Now that the Federal Reserve dollar liquidity swaps are out of the way, there is no buffer left holding the market together. In 2008, amidst one of the worst financial crises, the US dollar became very sought after. In the preceding years, non-US banks had accumulated hundreds of billions worth US dollar denominated claims. Their dollar claims grew at a much faster pace than their dollar deposits. Murphy’s Laws dictate that if something bad can happen, it most certainly will. Case in point: during the financial crisis, the market prices of banks’ dollar claims fell much faster than banks could come up with new dollar deposits to back their leveraged positions. The Fed ran to the rescue, throwing billions of dollars at foreign central banks so they could assure their members banks had the necessary liquidity. Of course, this did nothing to solve the underlying problem of too much risk and imperfect information (derivatives, anyone?).

Which brings us to today. As is evident, the dollar swaps did everything they were supposed to do. But now that they’re gone, there is a possibility that the dollar shortage will return. The dollar has been gathering momentum for quite some time. Those that look at charts had to have seen the massive divergence between the price action and most of the indicators (MACD is a good example) that first appeared in the spring. Now that the dollar is back in an uptrend with negative news from the Eurozone supporting it, we are looking at what could possibly be the second phase of the dollar shortage. It’s on the brink already and it only needs one little push.

Where could the push come from? A number of sources, really:

1. Higher interest rates
2. Negative news that would dismiss the validity of the recently published GDP gain of 5.7%
3. Second wave of home mortgage resets
4. Commercial real estate

Any one of these would have the effect of plunging asset prices. Given the huge amount of dollar claims amassed by the European and other non-US banks, it does not seem reasonable to assume that they have managed to sell those assets or hedge away their risk completely. The situation is quite a bit different from what it was in 2008, but there are a number of disturbing similarities. The Libor-OIS and TED spreads are both looking calm right now (this was not the case in 2008), but volatility is starting to pick up. Derivatives also pose a problem as there were $604 trillion worth of derivatives as of June 2009, according to the Bank for International Settlements. This is $79 trillion less compared to June 2008, but $57 more compared to December 2008.

If the dollar shortage were to return, equities as well as futures would get hammered just like they did in 2008. Some claim that gold is a safe haven during a liquidity crisis, but there is no proof to back up that claim*. During a liquidity crisis, all assets get sold. Even if gold and gold equities were to hold up for a while, they would be sold soon enough just because they could. Don’t be fooled into thinking that fully funded clients are different from those on margin – a plunging asset loses value regardless of leverage, some just get wiped out earlier than others.

*Gold is definitely a safe haven in the long term, but there is nothing to protect short term holders in case of a fire-sale.

Disclosure: Long physical gold and silver (long term)

2008 witnessed a spectacular rise in the US dollar. During 2008, the US dollar index  went from the low 70s to high 80s in just four months. After reaching a high of 89.62 in March of 2009, the dollar resumed its long-term downtrend. Yet the mainstream media is still painfully oblivious to what actually happened. All the talk about a flight to safety doesn’t really explain anything aside from the fact that most people who work for the financial news media know next to nothing about how the financial markets really work. The reason behind the dollar rally was an extreme dollar shortage that was caused by foreign banks dollar denominated claims’ spectacular expansion in the preceding years. The dollar liquidity swaps initiated by the Fed were a measure used to counteract the liquidity crunch and they have been very successful. I have spent quite a bit of time looking into this and have produced a short report that is available to read for free: The Dollar Swaps & The Financial Crisis: A Brief Overview of the Dollar Shortage of 2008. Readers are welcome to point out factual, conceptual and other errors and suggestions via the comment section right here or by e-mail: kristjan@kristjanvelbri.com

Economic contractions come and go, but the imprints they leave on people vary a lot. One of the good things about economic contractions is that they allow one to take the time off and reflect on the past in terms of personal finance. How did I end up spending so much? Why didn’t I save more? How come I bought assets when they were overvalued compared historical averages? I don’t think I’m the only person who is torturing himself (or herself) with questions like this. There must be millions like me. However painful these questions are, one has to start answering them to prepare for the future. It is the duty of present you to find answers and solutions to these questions for the benefit of future you. We humans have the strange habit of finding good in situations and relationships that are filled to the rim with pain, insults, face-slaps and humiliation. The current crisis is a prime example of the negative emotions that can arise, but after a short period of self remorse and blaming everyone else, we have to pick ourselves up and move one.

Moving On

The first thing you should do is start investigating what really happened. Pick up a few books and start reading. You might also want to add a couple of blogs to your reading list – there is plenty of free and reliable information on the internet, you just have to be a bit skeptical about what you read (if it doesn’t make sense of smells like a conspiracy, it probably is). If you already have a good overview of what happened the next step is to evaluate your own behavior and see if there is anything you could improve on the next time. Before the crisis I didn’t have the habit of saving money but a 15% fall in my home state’s GDP (I live in Estonia) and the bankruptcy of two media companies that paid me for content did plenty to change that . I now have a clear goal in mind – I want to grow my savings account to a minimum of three months’ expenses (the ideal would be a one year cash cushion). I don’t care that my savings account doesn’t yield much because I don’t want to risk my emergency funds. The bigger the potential reward, the bigger the risk.

