The market meltdown of 2007

Does the current investment turmoil signal an economic depression ahead...?

INVESTORS HAVE experienced extreme volatility, and fear, in the financial markets over the past few weeks.

   The event itself wasn't unexpected by us here at Casey Research. After all, we're on record as warning that the Greater Depression will materialize in the years to come.

  
Perhaps even starting now.

  
But simply because something is inevitable, that doesn't mean it is imminent. And you may be asking "Okay Casey, what makes you think that a depression is inevitable – forget about imminent?"

  
A proper answer to your question would take a couple of chapters, and this isn't the forum for that. Besides, I did that in my book, Crisis Investing for the Rest of the '90s. Unfortunately, the book has been off the shelves for some years now. If you have a copy, go over it, and see if the reasoning seems sound.

  
In essence, however, an economic depression is a period of time when most people's standard of living drops significantly. More exactly, it's a period of time when distortions and misallocations of capital – caused by government intervention in the economy, particularly by currency inflation – are liquidated.

  
Inflation sends false signals to both businessmen and consumers; it makes consumers think they're richer than they really are, so they spend more. Businessmen gear up to meet this artificially created demand, by hiring more workers and building more facilities. Currency inflation, in its early stages, gives the appearance of prosperity. It also tends to create lower interest rates, simply because interest is the price of money, and when you expand the supply of anything, its price tends to fall. In a currency nflation, everybody tends to save less and borrow more. Later on, however, rates rise, because people won't lend without compensation for the depreciation of the currency they put at risk.

  
This process causes a phenomenon known as the "business cycle". And a phony boom can cause a very real depression.

  
The long boom we've had since the bottom of the last cycle in 1982 – a time that was characterized by high unemployment, lots of bankruptcies, high interest rates, and a low stock market – has lasted 25 years. It could have ended badly a number of times along the way, including 1987, 1993, and 2000. Each time, however, the government propped up the house of cards – and built it higher – by injecting more currency into the system.

  
It's analogous to someone driving a high-performance car on a mountain road with a stuck throttle. The driver can mash on the brakes, slowing it from 50 to 30. The car charges to 80, but this time the fading brakes can only bring it down to 60. After a couple of cycles, it's going 140. And Ben Bernanke is no Michael Schumacher. Perhaps he can navigate the road. But the chances are better, at this point, that the economy will go off a cliff.

  
So if we're going to have a depression, long overdue and more inevitable with each fresh injection of cash by the government, what should you do about it? Our advice here at Casey Research has always emphasized Buying Gold – a lot of gold.

   That's because Physical Gold Bullion, owned outright, is the only financial asset that's not somebody else's liability. That's important whether the depression is deflationary or inflationary in nature.

   Deflationary depressions are characterized by lots of bankruptcies and defaults; the only assets you can count on are those in your own possession, like cash or gold. Currency becomes more valuable because so much is wiped out in defaults. But gold is the ultimate form of cash.

   Inflationary depressions, on the other hand, wipe out the currency itself, which loses value rapidly, because the government creates so much more. Gold profits from this process, as it holds its value thanks to its scarcity amidst the devaluation of official government-issued currency.

   Is this the start of something big and nasty? It's impossible to say. But the slap the markets have administered upside the back of everyone's head this summer should alert us to the possibility. You want lots of gold. Limited debt. International diversification. And some situations – like our recommended gold stocks – that present real speculative upside.

   The ultimate cause of all the problems we're facing is government, with its taxes, regulations, inflation. And wars, pogroms, confiscations, persecutions, and myriad other stupidities. But most people are more concerned today about the proximate cause of the recent unpleasantness. They want to know why the markets chose to slump this summer.

The Proximate Cause

   The genesis of the current crisis is subprime mortgages. For well over a decade now, lenders have been making mortgage loans available to literally anybody with a pulse who wanted to own a house. Several times in the mid-90s, I expressed astonishment at the fact lenders were loaning over 100% of the appraised value of a house. Even back then, it seemed that was the top of the housing bubble.

   But what do you know? It hadn't even turned on the turbos...just going to show how hard it is sometimes to pick an actual top.

   This leads to one of the more interesting distortions arising from a really big credit-driven boom. You know the old saying? "If you owe a banker a little money and you can't pay, you're in trouble. But if you owe him a lot of money, he's in trouble." That's exactly what's happened here.

   All those new subprime homeowners are already having trouble paying their mortgages. As rates go up, the ranks of late-payers will swell, since they're almost all on floating-rate mortgages. Higher rates and more distress sales will take house prices lower. Which, in turn, will encourage more people to leave their keys in the mailbox and simply walk away.

   On the other side of the trade are all the funds and institutions that bought the paper – the mortgage-backed bonds that enabled the free-for-all lending to continue for so long. They'll eventually recover some percentage of their money, after the houses in question have gone into foreclosure and are taken over by new owners. The ones who will really be hurt are the hedge funds, which have become so popular in recent years.

