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April 15, 2004 A Day Late and A Dollar Short
“Contrarian
Round Table” probes the outer limits of What do stock market bulls, stock market bears, goldbugs, homeowners, and commodity speculators have in common? This is not a trick question. The answer is that all of these people are betting that the dollar will purchase less in the future that it does today. In other words they are all dollar bears. Ask almost any stock, commodity or real estate bull about the future of their favorite asset class and they will invariably say that their assets are appreciating in dollar terms. This is the same thing as saying the dollar is declining relative to that same asset. Goldbugs and stock market bears claim that the dollar is dead and therefore only liquid tangible assets will have value in the future. Cash in the form of US Dollars is possibly the most hated asset class around. Dollar bulls are as rare as dodo birds. Dollar bearishness seems like a reasonable position considering the long history of dollar inflation and the reckless monetary policies of the US government. But we are contrarians and when we see so many people on one side of a trade we must analyze the consequences of such a lopsided market. We feel that the extreme level of US dollar denominated debt is at an inflection point. Dollar debt is functionally similar to a dollar short position. Those who have borrowed money to exchange for another asset with the belief that the other asset will appreciate in dollar value have taken out the equivalent of a short sale of the dollar. Massive short sales have characteristics and consequences in markets and these characteristics follow patterns. If the US dollar follows these same patterns, then there is a crisis dead ahead. This will not be a crisis of dollar collapse but one of dollar scarcity. Few investors are prepared for such an event. The vast majority of investors are positioned to profit from a declining dollar and would be devastated if the reverse occurs. This analysis flies directly in the face of conventional wisdom and the best efforts of our monetary authorities to devalue the currency. A dollar debt crisis would be a classic deflationary event, but unlike other more gradual deflationary scenarios, we envision the possibility of a rapid rise in effective dollar value that is similar to the characteristics of a short squeeze. A rapid increase in the value of the dollar is something that few are prepared for and therefore would hurt a large number of people. We are aware that this essay may disturb many of our devoted readers as we challenge cherished beliefs. But we are contrarians and that’s what we do. You have been warned so let’s get started. What is a Short Position? Purchasing a stock is called going long in the jargon of the investment industry. In the familiar long trade, an investor purchases a stock then sells it, hopefully for a profit. A short sale is the inverse of the long position. The stock is sold for cash then bought back later, hopefully at a lower price and therefore a profit. In other words sell high, buy low. How can an investor sell a stock that he or she does not own? Investment brokerages always carry an inventory of stocks as part of their assets. Brokerages are allowed to lend stock to short sellers who then sell the stock into the markets with the understanding that the stock will be purchased back and returned to the broker at some time in the future. The ability to sell a stock short allows the investor to profit from a decline in stock price. Other assets such as bonds, commodities and currencies can also be sold short. The process is the same. The security is borrowed from a broker and immediately sold into the market. The position is closed when the security is bought back and returned to the broker. Since a short sale requires the use of a borrowed asset, a short position is a debt that must be repaid. It is a debt that must be repaid in kind with that same asset that was borrowed. The debt created by a short sale is collateralized by the cash received from the sale of the asset. This cash must be held by the broker and will ultimately be used to buy back the shorted security and close the position. A short sale is a risky position for an investor. The asset that is sold short may not drop in price as expected. In fact the price may rise without limit, causing massive losses for an investor. At some point, an investor with a losing short position will be forced out of the trade either by choice or by the broker who must return the asset to inventory via the dreaded margin call. A margin call occurs when the cash collateral falls below a certain threshold and either the investor must either provide more cash or the position will be closed by the broker using what’s left of the investor’s cash. Short Squeezes One of the greatest risks in short selling is the possibility of a short squeeze where a large number of investors who have short positions in the same asset try to close their positions simultaneously. Since closing a short position requires purchasing the asset, a large number of buy orders hit at the same time causing a big price spike and further losses for the short sellers. Short squeezes can generate spectacular rallies that sometimes lift prices hundreds of percent in a very short time and cause devastation for those who are caught in short positions. Typically, a short squeeze occurs in a stock or asset that has poor fundamentals. Investors are quick to exploit the poor prospects by selling short. This causes the total number of shares sold short, called the short interest, to rise. At some point the short interest rises so high that there becomes a shortage of stock available to trade. The stock starts rising in price as a result and, as short sellers move to close positions, the price rise accelerates into a buying frenzy as panicked short sellers buy at any price to stem losses. The key characteristic of a short squeeze is the speed of the move. Short squeezes usually occur over relatively brief periods of time and catch many investors off guard. It is