Friday, September 30, 2011

Measuring Financial Productivity

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

"An Absolute Zero" discussed the relationship of credit growth to economic growth. (The measurement used in the article was the change in non-financial domestic debt divided by the change in nominal Gross Domestic Product.) The productivity of credit has sharply deteriorated over the past 30 years. In fact, the additional credit creation today may actually be a cause for economic shrinkage rather than growth. It is making us poorer.

There are other ways to look at the efficiency of finance. I would like to hear from anyone who has given this some thought.

Josh Friedlander, friend and Online Editor of Absolute Return magazine, has already chipped in. Josh writes: "I really loathe GDP." That makes two of us. If given the opportunity, I would ban the government from calculating GDP. Josh goes on to ponder whether GDP "probably [gets] some rise simply from the transfer of (newly issued) government securities from one place to another.... [B]ut maybe this is exempt from GDP." I don't think issuance of government securities changes total GDP, but would like to hear from someone who knows.

Josh asks whether I've "done this analysis as a ratio of debt to government revenue. Agreed, taxes change, but that's how I'd value the U.S. if it were a business."

The tables I found for tax receipts are organized by fiscal year. Some more research would surely turn out monthly figures which would be comparable, but my entire staff is draped in black so unable to function. Some Red Sox thing.

Back to the measurement used: the change in non-financial domestic debt divided by the change in nominal Gross Domestic Product. There are at least two advantages to using GDP in this comparison. First, it is widely recognized as a measure of growth. Second, since it is a widely publicized economic number it is manipulated - to the government's advantage. Thus, the measure of financial efficiency used in "An Absolute Zero" understates the deteriorating relationship of new debt to economic growth. It is better to err on the conservative side.

Error in such comparisons must be accepted. There is no perfect measurement. Economic numbers are always estimates and patterns within the object being measured change over time. The employment figures, for instance, are not an exercise in counting every working noggin in the country. Cutting-and-pasting from the Bureau of Labor Statistics website: "The confidence interval for the monthly change in total non-farm employment from the establishment survey is on the order of plus or minus 100,000... there is about a 90-percent chance that the "true" over-the-month change lies within this interval."

Now, for those who watch Bubble TV, think of all the hoopla when the employment numbers are announced each month. What an exercise in fatuity. (Bill King - The King Report - just reminded his readers of an August 19, 2009, story in The Onion: "CNBC: Anyone Who Owns a Suit Can Come on Television" From the story: "'Just come on down, run a comb through your hair, and if you're here by 8 a.m., we'll have you on Squawk Box at 8.15 making stock picks. But don't forget your suit!'")

Modern Kremlin watching includes the change in relative importance of economic numbers. GDP, the monthly employment figures, and the CPI are ascendant. Thus, they should be treated with the greatest skepticism. Income is rarely mentioned. Given that income, as a whole, have not risen since 2008, it is wise of the government mandarins to ignore it. The media's reason for not pursuing such a hot lead is a mystery. At least The Onion is publicizing the root of the problem.

A descending figure is productivity. In the late-'90s, an exhilarating productivity announcement (+0.1% was all Bubble TV needed) was good for a $50 boost to Webvan and This was Fed Chairman Alan Greenspan's doing, in a complicit alliance with heralded economist Michael Boskin. (See "Economists Serving Their Political Masters") The torturous destruction of GDP and productivity can be reviewed in "The Government's New Math: 3.5% - 5.1% = 1935." Chapter 12 of "Panderer to Power" is devoted to the subject.

Today, the quarterly productivity announcement is barely discussed. Again, this is for good reason, from Washington's point-of-view. Productivity is falling. Non-farm business productivity per hour fell -0.6% in the first quarter and by -0.7% in the second quarter of 2011. If this were 2000, Webvan might have gone out of business three weeks sooner. As an aside, I don't think we can measure productivity today. It may have revealed some trends when a large proportion of America's work was shipped from River Rouge.

Comments on how to measure the change in the efficiency of finance over the decades are welcome. This includes the return on capital, and on equity, even though one only need be alive to see the obvious deterioration in how we allocate our capital investments.

