Economist vs. Historian

I came across an interesting article this week that acknowledged that economists always think the future is bleak, and the past is always worse than they thought it would be. (So you shouldn't spend all your time listening to them.) However, this article stated that maybe we should read less about economics, and more about history.

"Historically, once a country uses the printing press to pay for its stated goals and ongoing obligations, there is not one instance in human history where those debts and obligations are ever being paid off. These actions always have resulted in the destruction of the currency. The unique aspect of today’s monetary inflation is that it is not limited to one country, but a host of countries are all inflating together."

Source: http://www.financialsense.com/fsu/editorials/degraaf/2009/0619.html

The Next Canary in the Coal Mine - California

The phrase "canary in a coal mine" is frequently used to refer to a person or thing which serves as an early warning of a coming crisis.

In 2007, the canary in the coal mine was the collapse of a Bear Stearns hedge fund with mortgage backed securities. It was largely ignored at the time as an isolated incident. By reading the opinions of some experts (and conspiracists alike), I now believe that the "canary in the coal mine for 2009" is the imminent bankruptcy of California.

Starting July 29, California won't have enough cash to pay its bills, state Controller John Chiang told the governor and legislative leaders today. The state will be in the red by $317.1 million that day, Chiang wrote them in a three-page letter. "Two days later, on July 31, our cash deficit increases to a negative $1.02 billion," he added.

Source: Chiang warns state leaders on cash crunch

Just like in 2007, this news is going largely ignored because it is commonly believed that the Fed will bail out California, as it is "too large to fail". It also comes off the heels of a GM bankruptcy and a bank TARP repayment. Unfortunately, what most people are ignoring is the fact that "if California were a separate country, it would rank among the ten largest economies in the world, with a GDP similar to that of Italy, and it would be 35th among the most populous countries." (Source: Wikipedia)

Everyone in the United States of America cannot fathom this great country going bankrupt... but I believe it's already happened. We've bailed out the banks, GM and soon it will be states. What is left?

And who will stand by to bail our government out?

I'm standing by my belief that "something bad is still coming" at the end of 2009, maybe early 2010. Possibly a deflation to hyperinflation trap that will reset the wealth food chain in a very big way. This is no time to be complacent with your investments!

See my previous post regarding Investing in Deflation vs. Inflation and place your bets.

Barack Says We're Broke

Sorry for the lack of posts, but I've been working on another project recently.

According to the United States Congressional Budget Office, if Barack Obama would have changed nothing after coming into office, by 2019, the US debt obligation would have amounted to 42% of annual GDP. How much is 42% of annual GDP? Roughly 5,991.13 Billion dollars, this (shockingly) is in-line with historic norms. However, the CBO goes on to say that after the past 6 months of spending, and the inclusion of Barack Obama's proposed budget, by 2019 the US will need roughly 82% of GDP to service its debt load.

Just a quick reality check... doesn't a bank want a buyer to have a below 40% debt load in order to qualify for a mortgage?

The only reason we can get away with this is because of the US Dollar's position as the world reserve currency. However, China's talking about replacing the USD as the world reserve currency. Common sense says that something has to give.

Source: http://www.financialsense.com/fsu/editorials/cnc/2009/0605.html

GLD Watch - 04/19/2009

A gold correction is currently underway. I think GLD will fill the bottom end of the Bollinger Band, which is currently at around 80. Not surprisingly, GLD's fall comes with a rise in the stock market and the lowest VIX (fear) reading in a while.

High VIX = High Volatility, which typically means High Fear. Relatively speaking, it's still high. But there are definitely a lot of people talking about a bottom lately. I find myself pulled to bottom pick the S&P500 here, but my instincts tell me that we are nowhere out of the woods yet. Comparing the economic environment to the last recession, it feels like 2001 because people are still talking about bottom picking (internet) stocks on the way down.

I'm staying cash and sticking to my plan of buying Gold on the weekly technical bottoms in 2009-2010 until the next "game changing" event like the fall of Lehman. The only clear trade/trend that I see is all currencies are becoming devalued, which only means good things for gold.

