Bulls Get Caught in the Credit Crunch

VIDEO: Ron Paul on Fox Business - Free Markets vs. Socialism & The Dollar Crisis [October 14th, 2008] (05:02)

After last weeks market crash, I think it is clear to everyone that the bears who analyzed the US financial landscape had been correct all along, while the bulls watched their profits from the last eight years disappear. However, the same people who have been bullish for all these years, remain bullish going forward still, as they now claim that the bottom is in, and now is a good time to be buying. The DOW is considerably lower than at any time over the last five years, and is lower now than at the turn of the millennium. But in addition to the nominal dollar value of the market being lower, when factoring in inflation, or measuring the market in foreign currencies or gold, the decline is even more dramatic.

If it were not for the rampant inflation that the government and Federal Reserve force fed the American economy, the declines would be observed as more severe. Inflation acts as a cushion to the dollar value of the stock market so that people cannot as easily comprehend the loss of the purchasing power that their money has lost by investing in over valued stocks whose business model depended on a phony, debt laden, consumer economy. People perceived inflated asset bubbles in stocks and real estate as real wealth, all the while believing that the economy of the United States was on sound footing.

But the wealth effect that Americans enjoyed was never real wealth. It was debt. Americans spent all their savings, and then resorted to borrowing money from abroad. Now America has spent all the money that they borrowed by squandering it on consumption rather than using it for productive purposes. America is now bankrupt. Americans thought that they could base their economy on the idea of borrowing scarce saving from the rest of the world, in order to consume products that were produced by the rest of the world. But Americans are waking up to find out that their access to credit is being cut off, and the Government is doing everything it can to get the credit faucets turned back on so that their bubble economy does not completely implode.

Savers around the world who lent money to America are now realizing that they are not going to get paid back, and their markets are now coming to grips with this reality. The investments the world made in America with their saving are now considered toxic assets worth only a fraction of their original value. However the problems that America faces are much more dangerous than that of the rest of the world. Because once foreigners stop lending money to America, the whole foundation the borrow and spend economy comes crashing down. This is what we are witnessing today.

The modern American economy was built on access to cheap credit. But what is credit and where does it come from? Well, credit is basically money and it comes from savings. America used to be the biggest creditor nation, because they had a lot of savings. Americans worked hard to produce goods and services, and then consumed less than they produced, which created savings. The savings could then be invested as credit and used to make capital investments to make people more productive. The interest gained on their savings allowed for greater future consumption, which came at the expense of reduced consumption in the present. But over the last few decades, the politicians that Americans elected have spent the country into bankruptcy. America spent all their savings, and then turned to borrowing the savings from the rest of the world to provide credit to the economy. But now, all that money is gone too, and foreigners are reluctant to lend any more. This is why we are in a credit crunch. But it’s really a money crunch. America is broke. America has no more savings, and the rest of the world does not want to lend out any more of their savings. And without any available saving, there can be no credit. And without credit, the house of cards that is the American economy comes crashing down.

What the government, Federal Reserve and the Treasury are doing is trying to replace the lost credit with a printing press. This is impossible. If the Federal Reserve creates money and credit out of thin air and drops it from helicopters onto the economy, this will only create inflation and will not replace genuine savings. Creating massive inflation also discourages real savings because inflation acts as a tax on earnings and savings that is only observed in rising prices sometime in the near future. The government is trying to turn the credit faucets back on with a printing press. All of these bailouts and the liquidity that is being injected into the system is all just inflation, which is stealing wealth from anyone holding dollars, dollar denominated assets, and future payments that are all denominated in dollars. The media constantly claims that these are taxpayer funded bailouts. However there is no talk about raising taxes. In fact, both major candidates want to lower taxes. So if all the money the government is throwing at this mess is not coming from taxpayers, and its not being borrowed from abroad, it must be coming from a printing press. They are creating all of this money and credit out of thin air, and that is going to affect everyone. Now that we are going down this path, it will become more and more difficult to change course as the system becomes more and more dependent on an ever increasing money supply. This path poses the very real danger of a hyperinflationary blow out that can ultimately destroy both prosperous and insolvent businesses alike. If the government would stay out of the way and allow the free market to bring upon the much needed recession, the dollar could be saved, many businesses would go bankrupt, but some would survive and go onto becoming the basis for a new economy. There is no doubt that the recession would be very painful, as Americans would be forced to pay the price for years of excess consumption. But as bad as this scenario would be, it is preferable to the Government’s alternative which threatens a decade long depression that would end up causing far more suffering as the agony is simply prolonged and the imbalances worsen. But if the government continues to bail everyone out, and prop the system up, it risks destroying everything, forcing Americans to rebuild from the ground up after the whole economy is completely destroyed and the dollar is totally worthless. It would be much easier to drastically reduce government spending now and being the rebuilding process while the global economic system is still functioning and the currency still has value.

