discussion on price flexibility of wages, and how prices too high would lead to unsold surpluses piling up (read: unemployment) is reiterated. Rothbard states the Austrian view, that the wider the extent of rigid wages, the more likely mass employment will be. German discussion of minimum wage comes to mind. And the ideas of early 1920s are cited – American prosperity is caused by the payment of high wages, that lowering wage rates would cut purchasing power. Rothbard lists several points, why the aggregate wage must not fall even if wage rates per hour come down. In addition, he argues for a sharp decline in wage rates to be allowed, as this will shorten the adoption process and minimize harm over time. Finally the effects on total demand are discussed, making a point that even with lower wages money did not disappear, unless it is ‘hoarded’. The argument carries on, that even if we assume consumption would have been reduced by lower wages and this has let to higher savings, it would still foster a faster recovery by lower interest rates.

SNB epic intervention move: now action has to follow words

In September 2011 the Swiss National Bank (SNB) aimed for a substantial and sustained weakening of the Swiss franc. In an epic intervention move, it declared to no longer tolerate a EUR/CHF exchange rate below the minimum rate of CHF 1.20. The SNB said it will enforce this minimum rate with 'the utmost determination and is prepared to buy foreign currency in unlimited quantities'.

Well, this lead to an immediate weakening of the CHF. Exchange rates jumped from a close to 1.00 ratio to well above 1.20. What happened during the last weeks is a development getting closer and closer to 1.20 - as of the time I write these lines, we stand at 1.2004 (see chart).

Seems like it is time for the SNB to let actions follow big words. I would not be surprised to see this topic hit the news in the next weeks.

America's Great Depression - Chapter I

I could not stand bloomberg.tv any longer - had to shut off the shallow arguments.

What I will do instead is start to read Murray N. Rothbard’s Americas’s Gread Depression. Not the first time I try to accomplish this, but so far I really could not focus enough to get over the first chapters. I really love his ‘The Mystery of Banking’, so I guess it’s my fault I could not get any further. One reason I did not finish this book straight away is the language: Rothbard is clearly able to write in simple and plain English. But whereas I could go through ‘The Mystery of Banking’ without looking up a single word, I feel the need to consult www.leo.org here quite often. I will take it as an opportunity to improve my English.

Skipping all the introductions to editions one to five we start with PartI: Business Cycle Theory. Note that the book was written in 1963, and you can get a full on-line-edition for free at: http://www.mises.org/rothbard/agd.pdf

Still I suggest you get a hard-copy of the book. 

Chapter I: The Positive Theory of the Cycle

Business Cycles and Fluctuations   -   Rothbard states, that there are always fluctuations in demand and that is nothing to worry about. Take a shift in consumer taste: if suddenly Windows operating system is no longer in demand, but Linux is – this is nothing to be covered by the theory of a (general) Business Cycle

Murry quite early links (general) price development here with the supply of Money. High supply of money will lead to increasing price levels, not in a specific sector, but in general. He expects a constant purchasing power of a currency, if the demand for holding cash (in aggregate) equals the cash provided by central banks. 

The problem: The cluster of error   -   Unfortunately, supply of money does not explain the development of business cycles at all. Why does ‘real’ output shrink? Who do entrepreneurs make errors in forecasting future demand? Why do they invest ‘too much’? Why are some industries hit harder than others (industrial goods vs. consumer goods) in a depression? 

The Explanations: Boom and Depression   -   Core thesis of Rothbard (and the Austrian School) is: there will be no cluster of error in a truly free economy. There will be errors – but the boom-bust-cycle is generated by intervention, specifically credit expansion and not a cluster of errors.
Markets will develop a ‘normal’ rate of interest, based on the time preferences of individuals. Printing money will distort this ‘normal’ rate of interest. Lower interest rates – indicating a higher demand for products now – will lead to higher investment, more output. And two steps down the road to higher wages, rents, interest. Unless time preferences have changed, things will revert back to the old equilibrium. But in the meantime malinvestments have occurred.
The depression is the ‘recovery’ process. The distortion coming from credit expansion and the following boom Is requiring a bust to get back to normal.

Secondary Features of Depression: Deflationary Credit Contraction  -   What happens next is banks will (have to) cut back on credit lines. ‘Being inherently bankrupt anyway’, banks cannot afford to look instable at all. There will be a flight to liquidity/money – falling prices follow. This ‘return to normal’ cannot be avoided, it can only be prolonged by fighting it. Prices of producers’ goods will even fall more rapidly than do consumer good prices.

Deflation (reduced money supply) helps to speed up the correction process – which will only end, when we return to the desired consumption-savings pattern. If those patterns change, the adjustment process can be shortened: what helps to speed up the process is not more consumption, but more savings. 

Government Depression Policy: Laissez-Faire   -   Rothbards view is clear: Don’t interfere with the markets adjustment process. He lists policies, which will delay the recovery and aggravate the depression:
- Prevent or delay liquidation
- Inflate further
- Keep wage rates up
- Keep prices up
- Stimulate consumption and discourage savings
- Subsidize unemployment

Rothbard’s suggestion therefore is, that a government should encourage deflation. To do a thing positively, it should LOWER its relative role in the economy. And he clearly warns from inflating its way out of the mess: this will only lead to hyperinflation – destroying the currency and thus the lifeblood of the economy.