If you've been waiting to buy gold, your opportunity is coming soon! Watch the action for the next few days and weeks. I'm targetting a 1/10 position buy between 80-85. So that means if I have $10,000 to invest, I'm going to buy $1000 between 80 and 85.

If it blows past 80, be careful and slow down the buying.

The Intelligent Investor - Tips #2

The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition)

While continuing my reading, I stumbled on some nuggets of wisdom that I thought I'd share.

1) Past performance does not indicate future success.

2) Be careful with high growth stocks. They have huge growth expectations which they WILL FAIL to meet at some time.

Some quotes from the book/commentary:

"Great expectations lead to great disappointment if they are not met; a failure to meed moderate expectations leads to a much milder reaction. Thus, one of the biggest risks in owning growth stocks is not that their growth will stop, but merely that it will slow down. And in the long run, that is not merely a risk, but a virtual certainty."

...
"Most investors simply buy a fund that has been going up fast, on the assumption that it will keep on going. And why not? Psychologists have shown that humans have an inborn tendency to believe that the long run can be predicted from even a short series of outcomes. What's more, we know from our own experience that some plumbers are far better than others, that some baseball players are much more likely to hit home runs, that our favorite restaurant serves consistently superior food, and that smart kids get consistently good grades. Skill and brains and hard work are recognized, rewarded- and consistently repeated- all around us. So, if a fund beats the market, our intuition tells us to expect it to keep right on outperforming.

Unfortunately, in the financial markets, luck is more important than skill. If a manager happens to be in the right corner of the market at the just the right time, he will look brillant-but all too often, what was hot suddenly goes cold and the manager's IQ seems to shrivel by 50 points."

....

"You can get ripped off easier by a dude with a pen than you can by a dude with a gun. -Bo Diddley"

Link to the book on amazon.com:
The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition)

Sweet Justice? House Votes To Recoup Bonuses

WOAH more big news today as the U.S. House of representatives passed a bill to recoup bonuses paid to AIG. Due to the public outrage that AIG paid $165M in bonuses for certain executives, the Obama administration and Democratic congress moved quickly to do something about it.

The House proposal's hefty tax provision would apply to executives with incomes over $250,000 who work for companies that get at least $5 billion in federal aid. That could include others besides AIG, such as mortgage financing company Fannie Mae.

"The whole idea that they should be rewarded millions of dollars is repugnant to everything that decent people believe in," said Representative Charlie Rangel, the Democratic chairman of the tax-writing Ways and Means Committee.

In a measure of the widespread outrage over bonuses, small crowds of protesters marched in cities across the United States to denounce the idea that AIG employees who helped push the insurer to the brink of collapse should be rewarded for it.

Sound like sweet justice? Not really. If you dig deeper:

1) A lot of firms were forced to take money from the Fed, even though they didn't want it. In fact, some are publicly saying they want to give the money back. Some of these same firms also came clean and did not give their executives ridiculous bonuses. But the Fed wants to have authority to look around their books to see what the companies are doing. Sounds awfully fishy to me. Why would the Fed want its fingers in so many pies?

2) The taxes apply to any family earning over 250k working at a bailed out firm. So if you worked hard in college, maybe even got an MBA and earned a job at a top wall street firm or any other top bailed out company, you've been forced to endure layoffs, endure even longer hours and now significantly less pay to boot. This was meant to punish the greedy executives, not necessarily all the smart hard working wall street kids just following orders and doing their jobs.

Who do you really think this hits harder:
The executive who already made millions the past few years
OR
The dual income middle management family who works hard and makes $251k a year?

I guess we found our scapegoats... everyone at the bailed out firms and guys like Madoff. I guess the people who passed the laws who got us here and the Fed whose balance sheet has increased by TRILLIONS are innocent bystanders.

People Who Live In Glass Houses Should Not Throw Stones

Source: http://news.yahoo.com/s/nm/20090320/bs_nm/us_financial_aig_17

Is a Housing Bottom in Sight?