Historical Averages

I remember buying stocks in October 2008, one of the worst times to be entering the stock market. I wasn’t too worried about my investment because I used money I could afford to lose, which is what one should be doing. Scared money will only bring you losses and misery over the long term. I bought the stock when it was trading around $25. When it fell to $5 in March 2009, I felt stupid. Really stupid. I knew it would rebound so I had no problem holding it. But I knew I had made a grave mistake. When buying stock in that company, I was so enthusiastic about it that I didn’t care about the broad market or the economy. I thought their products were positioned so good that there was no way they could suffer. Besides, the stock had already come off from its highs in the $70 range.

I should’ve kept the money and waited for a better opportunity. In hindsight I can see clearly that the dollar was in an uptrend (bad for US dollar denominated stocks) and the broad market was in terminal decline due to a credit crunch (due to the failure of Lehman). I eventually sold my stocks when it reached the $20 range.

When making an investment in any asset class, be it stocks, commodities or real estate, always check the historical averages and look at the trendlines. Estonia, much like the rest of the world experienced a spectacular real estate boom (without the option ARMs and RMBSs, luckily) and I always knew it was going to pop. I’m not saying I’m an expert, because that knowledge was largely based on the magazine cover indicator and the number of real estate shows on TV. But now I know how experts do it. The experts look at historical averages. There are many such as standard deviation plotted on a price chart, all the numerous housing affordability measures, population growth to asset price ratios, inflation adjusted prices etc. To top it off, it doesn’t hurt to buy a couple hundred bucks worth of books before buying a house. I’ve heard many people call in on the Financial Sense Newshour Q-lines saying that they avoided buying a house during the boom times and are now starting to look around for a bargain. Most people buy one house during their lifetime and it doesn’t really matter if you push the purchase forward a few years. They probably got at least 50% compared to the height of the boom.

Recession come and go but if we learn from our mistakes, we will most certainly benefit from them or, at the very least, we’ll be able to weather the storm the next time it hits. I’ve read about some great deals over the last year. People that are older than me and have more experience, who know the ins and outs of business cycles, picked up some great deals at bargain prices and are now selling at 100% or even 300% gains. They didn’t go along with the euphoria, held on to their money and bought assets when they were truly cheap, not just attractive.

In the end, we can’t do much to change the business cycle. They exist in every economic system so doing away with capitalism, as some have suggested, isn’t going to solve it. Swinging from one extreme to the other is a recurring theme in nature and since prices are a reflection of the collective action of all the market participants: private individuals, companies and organizations comprised of people; economies are bound to have booms and busts. The best we can do is adapt and prepare. Do a service to future you and start learning today. Future you will thank you for that.

Ratios, the price relationships between two prices, are extremely useful in determining relative weakness and strength in the markets. One such ratio is the HUI to gold ratio, HGR for short, which shows the buying power of HUI relative to gold (HUI is the symbol of Amex gold bugs index, a basket of unhedged gold stocks). If the ratio is going up, the buying power of gold stocks is increasing relative to gold. It doesn’t necessarily mean that gold stocks are going up – the ratio will go up in two cases a) gold stocks are going up faster than gold b) gold stocks are going down slower than gold. Adam Hamilton and his subscribers have been using the HGR for a long time and here is an excellent primer on using that ratio as it applies to this very week. If you enjoy his writings, proceed to his essay archive.

As this year draws to a close, it would be appropriate to take a look at the best of 2009. Since the last months of 2008, I’ve been a follower of Jim Puplava and his excellent weekly financial news talk show. The second hour of each Financial Sense Newshour features an author of a book written about economics or finance. Here’s my top 8 for the year that was. Enjoy!

1. Inflation vs. Deflation debate – 2009 was a year of endless debate for inflationists and deflationists and it seems that neither side has settled down yet. In the previous show Mr. Puplava hinted that there would be another inflation vs. deflation debate in January 2010.

2. Trend of 2009 – interview with Gerald Celente, the trends forecaster.

3. Fallen Giant: The Amazing Story of Hank Greenberg and the History of AIG – this is the story of how AIG grew to be such a large institution and what undid the company.

4. Oil 101 – the best guide to the oil industry: from the well to the pump.

5. Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy - if you like Barry’s style, you should check out his blog at www.ritholtz.com

6. Where Keynes Went Wrong: And Why World Governments Keep Creating Inflation, Bubbles, and Busts

7. “The New Market Wizards: Conversations with America’s Top Traders - an excellent interview based on the best-selling book by Jack Schwager

8. “Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse” – another great book by Thomas Woods. There are more interviews and presentations with Thomas Woods at the Mises Institute.

The full list of 2nd hour interviews is available here.