Tuesday, September 27, 2011

An Absolute Zero

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

The Federal Reserve Open Market Committee (FOMC) concluded a two-day meeting by initiating "Operation Twist." The FOMC's press release explained: "The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative."

This announcement initiated sell programs in almost every market. There are many reasons for this reaction, one of which was the recognition that every initiative has failed, and now, all they can think to do is drive down yields that are already below 2.00%!

A reason for the Fed's failure is the array of topics that never enter the mind of economists such as Federal Reserve Chairman Ben S. Bernanke. These include money, credit, debt, and capital.

The productivity of capital is an important consideration, one which most people understand, in their own words. A bank does not lend money to a business that can not earn its way to paying back the loan. A potential borrower understands the banker's hurdle. (This refers to the majority of smaller banks in the country where the officers lose their jobs or worse when the bank fails if it adopts such a strategy.) An investor buys shares of common stock in a company that will produce the most from the least. The higher the profits produced per share, the more the shares should be worth.

Ben & friends do not think this way. During the Fed's quantitative easing schemes, the additional debt has produced nothing. The Federal Reserve, including the Board, the FOMC, and the thousands of Ph.D. researchers may not know even know of this relationship, but there is a growing understanding, intuitive or quantitative, that sees the Bernanke Fed as failing by a greater degree with every new initiative.

During the 1980s, the change (rise) in non-financial domestic debt divided by the change (rise) in nominal Gross Domestic Product was 2.2. That is, for every $2.20 borrowed, the United States produced $1.00 of additional goods and services (nominal). In the 1990s, debt was less efficient. It took extra debt to accomplish the same. The ratio (rise in debt-to-GDP) was 2.7:1. Between 2001 and 2008, even more debt was needed to produce more stuff: the ratio rose to 4.2:1.

The Fed has been rolling out its various quantitative initiatives since early 2009. The ratio of debt to production has been 3.7:1 (through June, 2011). But, the increase in transfer payments (1-in-7 Americans now receive food stamps, Cash for Clunkers, shovel-ready bank bailouts) exceeds the rise in nominal GDP by a wide margin. As a measure of financial efficiency, the ratio is now meaningless.

The additional debt being manufactured is not producing any additional goods and services. The more Bernanke applies his senior thesis to the real economy, the less the economy is able to pay down old debt, much less manufacture additional goods and services to pay down the new debt.

The Fed has pegged short-term interest rates at zero; Operation Twist is an attempt to drive long-term rates to zero (or, close to it); the rise of incomes in the United States since 2008 has been zero; "real" GDP growth since QE1 has been less than zero; the FOMC is an absolute zero.

Somebody in the past couple of weeks, I forget who (my apologies), compared the central bankers' Mad Hatter policies to the strange physical transformations when approaching absolute zero (-273 Celsius). Solids, liquids, and gases behave strangely.

We have arrived at that point with financial markets. The Authorities have lost control of the markets they have been manipulating. Desperate tactics, with untold unintended consequences, such as the Swiss National Bank doubling its monetary base last month, ensure more fanatical outbursts from the Fed, the ECB, and the Bank of Japan. In this setting, gold fell more than $150 last week. Other than remote islands, this is the best bargain around.

Wednesday, September 21, 2011

The Financial Times Discovers Gold Stocks

Having read "Gold and Silver Stocks", the Financial Times decided to follow the trend with "Investors Bet Miners Will Follow Gold's Gain." (September 20, 2011) The article discusses efforts of gold miners to distinguish themselves from Gold ETFs: "[G]old miners are beginning to respond to their share-price underperformance. The most popular response is to raise dividends, offering investors one thing an ETF cannot: a yield." (See "Gold and Silver Stocks" for the same discussion.) The Financial Times continues, discussing two companies that are increasing dividend payouts, Newmont Mining and Gold Resource Corporation.

These are the same two miners discussed in "Gold and Silver Stocks." The Financial Times relays Newmont Mining's Monday announcement (September 19, 2011) that it will pay out an additional 10 cent dividend for every $100 above $2,000 an ounce. The FT discussed a novel dividend payout being considered by Gold Resource Corporation. The miner "might start paying dividends in physical gold."