important to note that short squeeze rallies do not signify any improvement in the fundamentals or prospects for the underlying asset. This is a technical market event that is solely the result of the actions of traders. In fact, the weaker the fundamentals of the asset, the more likely a short squeeze rally will occur. Many short squeeze rallies occurred in very weak tech stocks in 2003 because of excessive short selling in these securities. Many people assumed that these rallies were the beginning of a new bull market, but the fundamentals have not improved for most of these stocks, only the stock price is higher. Short squeezes can occur in any market that allows short selling including commodities, futures, bonds, and currencies. Each market has different rules for short selling so the details may be different but the process is the same. Similarities and Differences Between Cash Debt and Short Positions We have seen that a short sale creates a debt that requires repayment of the asset at some time in the future. A short seller of stock sells the stock for cash which becomes the collateral for the stock loan. A cash debt in the form of a collateralized loan is similar but reversed. Cash is borrowed and immediately traded for an asset that becomes the collateral for the cash loan which must be paid back with cash at some time in the future. In this way a cash loan is similar to a short sale of currency. If the asset purchased with borrowed cash increases in cash value, then the transaction was profitable because the loan value is now less than the cash value of the asset. In the case of a stock short sale, no payments are required to maintain the loan although interest may accrue. All that is required of the borrower is that the security be returned to the broker at some time in the future. With cash debt however, many different repayment options exist. A loan may have fixed interest payments with a balloon at the end of the term (such as a typical bond), or it may be amortized where principal is paid back continuously during the life of the loan (mortgages and consumer debt), or it could be “zero coupon” debt where the entire principal plus interest is payable at the end of the loan. Another difference between a stock short sale and cash debt is that there is a limited supply of stock to sell short. Stock can only be sold short if there is inventory to sell. Therefore the limiting factor for stock short interest and the typical cause of a short squeeze is lack of available supply. However, because of our fractional reserve banking system, there is a virtually unlimited ability to create new dollar debt regardless of the actual quantity of reserve cash available. The limiting factor for debt is the capacity to make payments rather than the amount of cash in the system. When a broker lends stock to a short seller, the broker (lender) is under total control of the transaction. The broker has possession of the stock and the cash collateral. If the short sale goes bad, the broker has the authority to close the transaction to prevent losses to the lender. The lender of a short sale asset is almost always able to collect from the borrower so is in a particularly strong position to recover assets. Troubles with short sellers almost never cause any systemic risk to the markets. In the case of a cash loan however, the lender has very little control over the progress of the loan. The lender rarely has possession of the collateral and must rely on the trustworthiness of the borrower to make good the loan. If the loan does go bad, then the lender must proceed though an expensive and time-consuming collection process that may include the sale of relatively illiquid collateral. In the case of a cash loan, the lender is at a distinctly weak position to collect from a troubled borrower. Because of the inherently weak position of cash lenders, widespread defaults on cash loans can cause systemic risks to the whole economy. There are important similarities but also important differences between a short sale and a collateralized cash debt. The universe of cash debt transactions is far more diverse than that of short sellers, but it is also far more entrenched in the working of the economy. The big question is whether the mountain of cash debt denominated in US dollars could unwind quickly in a situation similar to a short squeeze. To probe this question, we will next analyze the structure of dollar debt and money supply. Debt and Money Supply There is an important relationship between debt and money supply. In essence, most of what we call money is actually some form of debt. We hold “cash” in “money market funds” and bank accounts which are nothing but a bunch of short-term IOUs, in other words debt. Inflationists hail the huge increase in the reported money supply as evidence of hyperinflationary forces at work. However, broad money supply measures such as M3 and MZM include money market funds and other forms of short-term debt. It is true that more money in the system chasing a limited amount of goods will cause general prices to rise. By the same process, more credit in the system will cause prices to rise. The problem with using credit as money is that it must be paid back. Credit that is paid back disappears out of circulation and is equivalent to a reduction in the money supply. Credit that is defaulted on takes even more additional credit out of the system due to a multiplier factor. This is the difference between cash money and credit money. Cash money stays in circulation but credit money can be extinguished quickly. Less money in circulation, whether cash or credit, will cause a cash scarcity and ultimately lower general prices, i.e. deflation. The chart of M3 money supply below shows a huge increase since 1995, about when the stock market bubble took off. Since mid-2003 the chart is showing unusual volatility and may be foretelling a possible change in trend. The unprecedented drop in the “M”s during the second half of 2003 is still unexplained but shows that even long-standing trends in money supply can change quickly even without overt action from the central bank.