The only long term solution to this problem is to stop spending and replenish the pool of savings by purging the excesses from the economy through the liquidation of bad debt. Business that are not solvent need to go bankrupt, and Americans must stop borrowing and consuming, and go back to producing and savings. But the Government is not letting this transition happen. Politicians are claiming that this transition would be too painful, and therefore the government must intervene in the free market to prevent the disaster. But unfortunately, the government cannot prevent the disaster; they can only make it worse. Government created these problems in the first place by intervening in the free market and encouraging all this reckless borrowing and spending. Now they are trying to get the country out of this mess by doing more of the same. America will never be able to dig itself out of the hole that it is in with the government forcing everyone to keep digging deeper. And we are in grave danger of digging ourselves in so deep that we will never be able to get out.

With respect to recent stock market action, I believe that the markets in the United States are still in a bear market. They have been in a bear market for about eight years, and it looks like things just took a turn for the worse. But on Monday, October 13th, 2008, the market has a spectacular bear market rally after the prolonged crash the previous week, causing many investors to think that the bottom is in and that stocks are headed higher. I do not think this is the case. This was the 5th largest one day percentage move in the Dow Jones Industrial Average (dow) in history, and all four of the previous larger moves came during the Great Depression where despite the spectacular rallies, the market continued to go much lower over the following years. So I think the US markets will continue to go lower. It is impossible to say exactly when they will break to new lows. It is possible that we move higher in the short run, but I think the bear market is still very much in tact, and US assets have a lot further to go on the downside. I would encourage investors to use these rallies to sell their positions in US markets, and instead take positions in physical gold, the gold mining sector or undervalued foreign markets, particularly Asia, and hold these assets for many years to come. US markets will continue to slide down the slippery slope of hope, occasionally experiencing spectacular sucker’s rallies to lure investors back into the market. Whereas assets like gold will continue to climb the wall of worry, slowing climbing higher, occasionally experience violent corrections, designed to scare away timid speculators who are not confident in the long term fundamentals and therefore lack the conviction to remain the bull market for its duration. Even though the US markets erased pretty much all of their gains over the last eight years, many foreign markets are still considerably higher than they were at the start of the millennium. Even though there were violent corrections in the foreign markets in response to the crashing American markets, I still believe that many foreign markets outside the United States are still in secular bull markets. I expect foreign markets to recover long before the American market even begins to show signs of a real bottom, and many of these foreign markets will go onto make new highs in the coming years and decades. The crashes in foreign markets offer excellent value for long term investors who are able to lock in high dividend yields in conservative, respected companies with very low P/E ratios. With the dollar recently rising against most foreign currencies, this is the ideal time to spend your overvalued dollars on undervalued assets. However, I would caution any foreign investor that foreign markets may not have bottomed and could fall lower as the global economic crisis unfolds. Even though I still believe there is incredible value out there already, prices could still get cheaper still once the most recent government intervention fails and the economic crisis takes another turn for the worse.

In terms of putting some numbers on where I think the markets are heading, it is difficult to predict the dollar values of the assets, because it is difficult to predict what kind of value the dollar will have going forward. I prefer to measure asset values against the price of gold, rather than against the price of the US dollar because measuring assets in dollars does not account for the rampant inflation that is eating away at its purchasing power.

At the moment, the dow is at about $9,300. And gold is at about $840. Therefore, the dow/gold ratio is calculated by dividing the price of one share of the dow by the spot price of gold. 9300/840=11.07. Therefore, we can say that the dow to gold ratio is about 11:1. Late last week, the dow/gold ratio fell below 10:1. I expect this ratio to fall to around 5:1 sometime in 2009. Followed by a roughly 2:1 ratio in 2010, and a 1:1 ratio in 2011. These are just guesses as to when these ratios will occur. But I am confident that at some point in the future, there will be a 1:1 ratio of the dow to gold. However, if the government still maintains the same type of economic policies by this time, it is possible the dow to gold ratio could go even lower, maybe even as low as 0.25:1 in gold’s favor. This could happen in a hyperinflationary outcome where there is such a flight to gold that overinvestment in the sector occurs and bubble prices result.