This is fine but the FT story may cause confusion. The reason for owning gold is easily misunderstood. This ambiguity will continue to be the greatest problem for potential and current owners of precious metals. Gold will be bought and sold at the wrong times by many of the misinformed. (Note: what follows only fleetingly addresses an important consideration - prices and cash flow should rise.)

A lack of precision may lead to a misunderstanding just as a truth may stumble into a half-truth. A half-truth is often more dangerous than a lie.

Quoting from the FT: "Investors increasingly buy gold as a form of insurance against further economic turbulence. Mining companies - which can miss production targets, suffer strikes, accidents and higher taxes, or see their profits eroded by cost inflation - appear to offer less protection against this scenario."

The sequence is correct. It runs from (first sentence) gold to (second sentence) gold stocks. Gold stocks derive their price from gold, but they are stocks. The second sentence is a good synopsis of why the derivatives (gold stocks) have performed so poorly in comparison to the metal. Their attraction lies with the probability that these shortcomings have been excessively discounted.

The FT describes gold as being bought as a "form of insurance against further economic turbulence." That is true but not the whole truth. One might interpret this to mean "I should own some gold as a hedge against further volatility [my stocks might go down 30%]. I don't care about volatility because I read Stocks for the Long-Run, so I don't need to buy gold"

Quoting from "Gold and Silver Stocks": "The real story is that gold is money but only speaks up when the credibility of states and their currencies deteriorate."

The great minds at the central banks, by manipulating every market under the sun, have lost control of the world's financial system that, they apparently thought was a chalkboard theory. Official interference has failed. Last week, the great minds showered European banks with dollars, because some European banks are having great difficulty borrowing dollars. This massive flood has not regenerated trust. Siemens disclosed that it withdrew more than 500 million euros from French commercial banks and deposited them at the European Central Bank. (The ECB, itself, is extraordinarily leveraged. This should not simply be dismissed as a "boys will be boys" curiosity.)

From Reuters: 9/19/11:LARGE CHINESE BANK STOPS TRADING WITH SEVERAL EUROPEAN BANKS DUE TO FEARS REGARDING EUROPEAN DEBT CRISIS - Sources say the unidentified Chinese bank has stopped all swaps and foreign-exchange forward trading with Societe General (GLE.FP), Credit Agricole (ACA.FP), and BNP Paribas (BNP.FP). The bank has also stopped trading with UBS (UBSN.VX) due to worries about UBS's loss from the new rogue trading affair. (Remember the hastily planted rumor, just last week, and for the 63rd time, that China was buying Europe's debt?)

We are witnessing the insolvency of the fractional-reserve banking system, at the highest level. (At the lowest level, local banks and small insurance companies should be buying precious metals. Tell the regulators to scram.) It would be a mistake for the average investor to buy and sell gold and gold shares depending on one's view of market volatility over the next month or year. Gold, silver and other inanimate objects are assets without liabilities. Unlike dollars, these...things, do not bear the government's Lewis Carroll promise: "This note is legal tender for all debts, public and private." The dollar's value is a derivative of the loony professors who run the country. Choose your weapon.

Saturday, September 17, 2011

Gold and Silver Stocks

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

The prices of gold and silver shares are derived from the price of their reference metals. The referral method has gone astray, akin to a renegade ETF.

Osiris Investment Partners L.P. in Boston, under the authorship of Principal and Managing Member Paul Stuka, wrote to clients on August 18, 2011. The XAU Gold Index was down 6% for the year-to-date, and the GDXJ Gold Stocks Index of smaller gold miners had fallen 10%. On that same mid-August date, gold - the real stuff that hardly anyone owns but of which everyone within the media's range is expected to express an opinion - had risen 26% in 2011.