So who is taking out this debt? The US Federal Government for sure is responsible for a good portion of it, but they are in the enviable position of being able to create money from nothing. The lion’s share of debt is owed by the US consumer, particularly through the mortgage system. With all due respects to Joe Sixpack, we have to conclude that the consumer is the dumb money. By racking up unprecedented debt within an economic slowdown, the average consumer has set himself up for crisis. There is simply insufficient growth in income to manage the increased debt service load. People should know that they are in over their heads, but they refuse act responsibly and slow down the credit machine. Why are they doing it? We think that this is one of the great questions of our time. The source seems to be more sociological than economic and there may be several undercurrents. One possibility is that the events of 9/11 inspired a “live for today” mentality with lenders all too willing to cooperate. Another possibility is that many people feel that they will ultimately be forced into bankruptcy anyways, so might as well live it up until then and stick the lender with the bill. The popular media has glorified gluttony and self-indulgence to the point that these are considered virtues. Excess is in and frugality is out. Our waistlines are expanding as rapidly as our debt loads. There is some precedent for this social trend. Japanese in the late 1980s were acting in an eerily similar way to Americans today. We know how that ended. So who is the smart money and what are they doing? The charts above unambiguously show that US businesses (the smart money) are actually paying down debt. Commercial and Industrial loans have been falling since the end of 2000. Looks like the smart money once again bailed out before the dumb money. They started cutting back on loans in 2000, while consumers waited till 2001. What is remarkable is first the consumer never cut back as much as business did. Secondly even though they did cut back the ratio of consumer installment credit to personal income has gone from dangerous levels to insane levels. This is something that is not sustainable; sooner or later the consumer is going to say I can’t take it anymore and stop borrowing new money and attempt to pay of their exiting loans. This will have the effect of actually buoying the US dollar as it will effectively be short squeeze. It is very interesting to note that commercial paper market topped before so called consumer market. In fact the commercial paper market topped just before the markets started to tank and in around the same time the Dollar was topping. If one looks carefully now, they are trying to put in a bottom formation, which seems to coincide with the bottom formation that the dollar is putting in currently. Could it be that these markets see something that most of us are missing? Many readers are probably wondering how we explain the sharp rise in commodities as it pertains to our call on the dollar. Commodities, particularly the metals, made a spectacular performance in 2003. To many observers, this is an indication of inflation and economic recovery. We disagree. The rally was ignited by weakness in the dollar then fueled by misleading signals of recovery indicated by a sharp rise in GDP late in 2003. We believe that the GDP growth figures of 2003 are the direct result of massive stimulation from the government and also due to the deprecating dollar. These conditions are not likely to last much longer. The rise in commodities went parabolic in early 2004 and now seems to be sustained by speculation and hoarding. As of this writing, the entire metals complex is making a sharp correction coincident with a sharp rise in the dollar index. Although not yet indicating a true trend change, this action supports our belief that a rising dollar will reverse the commodities rally. In fact, the rise in commodity prices may be the trigger for a recession and cause its own reversal.
What Would Happen In A Dollar Short Squeeze? A dollar short squeeze would be functionally similar to a general deflation, but could unfold much faster. Deflation is a relative scarcity of cash and/or credit that causes a general price decline in a wide range of products, services, and assets. In other words cash becomes more valuable during a deflation. It would be triggered by some event that sucks enough liquidity out of the system to cause a chain reaction and serial debt defaults. Deflation is almost always accompanied by recession. The deeper the deflation, the deeper the recession. This is a scary scenario and one that few people see as a risk factor. In fact, in 2003 we witnessed the exact opposite effect as almost every asset class went up in dollar terms due to a weak dollar. There were a number of reasons for this, but it was largely the result of a vast increase in credit that was chasing almost every product and asset in sight. In essence, this was the effect of a large number of people and investors going short the dollar by putting more credit into circulation and using it to buy stuff. It would seem that we have inflationary expectations in the system and these usually take time to work out. However, there have been several instances in history where a sharp price inflation was followed by a sharp deflation. In 1921 and in 1949, the US experienced a sudden deflation after several years of double digit inflation. This shows that inflationary expectations, and by extension the dollar, can turn on a dime (pardon the pun). http://minneapolisfed.org/research/data/us/calc/hist1913.cfm We envision a number of possible triggers for a dollar short squeeze. Here are just some of the more obvious ones:
In the aftermath of such an event, it is quite likely that the dollar would resume its decline due to the continued deterioration of the fundamentals of the US economy. Remember, a short squeeze does not indicate any change in the fundamentals of any asset or security. In fact, it is a confirmation of its weakness. The irony of the situation is that those who are convinced that the dollar is slowly dying are probably right but their collective action makes their investment positions untenable. Official Countermeasures We can assume that the government and other authorities would fight a deflation tooth and nail. They have certainly pulled out all of the stops since 2000 with hyperinflationary fiscal and monetary policies. However, in past deflations the government has often usurped even more power and authority. Note that most of the huge increases in US Federal Government authority occurred during the Great Depression. Although a sitting administration would almost certainly be blamed for such an economic calamity, entrenched government bureaucrats may thwart the efforts of the senior authorities to expand their own influence during the crisis. Here are some possible countermeasures:
We feel that most of the official responses to a sudden deflation would be ineffective and bogged down in administrative delay. The Federal Reserve has the tools and authority to reflate the banking system, however most debt creation these days is outside the banking system and the Fed would not be able to easily respond in the case of widespread default. Winners and Losers
Other Voices We are not the only analysts to voice these opinions. Several other noted authorities have discussed the possibility of a dollar short squeeze in various contexts. Bob Hoye from Institutional Advisors states:
“The world
has experienced the biggest financial boom in history and
this has included the biggest debt issuance in recorded
history. And the majority of this in "street" terms is
equivalent to a huge short position in the senior currency.