Wow. Big news today. Bernake is living up to his "Helicopter Ben" nickname by vowing to pump another $1 TRILLION into the U.S economy, partly by buying government bonds for the first time since the 1960's. What does this mean for you and I?

"The Fed’s announcement signals a clear intent to continue to drive mortgage rates lower and we expect them to meet this objective. ... In 2008, the average mortgage rate on the outstanding stock of loans was about 6.50%. So, if the Fed brings 30-yr fixed rate mortgages down to 4.50% and all homeowners are able refi, the aggregate permanent cash flow savings would be on the order of $200 billion per year."David Greenlaw, Morgan Stanley, WSJ Real Time Economics March 18, 2009

This could be really good news in pretty dark times. Combined with data showing some life in new housing starts, this is the first sign of life for a housing bottom. This is why we need to be a contrarian, because in the darkest of times, sometime always seems to pop up that changes everything.

BUT WAIT. Don't go rushing in to buy everything just yet. I did a little more digging. Calculated Risk puts it very succinctly:

"But some readers are confusing a bottom in housing starts with a bottom in pricing. It doesn't works that way! There will be two distinct bottoms for housing:

1) First single-family housing starts and new home sales will bottom

2) Then some time later, prices for existing homes will bottom

Just about every housing bust follows this pattern. The bottom in prices could be a year, or two, or more away. It is way too early to try to call the bottom in prices. House prices will almost certainly fall all year and probably next year too. Prices will continue to fall. Prices are not at the bottom."

OK SO NOW WHAT?

It's tough to say. If I had to guess, I'd say that:

1) We'll at least get a stock market rally for the short term. I think it will be short lived as reality will catch up with optimism, but we gotta start somewhere!

2) You should run, not walk, to see if you can refinance your mortgage near or below 4.5%. There WILL be renewed interest in housing this summer, coinciding with the school year. Hopefully they help out those in jumbo mortgages!

3) The gold trade is still very much in tact. In fact, this bodes VERY badly for my "wait" approach and others are clearly wise to the theory and jumped in and bought gold on the news.

Source: http://www.calculatedriskblog.com/ and WSJ

The Intelligent Investor - Tips #1

The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition)

I just started reading "The Intelligent Investor" by Benjamin Graham. The cover advertises that it's the "definitive book on value investing". Warren Buffet says it's "by far the best book on investing ever written".

I was bored at the airport and bought it and started reading it. So far, it's been good. It's a little confusing on which voice is the author's because my edition has commentary by Jason Zweig, but it definitely has some interesting points or tips which are directly relevant to this blog!

Below are snippets of good quotes/advice that seem very applicable to investing today.

1. Obvious prospects for physical growth in a business do not translate into obvious profits for investors.

2. The experts do not have dependable ways of selecting and concentrating on the most promising companies in the most promising industries.

By the time everyone decides that a given industry is "obviously" the best one to invest in, the prices of its stocks have been bid up so high that its future returns have nowhere to go but down... The people who now claim that the next "sure thing" will be health care, or energy, or real estate, or gold, are no more likely to be right in the end than the hypesters of high tech turned out to be.

Finally, what was most sobering so far was the following comment in a 1949 edition of the book, regarding the high flying airline stocks of its time, which might have been similar to the dot com tech stocks earlier this decade. I find it interesting and ironic that airlines are still a troubled industry today, but at one time, it was "the hot industry".

"Such an investor may for example be a buyer of air-transport stocks be cause he believes their future is even more brillant than the trend the market already reflects... In the year 1970, despite a new high in traffic figures, the airlines sustained a loss of some $200 million for their shareholders... It is commonly accepted today that the cumulative earnings of the airline industry over its entire history have been negative."

Link to the book on amazon.com:
The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition)

Stock Market Turmoil - 03/03/2009

I was watching Fast Money on CNBC tonight and they were talking about the recent turmoil in the markets:
- The Dow falls to lowest since April 1997.
- 52% of Americans are afraid they will lose their jobs.
- 1/3 of Americans are losing sleep due to economic concerns.

The sky is falling! Fear reigns! Time to Buy Low?