Preventing Depressions   -   no easy task for governments. First of all, Rothbard suggests to prevent any inflationary credit expansion (leading later on to a depression). Allowing fractional reserve banking he deems a first step to failure. But governments followed that path, ending up with central banking, the worst outcome possible. Rothbard instead suggests to outlaw fractional banking, to impose a 100 % gold standard. Failing such extreme measures, it should at least use every measure possible to prevent the expansion of money and credit. 

Problems in the Austrian Theory of the Trade Cycle --- Rothbard closes the chapter with citing some critical arguments against the Austrian Theory and provides counter-arguments why those critics are not right.

Outsmart the market: what to learn form Q1 gold stock performance

Gold stocks are (still) pretty much in negative territory for the year. How comes is not clear to me, as gold is up for the year. Yes, we are below the peak of 1,900 plus something USD, but at 1.660 USD many mining companies are printing money. Some of them have started to pay dividends - a few even do since a longer time.

Two of my recent favorites performed quite different during the last days: Agnico-Eagle (AEM) up 20 % - Goldcorp (GG) down 7 %. Whats the difference?

Well, this is earnings season.

AEM was beaten down a lot lately - being more than cut in half since end of 2010 was the reason I entered a position here. The cut was due to large operational problems of AEM, leading to a shut down of Goldex mine in Quebec (water entered he mine) and profitability problems at its Meadowbank gold mine (leading to an asset write-down). Looking at some investor presentations, I found GoldEx reserves being below 10 % of the whole company. Meadowbank was more like 20 % of the total, but its not a total write-off. A share price cut of 50 % seemed unwarranted, especially as gold stocks have been depressed to the metal anyways.
AEM Q1 came in strong, with gold production up 19 % qoq, USD 196 mn cashflow and the ability to repay USD 90 mn in debt. Dividends are 0.20 USD a quarter - around 2 % pa. even after the latest rise in stock price. Gold production was up at LaRonde (+17 %), at Kittila (+16 %), and in Mexico (+11 %). Costs in Meadowbank were still high - USD 1.000 an ounce. This is ugly compared to 300 to 650 USD on the other sites. But deduct it from current gold price - you can do the math!

GG is a different kind of cake.Stock performance over the last couple of quarters was sideways - I collect a monthly dividend on that one since quite a time, roughly 1.25 % pa. Over 5 years the stock doubled, but dropped back from above 50 to just 38 CAD recently.
Recent Q1 earnings have been  0.49 USD only instead of market consensus of 0.53 USD. Major operations set-back was produciton at Red Lake, being down 40 % qoq due to poor ground conditions and lower than expected grades. Taking that into consideration, overall production was roughly 525.000 ounces (vs. 637.000 a year ago) at cash costs of 250 USD - and realized price of 1.700 USD per ounce. With cash costs up 60 USD per ounce, selling price was up 300 USD per ounce. When i do the math, volume times (selling price less cash costs) is roughly the same as in last years quarter. But the stock dropped almost 10 %.

So, what are the lessons to learn here?
 1)  Both companies are solid plays. Good balance sheet. No financing problems. Low cash costs on average - far below current Gold price. Solid management. Paying dividends. Recent issues are either in the past, or seem to be not permanent. Why should I change the long term bearish view?

2) These are mining stocks. Both have several projects in operation - still you have to expect issues here and there over time. Even the best management cannot ensure there will be no set-back on grades, a quarter with production difficulties, or even a close-to-catastrophic event like water pouring into an under-ground mine.

3) Current cash-flows of gold producers are high, and this is not reflected in the stock prices. Gold is up for the year - for every of the last 8 years. Gold stocks are not. The market is missing something here - part of the explanation being the ETFs, who attract money that does not flow into precious metal stocks. (Its the same money, that would avoid to buy the physical metal because of the hassle included with that. But now it does not enter a stock ticker symbol, but just GLD - avoiding the due diligence on single companies, too.)

4) Given 1 + 2 + 3 you would like to invest in gold producers. You would like to avoid some risk - doing so by not buying the single mine producer (that goes under if its mine is under water), by not buying the south-American or African producer, by not going long the may-be take-over candidate having no current production at all but just a prospect. And you would like to invest in more than one.

5) Limiting your risk, you still have to stand strange market movements. See AEM dropping like a stone and coming back after a single good quarter. See GG, being hammered after Q1 when the long-term outlook has not changed.

The way to do it is this:
- Create a short list of companies you like to own, maybe 5 (all of them with good cash costs, producing in stable jurisdictions, several production places, maybe a dividend, good balance sheet making them independent form outside financing, history of little stock-dilution, good management)

- If you are not into gold or precious metal stock at all so far, start your due diligence with the two companies mentioned here. Putting in some 4 to 10 hours a week will make you knowledgeable till the end of next month.