The eventual problems in servicing debt, which in a world of
traders can be construed as "short covering", in the past
became intolerable.” Stock analyst Rick Ackerman speaks about a short squeeze as a countertrend event within a dollar bear market:
“In a
financial crisis, might the unwillingness of lenders to roll
short-term paper create a short-squeeze demand for cash
dollars? Maybe. But the spike would be so precipitous as to
be unsustainable, and that implies the dollar could only
collapse back into itself once the squeeze had subsided.” Did you known that most mortgages are contingent loans? BEI of Oregon shows how even homeowners in good standing can face foreclosure:
“Because most
home loans have clauses to the effect that the lender may,
at its option, call the loan due in full if the collateral
value falls to a point they believe puts the loan in danger.
The bottom line? Even if you never miss a payment, even if
you are ahead of schedule, if your collateral falls in
value, your home may well be foreclosed by the lender.” On the issue of the inflationary impact of rising commodity prices, Van Hoisington reminds us that:
“The unhappy
fact is that rising prices of commodities, gasoline, medical
care, food, and other non-discretionary items that people
buy without concomitant increasing income is not
inflationary, but disinflationary. In essence, the hike in
such necessities acts as a tax in an income constrained
environment. Income growth in excess of price changes is
critical to getting the inflation ball rolling, and that
simply is not happening.” ~ CONCLUSIONS ~ George’s Conclusions This is probably the most difficult essay I’ve ever written. Partly it is because of the difficulty of the subject matter, but mostly because of the disturbing conclusion I must make. As a child I was taught to say nothing if I don’t have anything good to say and I’m afraid I don’t have anything good to say as the result of this analysis. A dollar crisis in the form of a short squeeze would be devastating to millions of people and to the global economy. Paradoxically, a short sharp rally in the US dollar may further weaken the already creaky US economy by collapsing exports. Investors and consumers seem to have an almost religious belief in the ability of the Federal Reserve to handle any potential liquidity crisis. Indeed, they have been extraordinarily successful at handling crises such as LTCM and the S&L debacle. But the scope of these crises was limited and this was when banking system still had control of most credit creation. This has changed and now most of credit creation is outside the banking system where the Fed has only marginal influence. I think that the monetary authorities are acutely aware of this and their policies reflect an extreme level of concern. As we wrote this essay, the dollar rose sharply, interest rates spiked, stocks and commodities fell. This may only be a temporary trend, but it seems to follow the pattern that we have described. Honestly, I hope that this analysis is wrong because I don’t want to see people hurt, but even if it is partly valid investors must make preparations for such an event. The most useful preparation that any investor can make is to get out of debt. This is good advice in any event but particularly now. Other preparations can include purchase of some gold and silver coins or bullion and to have an adequate supply of paper cash in the form of a selection of national currencies including US dollars. The recommendations in Robert Prechter’s book Conquer The Crash are sensible and appropriate defenses against a rapid deflation. These are certainly not radical suggestions and do not preclude investors from playing the inflation trade simultaneously via non-leveraged stock and commodity investments. Preparations for deflation are typically conservative and straightforward. The scenarios outlined in this essay may or may not come to pass, but I feel strongly that they have a definite possibility of occurring. It is prudent to take out some insurance against deflation even if the possibility seems remote. We take out insurance against many unlikely events and think nothing of it. Prepare for the worst, but plan for the best. George