While you might interpret this as a "buy low" moment, a Fast Money guest analyst Yamada looked back at the Great Depression and made a great observation that the real wealth destruction did not occur in the crash of 1929... it actually occured in the 3-4 years after the crash.

My thoughts?
I think we're STILL in dangerous investing times... so be careful out there. Cash is still king. "Buy and Hold Forever" is officially dead. This is no ordinary recession.

Two months ago, I said right here that stocks were NOT CHEAP and that it was a sucker rally. I hope you got out while you could. Based on how bad the last quarter was, the estimates I had in that January post might be considered "very optimistic". It appears things are much worse.

Below is a chart on how we compare to three of the last bad bear markets courtesy of Calculated Risk Blog and dshort.com:

By being on television on a weekly basis, President Obama has scared everyone and the entire stock market has plunged. If you follow this blog, you'll note that I like Gold here, but even Gold is getting dragged down as well. But if the fundamentals for Gold are in tact, why the selloff?

I suspect that someone is being forced to sell their gold holdings and we're going to have another major event (bank/corporation failure, another industry asking for money, alt-a mortgage defaults, etc.). It could be anything, but I think this could happen in the next few weeks. Watch the weekly GLD chart, this could be the entry point we've been waiting for!

GLD Watch - 02/24/2009

Hindsight is 20-20, but in December, I said that GLD looked like it was due for a run because of the MACD turning positive. It's now safe to say that I was right. Unfortunately for me, I didn't buy in... I was hoping for another dip to get in cheap, but it doesn't look like that will happen now. However, even at these levels, gold could still be cheap.


We did have a decently sharp pullback on gold tanks to the "Bernake Rally" today, but it didn't do much damage to the daily chart. Short term entry targets look like ~92 or ~87.

The investment objective of the SPDR Gold Trust (GLD) is for the Shares to reflect the performance of the price of gold bullion.

CNBC House of Cards

"Let's hope we are all weathly and retired by the time this house of cards falters." - Internal email Wall Street 12/15/2006

I just watched a great CNBC documentary by David Faber that recaps the origins of the global economic crisis. For replay: http://www.cnbc.com/id/28892719

Some key points:

- 911 disaster causes Fed to cut interest rates
- Mortgage rates dropped to lows not seen since the 1970's.
- Wall Street saw an opportunity to get into Mortgage Backed Securities (MBS) and compete with Freddie Mac/Fannie Mae
- Chasing the American dream, Americans bid up real estate prices, but they didn't read the fine print of their loans, overstated their incomes, and planned to withdraw equity from their future home values or planned to refinance at a later time.
- Wall Street's demand for mortgages allowed lenders to get creative and loose with "Stated Income" and "No Money Down" loans. (Lenders would give a mortgage to anyone.)
- While there was concern on Wall Street, imposing stricter standards would have effectively put any firm out of the market.
- People refinanced and tapped the equity in their homes to fuel home improvement and retail spending.
- Wall Street's MBS business exceeded expectations and foreign demand increased.
- Highly unqualified people became loan officers and were highly incentivized to close loans and refinance. Homes became ATM machines.
- Loan originators "never made a mortgage that Wall Street didn't want to buy."
- In 2004, President Bush brags about new home ownership rates. Greenspan encourages mortgage industry to come up with more creative loan alternatives.
- Negative Amortization Loans allowed buyers who couldn't afford loans to buy. In fact, these toxic loan had balances that increased over time.
- To attract institutional buyers, ratings agencies rate "investment grade" securities. Rating agencies had a conflict of interest to properly rate investments, for fear of losing future business.
- Banks created Collateralized Debt Obligations (CDO's), allowing investors to own small pieces of many properties to diversify their risk.
- CDO's were a vehicle to package bad loans with highly rated ones in order to give them AAA rating.
- Salesmen, lawyers, and investors alike did not understand what a CDO was. However, the investment pitch was convincing - It's safe, it's a sure thing with low risk. The AAA rating was more important than knowing what the investment was.
- Greed was prevalent. Buyers wanted their dream home. Lenders couldn't say no. Bankers asked for more mortgages and more loans. Investors sought higher returns.
- Lack of oversight by SEC and Federal Reserve. Greenspan says even if he had known the extend of subprime mortgages (representing 20% of all new mortgages in 2005), Congress probably would have stopped him, since new home ownership is a good thing.
- Warning Sign #1 - Mortgage Origination is a trillion dollar market that touches consumers without regulation.
- Warning Sign #2 - Housing Prices were going up significantly higher then Median Income.
People and even rating agencies assumed that housing prices would continue to go up in perpetuity.
- If Greenspan with hundreds of PhD's on his side, could not understand CDO's, how could the majority of the world understand them?
- In 2006, Subprime loans began to default and bankrupt lenders. MBS's delinquency rates rise and Wall Street stop buying mortgages from Subprime lenders. Mortgage credit begins to dry up and there are fewer qualified buyers. Home prices stop rising. People can't refinance out of adjustable mortgage rates. People fall behind on the payments that they didn't understand. Many are foreclosed. When people discover AAA rated investments are junk, wall street confidence is shattered and the global economic crisis begins.