   Hedge funds are investment pools, available only to sophisticated investors, which are essentially unregulated and can invest in anything, long or short. And, most important, they can trade in any amount of debt.

   In fact, what many hedge funds appear to have been doing in recent years is borrowing money cheaply (perhaps paying 1% per year to borrow Japanese Yen), and then using the proceeds to buy high-yielding paper (such as subprime mortgages yielding perhaps 8% per year). A million dollars of capital invested at 8% would impress nobody; a million dollars invested at 8% alongside another $9 million that was borrowed at just 1%, however, would yield 64% in total. This was essentially what Long Term Capital Management was doing when it blew up in 1998. What's happening today is a repetition of that misadventure, except on a much larger scale.

   It is said that some large percentage of the estimated 9,000 hedge funds in existence now control over $1 trillion in debt. The future of those funds is now very much in doubt.

   Of course, the government will probably come up with some moronic and counterproductive scheme to keep people who can't afford their houses – and should be renting, which is a much better bargain today – in them. That will also serve to save the investors' bacon. What it will also do is place a massive burden on taxpayers, already over-burdened as it is. And it will also accelerate the destruction of the currency, in this case the US Dollar itself.

   As an aside, it will also give the US regulators, the SEC, an entrée to regulating hedge funds, which will serve no useful purpose.

   What you might also be asking yourself, in view of our specialty here at Casey Research, is: "What about mining stocks?"

Mining Stocks

   Junior gold mining stocks, as you should well know, are probably the most volatile securities on the planet. And you've just had a demonstration of how volatility can go both ways. Many have risen by a factor of 10 or more since the current bull market in Physical Gold Bullion started in 2000.

   But on August 16th alone, the average mining stock went down by about 10%. I'd say most stocks are off 40% from their previous highs. Many people Investing in Gold are asking themselves if the bull market is over. I'd say, almost certainly not. This is for several reasons:

1. We're still in the Wall of Worry stage of the market. The Stealth stage ended in 2003, and the Mania stage hasn't yet begun. The bulls and the bears are still fighting. Retrenchments like this happen. Bull markets naturally try to take as few investors along as possible; it simply wouldn't do if everybody could make a living in the market. Who'd do the real work? But the market will continue to climb the Wall of Worry in my view. And we will then have a Mania.
2. The public is still out of the Gold Market. I promise you that every market top I've witnessed in my life was accompanied by cocktail party chatter about the asset class in question. I have yet to have any indication that the public has a clue about gold and other resources. If this is a market top, it's unique.
3. Extraneous factors, not fundamentals, caused the sell-off. In other words, Spot Gold Prices went down simply because there was a bid for the metal, and sellers needed cash to meet their obligations. All the other metals were in the same position. Hedge funds appear to have owned a lot of metals, simply because they could trade them using a lot of leverage. And the mining stocks were showing their usual leverage, only this time on the downside.
4. Governments all over the world are pumping hundreds of billions into the system. They're doing that to ward off a credit collapse, and will almost certainly succeed. But all that extra purchasing media means higher inflation and brings us closer to the day that the foreign holders of $6 trillion in US bonds will step up to the cashier and ask for their money back. The attention of the markets will soon shift from the credit crunch on to Physical Gold Bullion.

   
My guess, therefore, is that the ugliness for the mining stocks won't last long. I don't have any prediction about exactly when the gold mining stocks will come back. But I think that by year-end, they'll be heading strongly back toward new highs.

   What I will say for sure is this: You want gold stocks, not copper, nickel, lead, zinc, or even silver. Gold is the cheapest asset out there. Uranium remains my second favorite.

   Here at Casey Research, we saw the meltdown of the subprime market coming. And correctly anticipated the government's response. But we didn't, I think, adequately clock how ugly it would be for the juniors. Why not? The fact is that once you sell, you tend not to buy back in. And trading is a sucker's game; the odds are greatly tilted against you by the bid/ask spreads, commissions and, most importantly, your own emotions. So we only like to sell when we think a particular company is going in the wrong direction.

   Recall the recent Tech-Stock boom. There were numerous brutal sell-offs on the way to the ultimate top in March 2000. We'll have other sell-offs in this market – in the gold mining sector – on the way to the top, too.

   Rest assured, we're anxious to give an all-out sell on all these resource stocks. At that point, we hope to have found a market sector that's as cheap as they were back in 2000. But that's not yet, and probably not for a couple of years.

   Hang tough. Buy more of the best of the best.

The current edition of BIG GOLD from Casey Research contains a comprehensive analysis of the unfolding credit crisis and what it means for investors who want to Buy Gold Today. You can read a copy, risk-free, by accepting a three-month trial subscription here...