The stock market bubble of 1929 reached a peak with a dow/gold ratio of almost 20:1. After the crash, and once the depression set in, the ratio fell to about 2:1 in the early 1930’s. In the late 1960’s, the ratio peaked at almost 30:1, before falling to about 1:1 in the early 1980’s. And in the year 2000, we saw a dow/gold ratio peak of over 40:1. And just eight years later, we hit 10:1, which is a 75% decline in the value of the dow measured in gold. Even now pricing the dow in dollars, the dollar value of the dow is now lower than it was in the year 2000. But if you price the dow in gold, oil, Euros, Canadian dollars, wheat, soybeans, copper, etc. the value has declined substantially. The idea that you can just buy into the stock market and hold for the long term and make money is not true. If you buy overvalued assets, you are probably not going to make any real money.

With the Fed and other central banks around the world offering “unlimited dollars” to combat the credit crisis, it should be clear that inflationary pressures will continue to mount. The financial media is still fearful of a deflation because banks are unwilling to lend money, but I am confident that the central banks will come up with creative ways of introducing massive inflation into the system. They are able to do this through bailouts, auction lending, buying up stocks or other assets, and even mailing out checks to every American in the hopes that they go and spend the money on consumption. Given these facts, I will admit to the possibility that the dow has bottomed valued in dollars. I still think that the dow will make at least one more new low in dollars before the inflation really takes over and drives prices up, but it is impossible to say with any certainty at the moment. Since the Fed now seems to be printing up money and buying stocks with it, the fed will be able to control the dollar value of any asset it wants. As more inflation is created by the Federal Reserve, this will put upward pressure on the dollar value of US stocks. So next year, if gold hits $2000 and ounce, the DOW might be at $10,000, which is a moderate increase from today’s prices. But in my opinion, this would still be considered a decline in real terms. If inflation gets as bad as I think it will, we could see the dow go to $36,000 for instance. But if this happens, then gold will also be about $36,000 an ounce and gas might be $30 a gallon at the pumps. So if we start to see sustained gains in the dollar price of the dow, this will be due to inflation. If the inflation can be kept under relative control, we could see the dow hovering around this range for many years as inflation eats away at the underlying value of the assets. Absent inflation, I think the dow would fall to around $3000, which would represent its true value based on the current value of the dollar. I of course do not expect the dow to fall anywhere close to 3000, because I think the fed will print enough money to erode the dollar’s value so that any asset measured in dollars will look like it has not lost as much value as it really has. So I am certainly not advocating selling US stocks and buying US dollars instead, because I think that is just jumping out of the frying pan and into the fire. I am recommending people sell their US stocks and US dollars, and buy gold, foreign currencies, and foreign stocks. If I had the choice of holding dollars for the next 10 years, or holding US stocks for the next 10 years, I would still take US stocks. Even if this decision had been offered to me before last week’s 20% crash, I would still take the stocks long term over the dollar, knowing I would lose around 20% over the course of the next week. In my opinion, the real danger is in the value of the dollar, and in fact, all currencies around the world. Even though I think US stocks are over valued, I think the dollar is even more over valued.

The true crisis that the US and the world face is a rush out of the dollar. There are so many dollars already in circulation, being held by central banks and citizens all around the world, that if the value of the dollar started to fall precipitously, this might cause people to dump dollars, leading to a crash that could come about very quickly. And since other currencies are backed by nothing other than dollars, then people may lose faith in all paper currencies and scramble to buy up real assets instead of holding onto the depreciating currencies. Like Voltaire said, “Paper money eventually returns to its intrinsic value – zero”. The world’s experiment with paper money over the last 35 years is likely coming to an end. And with Bernanke running the printing press at full speed to fight the credit crunch, a substantial decline in the value of the dollar is all but guaranteed, and a Weimar Republic or Zimbabwe style hyperinflation is looking more and more likely. This is the end game scenario that investors need to prepare for by owning physical gold and real assets around the world like utilities, agriculture, energy and commodities, especially in the Asian-Pacific region.

The United States is in the early stages of a complete economic collapse that will be followed by a currency collapse. Unfortunately, things are going to get a lot worse before they get better. This is not the time to be optimistic or pessimistic; it is time to be realistic. The US Government is grabbing power on the march towards a totalitarian government that will threaten the prosperity and liberty of people in the United States and around the world. A dangerous shift away from personal freedom and towards government control is well underway. The bright beacon of freedom that used to shine from America is quickly fading away. As people continue to give up their liberty for security, they will end up with neither.