The American Dream is shattered.
"If it sounds too good to be true, it probably is."

Gold vs USD

Typically, the U.S. Dollar and Gold share an inverse relationship. If the US Dollar rises, then Gold falls. If the US Dollar falls, Gold rises. Below is a chart I found that illustrates this relationship since the 1970's.

Over the past few weeks of January 2009, gold has been rallying WITH the dollar when, according to conventional wisdom, it should be declining. This does happen from time to time, but it is unusual.

In the diagram below, I was anticipating a decline (green circle) but it never happened. Instead, we rallied (red circle). As you can see, that doesn't happen too often.

What does this mean? Is this a greater trend? A sign of bigger moves ahead? Is it telegraphing more trouble in the financial markets? Is Gold now decoupling from the U.S Dollar as investors see it as the only true safe haven?

I'll be watching.

Sources: http://www.whiskeyandgunpowder.com/ and http://www.futuresource.com/

GLD Watch - 01/23/2009

Sigh. Well, as I said in my last GLD post, we did in fact retest 80... but we didn't get past it to test 70. It seems like we're breaking out of key resistance and above the 50 day moving average, when we should be declining. This seems bullish. To be honest, I thought we'd drop to 70 with an Obama stock rally. Instead, Gold rallied on "true safe haven" buying.


The daily chart seems to point to a near term breakout as well. Right now I feel like I missed the boat.


Next week is key. If we don't get a sharp decline, we're probably going to take off. However, I don't chase and I don't like mixed signals. I'm still going to wait for the next short term bottom. If it bottoms above 70, I'm buying. I keep telling myself to have some patience.

Visual Guide to the "Subprime" Financial Crisis

I saw an interesting (and complicated) diagram of how we got to where we are now in the financial crisis in September 2008. Some argue it's missing some details, but I think its pretty decent... albeit long.

Source: http://blog.mint.com/blog/finance-core/a-visual-guide-to-the-financial-crisis/

Peer To Peer Lending

I was watching CNBC and they discussed an interesting concept that has gained momentum during this credit crunch: Peer to peer lending. In other words, there are websites that allow individuals to lend to others individuals. The borrowers have 660+ FICO scores and provide a description of why they need the loan. Supposedly the default rate is below 1%.

Note: I haven't tried this out at all, but I'm thinking about trying the lending side with CD rates plummeting. It sounds like a win-win. Borrower gets a lower rate and a LOAN. Lender gets an above average rate of return.

I'm sure there are plenty of other competitors, but has anyone tried this? Or know of other competitors?

http://www.lendingclub.com/home.action

CEF vs. GLD

It recently came to my attention that CEF is another good alternative to GLD. The differences:

1) CEF is a closed fund that holds Gold and Silver bullion in Canada.

Please note that they are held in Canada (not the U.S.) so there's less chance of a confiscation. Paranoid you say? Pop quiz, when was the last time gold was confiscated in the USA? (Hint: Google "FDR Confiscate Gold")

2) GLD is taxed at a "collectibles" rate of 28%, whereas CEF is taxed as a "mutual fund" which is subject to capital gains.