J. Paulos Sol’s Conclusions Many people have written on this subject recently though not in such detail, however George approached me with this idea last year. At that time no one even broached the subject. So while George may not have put his ideas to paper as fast, I had some part to play with the delay as I did not jump on his idea immediately. I think he was the first one to really see the true negative effects of our current debt levels and in my opinion was the first one to really point out that this insane level of debt could actually be viewed as a short position against the dollar. I also agree with him in that this is perhaps the most difficult and complex topic I have ever had to deal with and probably will be the most difficult one for a while. There are just so many possibilities that it is hard to predict just how dire the situation will be once the house of cards starts to crash. There is no doubt that the situation eventually is going to be terrible the question is just to what degree. All wise contrarian investors should significantly reduce their debt levels and stop taking on any new debt. In addition one should have some money parked in Gold and Silver Bullion. If you have no positions in either, then look to take new positions on any significant major pullback. Credit facilities are being extended to anyone that can breathe. In fact as far as mortgages go, I think all you need to do is have a pulse and just scratch your name on the signature line. They have mortgages for every category, those with not so good credit, those with terrible credit, even those with bankruptcies can get a loan now and just a few years ago they came up the with the ultimate mortgage, a "no income verification mortgage.” Recently I found out that an even more insane mortgage exists, it’s called a complete no document mortgage. One only needs to come up with 5-10% of the down payment; depending on your credit and voila you are now a proud Slave. I cannot call anyone a proud owner unless they are buying these houses in few select areas of the US where housing prices are still somewhat sane. Just recently they have introduced what I call the Death mortgage, the so-called 40-year mortgage. As if 30 years of tying your neck around a rope is not enough, now they find a way to enslave you for 10 more years. This mortgage is being touted as the solution for new buyers to compensate for the increased prices of houses. So now you can still buy that 500k house and have monthly payments that fit into your budget. Insane offers usually come right towards the last stage of a bubble. The 40-year mortgage certainly qualifies as one. For those of you interested in details, you can click on one of the 3 links below. (Ed. note: 100-year mortgages are often taken out in Japan. Nice gift to the grandchildren.) http://www.startmymortgage.com/Mortgage_Types/40-year_mortgages.htm http://www.bankrate.com/brm/news/mtg/20000316.asp http://www.detnews.com/2002/realestate/0207/18/g03-535119.htm The real wild card in this situation is the US consumer. How is he going to react? I noticed that Yahoo! had a top story stating that US consumers are getting nervous to buy new houses because of rising property taxes. Now how nervous will they get if the housing market suddenly starts to crumble? Imagine a 50% drop in sales of new homes; this would blow the last legs from this market. Or for that matter, let's just say they stopped taking new loans from banks to buy cars they did not need or appliances that were not really necessary or buying a second home for investment purposes or taking out home equity loans to buy stocks or bullion and the list goes on. The scary thing in a deflationary situation is that cash is usually hard to come by. So let’s assume you want to cash in some of the huge profits you have in bullion, so you go to your local bullion house only to be told that they have no cash on hand. Stop to think for a second. You still need paper cash to be able to buy things, I mean people don’t go around using gold coins or gold bars to pay for groceries and even if they wanted to, the system is simply not set up for it yet. For those of you who might think that we are getting negative on Gold and Silver, look at our comments once more under commodities. We don’t think the general long-term trend is going to be broken, but that does not mean a significant correction is not a strong possibility. This whole economy is build on credit. This so-called economic era of huge gains is nothing but a lie. Without taking on new debt, this great era of so-called prosperity is nothing but an illusion. We are sitting on a glass house and the first hairline cracks have appeared. The transition from all to nothing will be so fast most won’t even know what hit them when this is all over. The rise of the dollar could just be the tip of the iceberg, but remember it could also be the tip that you need to get your house in order. Debt will become a very dirty word and savings will be treasured once more. The only variable is time. It’s not about whether or not it will happen, but just a question of when. Sol
Palha
© 2004
George J. Paulos, Sol Palha
Acknowledgement Contrarian Round Table Series The Dow has never been in A true Bear Market Contrarian Round Table II- Central Bankers Contrarian Round Table III- Inflation good or bad? Contrarian Round Table IV- Bear Market Etiquette |
We would like to thank Mary Puplava of www.financialsense.com for helping put all the articles from the various writers together and producing a coherent piece of work. Without Mary the Contrarian round table series would not exist.