The gap between gold and the diggers will close - when is hard to say. In which direction we will discover. The view here is that the stewardship of paper currencies, the medium in which gold, silver, and oil (crude, canola, and palm) are priced, has never been in worse hands. This is saying less than might be thought since it was not until 1971 that official money went untethered from impartial restraint (usually, gold). Alas, the world is slow to grasp central banks are peopled by political hacks (as Senator Harry Reid called then-Federal Reserve Chairman Alan Greenspan in 2005, but equally true of today's empty suit) so now is the time to make money.

Money is to be made by holding anti-dollars. Federal Reserve Chairman Ben S. Bernanke continues to decompose before our eyes, stating on September 8, 2011, that the United States is blessed with lower inflation than other countries and "
Low inflation means that the buying power of the dollar, in terms of domestic goods and services, remains stable over time." It does not take a trial lawyer to see the inconsequentiality, inconsistency, or mendacity in that labored claim. Ben may be fishing turtles from the local creek, painting his barbarous equations on their backs, and selling them at the local five-and-dime (which would still be overvaluing his scholarship by at least a nickel), but shoppers at local farmer's markets are paying the price for purchasing with dollars.

Osiris Investment Partners went on to write: "[S]ince the early 1980s, when the XAU Index was first constructed, until the fall of 2008, this ratio remained in a range of .16 to .38, even during the depths of the gold bear market. [That is the ratio of the XAU Gold Stock Index divided by the price of an ounce of gold in U.S. dollars. - FJS] During the financial crisis of 2008, this ratio dropped briefly to .09. Since that time, it has traded up to .16, but it has never exceeded the former floor. As I write today the ratio is .114. In other words, the gold shares are currently the cheapest that they have ever been, excluding a one-month period in the fall of 2008. On a fundamental basis, gold stocks have historically traded at 10 times or more annual cash flow. We are presently seeing many companies priced at one to three times potential forward cash flow, if they can execute their plan. Clearly, not all of them will realize the potential. However, many will."

Of the cash flow, Erste Group, (Erste Bank, Vienna: "In Gold We Trust;" July, 2011; Ronald-Peter Stoferle), estimates the "aggregate free cash flow of the 16 companies in the Gold Bugs Index will amount to [$8.5 billion] this year and will increase to [$14 billion] by 2013." Erste Group continues: "The companies in the Gold Bugs Index currently command an estimated 2011 [price-to-earnings ratio of] 14x, which is expected to fall to 12x in 2012. This is extremely low in terms of its own history (average PE 2000-2010: 33x) and in relation to many other sectors." (The Gold Bugs Index consists of 16 mining companies that do not hedge their gold production. This is not necessarily true of the miners in the XAU Index.)

Potential investor seek the potential catalyst. What might that be?

First, the correlation among sectors in the S&P 500 has never been greater. ETFs and high-frequency trading rule the waves. Machines trade stocks in bulk, with little distinction among industries and companies. Such periods of over-zealous gimmickry and of intimidated investors are often good times to buy stocks that will later assert their superior characteristics.

Second, gold- and silver-mining shares are underowned in relation to one-stop-shopping ETFs. The miners know this. Shareholders have enlightened management: they need to pay out dividends to distinguish themselves as real companies. Recently, Newmont Mining stated it will increase its dividend by twenty cents per share for every $100 rise in the price of gold. Gold Resource Corporation has set a target of paying out one-third of its cash flow in dividends to shareholders.

Third, the argument of whether the world is inflating or deflating is tangential to the price of gold. Better expressing the "price of gold": how many units of paper currency (such as the dollar) does it cost to buy an ounce of gold? (We are returning, now, to the reference metal). Gold has performed better in deflations than inflations, but the cause and effect that this relationship addresses ("gold is an inflation hedge") may be misleading. Monetary, military, and political chaos have more often corresponded with deflationary than inflationary times. The real story is that gold is money but only speaks up when the credibility of states and their currencies deteriorate.

Fourth, the proportion of people who own gold and silver is small. (Particularly so in the United States, but that is not the point, here.) This is the greatest flaw of the "gold in a bubble" chorus. There has been no panic into gold, or, more likely for the Average Joe, into gold shares. At some point, the sight of Bernanke may be worth a quick $500-an-ounce trading profit. It should be, already.