Short term capital gains (held less then 1 year) are taxed at normal income tax rates. Long term capital gains (held over 1 year) are subject to 5% or 15% tax depending on your tax bracket.

3) Unlike the popular ETFs such as GLD and SLV, CEF does not lease out your gold.

They always maintain 90% or more of assets in unencumbered, segregated and insured, passive long-term holdings of gold and silver bullion. There are pundits out there that think GLD and the Comex will break due to "price manipulation" of gold by the big banks and Fed.

4) CEF does come with a hefty premium (currently at ~15% to NAV).

But this premium is less than the premium you are likely to pay on physical bullion. Check current NAV here. Supposedly, below 15% NAV is "good" for this fund.

5) CEF is diversified using a 50:1 silver to gold weight ratio.

GTU is another option for those that want only gold and not silver. For my gold watch, I'll still continue to monitor GLD as it tracks the "price of gold" more closely, but I may consider taking a position in CEF also or instead.

GLD Watch 01/12/2009

We finally had a big decline in Gold! I was beginning to doubt myself. But as I posted here in GLD Watch 01/07, we are now testing 80 and the next support levels are ~70 and ~65. I wouldn't be surprised if the action was choppy in the 70-85 range for the next few months as the buying base consolidates. I'm not a daytrader, but I'm looking for a good entry point where the daily and weekly charts say "Buy" so I can put some cash to work.




If we continue the decline, the daily chart suggests support at 70-72. Or, we'll snap back from the 78-80 level, which would probably be very bullish, but I'm too scared to chase that. Actually, any short term low above 70 would be a higher low, which I believe is a bullish indicator.

Investing in Deflation or Inflation?

Lately, I've been asking myself: "What is a safe investment during deflation or inflation?" I did some digging, and the best answer I could find is that some people think Gold is a good investment whether we enter hyperinflation or deflation. Others disagree. I've posted both sides, but I happen to think Gold is a good trade until it pops up big.

Investment Themes For Hyperinflation
- In hyperinflation the last place one wants to be is in cash.
- Commodities in general are a standout.
- Gold is a standout.
- Precious metals are a standout.
- Property is a winner.
- Equities are a winner.
- Treasuries are distinct losers if not an outright short.
- Foreign currencies
- Energy

Investment Themes For Deflation
- In deflation, debt is the enemy.
- Risk is to be avoided.
- Cash is raised.
- Treasuries are sought out as a safe haven.
- CD ladders offer a good investment structure.
- Gold, acting as money does well.
- Select equity shorts or PUTs are a standout.
- Renting as opposed to owning a house should be considered.
- Currency plays

Anti-Gold Argument:
"Do not make the mistake of thinking that gold always does well. It does not. It fell from over $800 to $250 in a decade's long crash. There was positive inflation all the way. Thus gold is not an inflation hedge no matter what anyone says, except perhaps in the very longest of timeframes. The key here is that gold does well at extremes. Those extremes are severe inflation and deflation."

Source:
http://globaleconomicanalysis.blogspot.com/2007/12/how-does-one-invest-for-inflation-and.html

Are Stocks Cheap?

Many people are wondering if this is a good time to buy. The prevailing theory is that the stock market looks 6 months out and many sources are claiming the recession will bottom by Q2 2009 and end in a two year long recession.

I think it's a sucker rally.

See the below chart for a simple breakdown of S&P500 Earnings and what the equivalent PE ratio would mean for the target price. Historically, the S&P500 has a PE of 15. 12 is used here to illustrate the likely initial overcorrection.

Earnings PE Target
$25.00 12 300
$35.00 12 420
$45.00 12 540
$55.00 12 660
$25.00 15 375
$35.00 15 525
$45.00 15 675
$55.00 15 825
$25.00 18 450
$35.00 18 630
$45.00 18 810
$55.00 18 990

So, in other words if the S&P500's earnings are $45, a PE of 15 puts us at a 675 target price. We're around 900 today. We could have a little rally here, but I think some sort of fear event will pull us down... maybe it'll be the jobs report tomorrow.