- Enter a small position with each of your short list candidates once you have identified them over the next 5 weeks. Maybe allocate 25 % of you gold-stock-capital to this first entry. So if you start with 25.000 USD , invest 1.000 USD or 4 %  each. This may sound stupid, as fees are high percentage-wise compared to a larger investment. But it will a) bring you into the market, b) get you involved with those 5 companies, and c) avoid the risk of entering on a particularly bad day/week with all your initial money. And as daily movements can be 5, 10 or even 15 %, what difference does a 1 or even 2 % fee make? Not much, if you play right!

- Follow the development of your 5 picks now, and once you feel the market is not getting the big picture (like for AEM over the last year or for GG over the last week) add to your position. Maybe a 2.000 USD or 8 % on the next entry. Your goal is to stay invested with each of the 5 plays for those 2 initial entries or 12 % over the long run. Always stay invested with the 4 % initial entry.

- If the prices still drop after your second entry in a position, and you still think the big picture is with you and the market does not get it: raise your stakes by the remaining 2.000 USD or 8 %  you allocated to this share initially. But be careful here: can you really out-smart the market, or is there something wrong with your stock?

- Once one of your stocks picks up speed, moves ahead compared to the others, once the chart shows an exponential rise - this is when you might want to take some money from the table. If you are in your full 4 + 8 + 8 = 20 % this level might be reached sooner then when you are in only 4 + 8 = 12 %. But you never want to go below your initial 4 % (with one exception - see below). You do this, when you think the stock might come back - either because it over-performed, or if you expect the whole market to come down. The goal is to re-enter with the money you take of the table later on. With prices dropped, you will be able to buy more shares of the same company this time. You hold for (almost) ever with your initial 4 %. But the mining / precious metal market is volatile. You will only put in an extraordinary performance when you learn to trade the waves.

- Doubling down does not work in casinos. It does not work with stock markets, either. When I tell you to enter your initial position, and to triple up when you see a good opportunity, and to add more if the stock still falls: be aware! The lowest price a stock can go is zero. You do not want to hold on that long or bet more of you capital. You should really check and check and check again on the evaluation you did. Maybe the stock price if falling for a valid reason. This will hardly be something you cannot find out, just secret to the insiders. If there is a flaw, you can and will see it. Just keep an open mind, be willing to challenge your position, follow the ones suggesting to short your stock. Stay alert.

I would love to read your comments on this.

Disclosure: I am long AEM and GG.

We escaped the big drop - for now

Hey, I have not posted for almost a month and got only one (direct) comment on my silence. I know you out there can do better in cheering me up.

Well, business trips, Easter holidays with my precious, good weather and - i have to admit - reading 'The Hunger Games' kept me from posting. But not from trading.

20 days ago, I was pretty pessimistic on stock markets, especially German ones. It looked like major support had been broken or was on the verge to break. Like the 6.600 on the DAX, which I consider an important level. Or the big drop in the S&P500 below 1.360 on the 10th of April - representing weakness by dropping below the 50-day-average.

My market sentiment was kind of mixed. We had a nice run since the beginning of the year in major indices. It somehow slowed down a little - especially the DAX. Also with a break in the European debt crisis and reasonable 'okay' economic numbers in the US, central banks had stepped of the easing throttle a little. Still, til the presidential elections would be in, a full-scale break-down was unlikely. But a correction seemed to be around - especially with Q1 numbers coming in and my sentiment being that outlooks would be not too rosy.

So what I did was entering 5 short positions on the DAX30 companies looking worst:
Siemens at 73.10 (S/L at 76.4)
Metro AG at 26.23 (28)
Daimler at 41.37 (45)
Commerzbank at 1.70 (1.90)
BMW at 66.76 (70)

It pretty much looks, like the markets recovered since then. The DAX dropped below 6.600 shortly, but recovered to 6.801. My chart indicators tell me to take a neutral stance here for the moment. DOW30 is close to a new high. S&P500 recovered significantly with 75% of stocks on an uptrend right now. With Apple Q1 results, NASDAQ jumped up also, looking like it might attack new highs from here.

From my 5 short positions (I used my CFD-account to trade them) BMW was stopped at 69.01 and later on Daimler was stopped at 41.01. I had lowered the S/Ls after first progress was made. Being neutral or slightly positive on the markets right now, I will further take down those S/L Limits now. If the markets further improves, the whole trade will be a wash. Commerzbank and Metro still have ugly charts; Siemens might be through with trending down, as they took down their guidance for 2012 a few days ago.

Generally speaking, I think we escaped a major break-down for the moment. This fits into the overall picture of mine, not expecting a bear market until the US presidential elections are behind us. But sometime later this year, the attention will focus back on the huge tax increases the US consumer has to bear in 2013. And with the elections gone, the US government and the FED will have bought some time. Kicking the can down the road, they will maybe ease their support for the markets. Being aggressive, you can ride the wave upwards a little longer. Otherwise - keep your powder dry and prepare for a drop several week or months down the road.
Disclosure: I am short Siemens, Metro AG, and Commerzbank. I do not plan to open positions on Daimler or BMW during the next 72 hours.