2-1-10

The Ugly Black Swans

Wait! Before you groan at the thought of hearing yet another rant and reckoning from that pessimistic (realistic) pundit, Mark Patricks, this week is a little different...

This week I'm being somewhat contrarian on my contrarian stance. Yes, I was a little confused too when I dreamt this up, but bear with me as I think you'll find this interesting. What triggered this theme was asking myself something YOU should ask yourself before you enter into any trade or investment:

"What if I'm wrong?"

This doesn't mean you freeze up in fear and do nothing (often worse than making the wrong choice); it means you analyze the downside and prepare for it so you're not surprised if it happens. Most importantly, it means you're not wiped out if your call is wrong and perhaps this means you even hedged against this scenario.

As you know, we refer to an 'out of the blue' event that most people didn't expect as a 'Black Swan'. The fact that most people don't expect it spells opportunity because the 'odds' will be priced accordingly on the financial markets.

I'm about to give you 2 Black Swan scenarios. Neither 'swan' is pretty. All the pretty black swans are dead; these are mean, scraggy-feathered, and bloodied black swans. We have made terrible choices this last 20 years and must pay the price one way or the other. The best outcome we can hope for now is maintaining the status quo of the US dollar retaining its status as the world's reserve currency and hence American supremacy. That last sentence should immediately tell you this is describing a Black Swan event because it's now a widely held belief that the days of the dollar are numbered one way or another as America drowns in debt.

The debt obligation of the US government has become an un-payable sum, amounting to multi-trillions of dollars. That is, the US could not collect enough in taxes, reduce its expenses enough, nor produce enough material wealth with its degraded manufacturing infrastructure and work force to pay off this debt in the foreseeable future. It's a debt that is the largest ever incurred by any society in world history.

I'm going to describe alternative scenarios that massively reduce America's debt problems, but both come with a price...

Scenario 1: Inflation but The Fed Plays its Ace

Background: The US Treasury has a declared hoard of 261.5 million ounces of gold, the largest in the world by far. Significantly, the US government shows this asset on its balance sheet at a ludicrous valuation of $42 an ounce (compared to the current market price of circa $1,100 an ounce).

My prediction has been that The Fed has decided to inflate away its debt, it will succeed, and destroy the dollar in the process. Some of the smartest traders I know share this view.

How could this prediction not quite play out?

Here's how:

The Fed does have a plan for this event and is fully prepared. It will print money to pay off its debt. As they expect, noises get louder about replacing the dollar as the world reserve currency.

Countries the world over, especially China, howl as they watch the Fed debase the dollar reserves they hold. But what would the replacement be? Other countries have debt problems too? China steps up and proposes their currency be the reserve.

The Fed counters by reintroducing The Gold Standard. The dollar is now completely backed by gold and therefore retains its status as reserve currency. Gold soars to $5,000 an ounce. Other countries have such relatively low gold holdings by comparison that even though they may follow suit with their own gold standard, the dollar would be supreme.

The bad consequences: prices soar and riots break out across America with fears of hyper-inflation abound. Think hoarding and looting with the army being called in. But America retains its status and doesn't suffer as bad a decline in the standard of living as elsewhere.

The good consequences: The Fed just made itself redundant as money is real again according to the Constitution. My subscribers who acted are smiling and doing a victory dance. Stocks soar (as historically, stocks are the best defense against deflation- more so than gold.

A return to a gold standard seems unthinkable to almost every trader I respect, not to mention the public. A perfect Black Swan event.

Scenario 2: Deflation Takes Hold

Background: The global economy has seen rocketing growth in the last 30 years primarily as a result of being on a credit binge that is now in the early processes of deleveraging. Consumers are saving instead of spending. The list of evidence here is endless and undeniable; the only sensible debate remaining on deflation is whether governments can beat it by inducing inflation (see first scenario).

My prediction has been that the deflationary forces are extremely powerful and will prove extremely destructive to all asset classes in the years ahead and that this will result in panic measures by governments who resort to the printing press and cause hyper-inflation.

How could this prediction not quite play out?

Here's how:

Deflation wins despite all efforts. The forces are just too powerful. In fact, the intervening of governments to delay the inevitable and put off the reckoning only serve to make the situation worse. Higher taxes and government takeovers of the private sector and mortgage market only exacerbate the downward spiral. Consumers retrench even harder now and so the cycle grinds further down into Hell. It's the 1930's again. The US and global economy flounders, going nowhere but into a slow descent a la Japan 1990 to present. Cash is king. Things are cheaper. Individuals and governments suffer according to their level of debt. China collapses under civil unrest from its inability to export at the levels it needs to maintain employment.

The bad news is that a new and exhaustive study of over 250 financial crises in 66 countries over 800 years shows that this outcome is a lot more likely than most people expect. The "this time is different" defense is blown out of the water in this study as all idiosyncrasies for each event are accounted for. This time is NOT different.

The good news: As we saw in late 2008, in a panic money flows into US dollars through the Treasury market and so America gets the money it needs to borrow to finance its deficit. The dollar soars in value against other currencies hence maintaining its reserve status, but this is also bad for exports and the recovery gets delayed even further. Gold still soars (after an initial scary plummet) as it's also a safe haven in these times where governments will still pursue a policy of printing money that may yet end up with hyper inflation as they 'overshoot'. My subscribers who listened are still smiling.

The world has written off the US dollar as reserve currency in the years ahead, and has all but assumed that a new global leader will emerge, probably China. It seems an impossible task for America to fund its debts through the Treasury market. Thus, the opposite happening would be a perfect Black Swan.

Anytime a prediction meets with fierce resistance and 'boos' from the crowd, take notice. You probably just heard a sensible prediction. The second scenario is particularly unpopular currently.

Whatever your strategy, hedge for the Black Swan. You may even come out ahead as a result. Most of all, have a strategy.

Until next time,

Mark Patricks

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