Source: MIKE MISH SHEDLOCK @ http://www.financialsense.com/

GLD Watch 01/07/2009

Heads up. It looks like the recent Gold rally could be pulling back. Stay tuned for a buying opportunity in the next few weeks. We'll test 80, if that doesn't hold then maybe 70. The more I read, the more I think that I might be a little early on this Gold trade so I'm not going to chase it. I'm planning to buy a 1/10 position at every weekly chart bottom in 2009 and 2010.

As for the broader stock market rally, I think it's short lived. Fear, as measured by the $VIX, has definitely subsided, but my gut says its a sucker rally. It appears we might be just waiting for an excuse for fear to spike again. I'd say if you want to lighten up on something, now might be the time.

We Are Squanderville

The below is an excerpt from a story written by Warren Buffet in 2003 for Fortune magazine, called “Squanderville vs. Thriftville.”. The recent economic turmoil made me think of it. Cliff notes version:

"The United States has started consuming considerably more then it produces. It’s relied on the labor of others to provide things that are used every day. Because the country is so rich, this can continue for a long time, and on a large scale — but not forever.”

More of the story here:

And my reason for finally putting my money where my mouth has been so long is that our trade deficit has greatly worsened, to the point that our country's "net worth," so to speak, is now being transferred abroad at an alarming rate.

A perpetuation of this transfer will lead to major trouble. To understand why, take a wildly fanciful trip with me to two isolated, side-by-side islands of equal size, Squanderville and Thriftville. Land is the only capital asset on these islands, and their communities are primitive, needing only food and producing only food. Working eight hours a day, in fact, each inhabitant can produce enough food to sustain himself or herself. And for a long time that's how things go along. On each island everybody works the prescribed eight hours a day, which means that each society is self-sufficient.

Eventually, though, the industrious citizens of Thriftville decide to do some serious saving and investing, and they start to work 16 hours a day. In this mode they continue to live off the food they produce in eight hours of work but begin exporting an equal amount to their one and only trading outlet, Squanderville.

The citizens of Squanderville are ecstatic about this turn of events, since they can now live their lives free from toil but eat as well as ever. Oh, yes, there's a quid pro quo -- but to the Squanders, it seems harmless: All that the Thrifts want in exchange for their food is Squanderbonds (which are denominated, naturally, in Squanderbucks).

Over time Thriftville accumulates an enormous amount of these bonds, which at their core represent claim checks on the future output of Squanderville. A few pundits in Squanderville smell trouble coming. They foresee that for the Squanders both to eat and to pay off -- or simply service -- the debt they're piling up will eventually require them to work more than eight hours a day. But the residents of Squanderville are in no mood to listen to such doomsaying.

Meanwhile, the citizens of Thriftville begin to get nervous. Just how good, they ask, are the IOUs of a shiftless island? So the Thrifts change strategy: Though they continue to hold some bonds, they sell most of them to Squanderville residents for Squanderbucks and use the proceeds to buy Squanderville land. And eventually the Thrifts own all of Squanderville.

At that point, the Squanders are forced to deal with an ugly equation: They must now not only return to working eight hours a day in order to eat -- they have nothing left to trade -- but must also work additional hours to service their debt and pay Thriftville rent on the land so imprudently sold. In effect, Squanderville has been colonized by purchase rather than conquest.

It can be argued, of course, that the present value of the future production that Squanderville must forever ship to Thriftville only equates to the production Thriftville initially gave up and that therefore both have received a fair deal. But since one generation of Squanders gets the free ride and future generations pay in perpetuity for it, there are -- in economist talk -- some pretty dramatic "intergenerational inequities."

Let's think of it in terms of a family: Imagine that I, Warren Buffett, can get the suppliers of all that I consume in my lifetime to take Buffett family IOUs that are payable, in goods and services and with interest added, by my descendants. This scenario may be viewed as effecting an even trade between the Buffett family unit and its creditors. But the generations of Buffetts following me are not likely to applaud the deal (and, heaven forbid, may even attempt to welsh on it).

Think again about those islands: Sooner or later the Squanderville government, facing ever greater payments to service debt, would decide to embrace highly inflationary policies -- that is, issue more Squanderbucks to dilute the value of each. After all, the government would reason, those irritating Squanderbonds are simply claims on specific numbers of Squanderbucks, not on bucks of specific value. In short, making Squanderbucks less valuable would ease the island's fiscal pain.

That prospect is why I, were I a resident of Thriftville, would opt for direct ownership of Squanderville land rather than bonds of the island's government. Most governments find it much harder morally to seize foreign-owned property than they do to dilute the purchasing power of claim checks foreigners hold. Theft by stealth is preferred to theft by force.

So what does all this island hopping have to do with the U.S.? Simply put, after World War II and up until the early 1970s we operated in the industrious Thriftville style, regularly selling more abroad than we purchased. We concurrently invested our surplus abroad, with the result that our net investment -- that is, our holdings of foreign assets less foreign holdings of U.S. assets -- increased (under methodology, since revised, that the government was then using) from $37 billion in 1950 to $68 billion in 1970. In those days, to sum up, our country's "net worth," viewed in totality, consisted of all the wealth within our borders plus a modest portion of the wealth in the rest of the world.

Additionally, because the U.S. was in a net ownership position with respect to the rest of the world, we realized net investment income that, piled on top of our trade surplus, became a second source of investable funds. Our fiscal situation was thus similar to that of an individual who was both saving some of his salary and reinvesting the dividends from his existing nest egg.

In the late 1970s the trade situation reversed, producing deficits that initially ran about 1 percent of GDP. That was hardly serious, particularly because net investment income remained positive. Indeed, with the power of compound interest working for us, our net ownership balance hit its high in 1980 at $360 billion.

Since then, however, it's been all downhill, with the pace of decline rapidly accelerating in the past five years. Our annual trade deficit now exceeds 4 percent of GDP. Equally ominous, the rest of the world owns a staggering $2.5 trillion more of the U.S. than we own of other countries. Some of this $2.5 trillion is invested in claim checks -- U.S. bonds, both governmental and private -- and some in such assets as property and equity securities.

In effect, our country has been behaving like an extraordinarily rich family that possesses an immense farm. In order to consume 4 percent more than we produce -- that's the trade deficit -- we have, day by day, been both selling pieces of the farm and increasing the mortgage on what we still own.

To put the $2.5 trillion of net foreign ownership in perspective, contrast it with the $12 trillion value of publicly owned U.S. stocks or the equal amount of U.S. residential real estate or what I would estimate as a grand total of $50 trillion in national wealth. Those comparisons show that what's already been transferred abroad is meaningful -- in the area, for example, of 5 percent of our national wealth.

More important, however, is that foreign ownership of our assets will grow at about $500 billion per year at the present trade-deficit level, which means that the deficit will be adding about one percentage point annually to foreigners' net ownership of our national wealth. As that ownership grows, so will the annual net investment income flowing out of this country. That will leave us paying ever-increasing dividends and interest to the world rather than being a net receiver of them, as in the past. We have entered the world of negative compounding -- goodbye pleasure, hello pain.

We were taught in Economics 101 that countries could not for long sustain large, ever-growing trade deficits. At a point, so it was claimed, the spree of the consumption-happy nation would be braked by currency-rate adjustments and by the unwillingness of creditor countries to accept an endless flow of IOUs from the big spenders. And that's the way it has indeed worked for the rest of the world, as we can see by the abrupt shutoffs of credit that many profligate nations have suffered in recent decades.

The U.S., however, enjoys special status. In effect, we can behave today as we wish because our past financial behavior was so exemplary -- and because we are so rich. Neither our capacity nor our intention to pay is questioned, and we continue to have a mountain of desirable assets to trade for consumables. In other words, our national credit card allows us to charge truly breathtaking amounts. But that card's credit line is not limitless.

Source: Warren Buffet
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