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James Hong

Sunday, February 22, 2009

My economic projections

I had breakfast with my friend Jeremy Liew this morning, and he mentioned I don't really blog anymore. It seems to me that services like Facebook and Twitter are growing at the expense of blogs because most things i write in my blog could probably be reduced to 140 characters, and that is just plain easier.

In the interest of blogging something meaningful, I've decided to write about what's been on my mind nonstop since selling HOTorNOT in February 2008.. the economy.

I liquidated the majority of my equity holdings last Summer and have been in a cash position ever since. So as the market continues to tank, I should be feeling good, right? Wrong. I've been worried sick that the American Dollar is going to collapse and that cash may be rendered worthless. My fear has grown to the point where even if I have an opinion on what to do, I'm too scared to do it. Deer-in-headlights mode.

Last December, I tried to encourage myself to man up by writing down my investment thesis on paper and stuck it on the wall. Unfortunately, even going to this length didn't change my behavior, and I'm still all cash. But here is what I wrote:

My theory was that we would experience three stages: Deflation, Transition, (Hyper?)Inflation

Stage 1 - Deflation

The economy is still contracting has deleveraging continues to happen. The entire world starts to feel the full impact of increasingly lost jobs, people tightening up their pocketbooks, and mortgages defaulting (at all price levels and in all locations.. and no, San Francisco City is not "special" or "different", just like real estate is NOT always a good investment in the long run.).

As all of this happens, industry slows, commodity prices fall, energy prices fall, and the pains of recession start to be felt. Basically everything falls with a few exceptions like gold, where people who are pulling out of the market flee to for safety. I was actually wrong on this one, I had gold going sideways because i wasn't sure whether downward pressure from economic slowdown or upward pressure from flight to safety would be stronger. It looks like right now, gold is going up up up. Sure wish I'd bought some.

The rest of the world falls too, as their economies are so linked to Western consumption.

Stage 2 - Transisition

As my theory progresses, it gets more controversial. I call this stage "transition" because this is where the balance of power between first world countries and certain second/third world countries shifts.

Ever wonder how empires fall and how other's rise? Like how Spain and Portugal used to be the most powerful nations in the western world, and where are they now, relatively? It happens through dislocations like the one we are having now.

My theory is that as stage 1 starts to end, the world economy starts to pick up. consumption starts picking up. The only problem is that it won't happen uniformly. People in China will start buying more stuff (from themselves), and their economy will start growing like crazy as a result.

In other words, the recovery happens, but mostly in other countries, as their economies have decoupled from ours and they start driving their own demand. In this scenario, commodities and energy prices rise (and will surpass previous highs, including oil), Gold also rises. US equities don't drop anymore, and they might even start growing again, but not at the same rate the rest of world is. (keep in mind, china is still growing even now, just not as fast as they were before. in contrast, the US has been contracting like crazy.)

Stage 3 - (hyper?)inflation

Here's where the scary part comes.

As energy prices jump, but not based on US demand, the cost of energy massively outpaces our ability to afford it. The price of energy is embedded in practically everything you buy, through it's use to process raw goods to powering factories to transporting goods. All of a sudden, things start getting REALLY expensive. The dollar is severely weakened. In order to respond, the government may or may not start printing money like crazy, at levels well beyond what they are doing today. (Despite Monetary and Fiscal policy supposedly being independent in the US, in tough times boundaries tend to break down).

Maybe we don't have Zimbabwean levels of inflation, but maybe we see just a 10x drop in the value of the dollar. In US dollars, things like oil and gold shoot through the roof.

Some people claim that they do not believe it's even possible for the US to experience hyperinflation. Of course, many of them thought the US economy was sound just one year ago. I've been doing a lot of thinking about this, and I haven't really reached any conclusions.

I don't think it's impossible, the question is just how likely?

What I do know is this.. I can ignore stage 1 and stage 2, but if stage 3 happens, anyone with significant assets that fails to protect him/herself is going to really regret it.

I'm very interested to hear what other people's thoughts are.

update: Heard back from some people, and want to clarify a few things. The timespan in which I see this potentially happening is on the order of decades, not years. I think we are going to be in stage 1 for at least 2-3 if not 5 years. Step 3 also doesn't happen unless the dollar stops being the de facto global currency. Some other currency like the Chinese Yuan would have to take over that role first. Until that happens, I don't see hyperinflation happening in the US.


Anonymous Anonymous said...

I've thought along the same lines, but I think hyperinflation is unlikely, at least in the foreseeable future, because the dollar is the GLOBAL standard currency. As we've seen so far, any weakness that hits the U.S. tends to reverberate worse in foreign currencies and actually strengthen the dollar. And when times are scary, people tend to hoard even MORE dollars. The fact is, countries that provide goods to the U.S. (like China) have far too much money in dollars for hyperinflation to occur. There are many more dollars being used as a global mechanism of trade than by consumers who spend them on actual goods.

What I see as the real risk is what has happened to England - a slow spiral into bureaucracy and stasis, and a jagged shift to another currency standard (probably the Yuan or Euro, or perhaps even a fundamental shift away from currency). But until that process strips away the power of the dollar, I don't see any hyper-anything happening.

11:41 AM  
Blogger rob said...

Hey James...

I am with the last commenter. HYPER, not so likely. Inflation right now is a long shot, even. We are dealing with a paradigm change in house people deal with credit. There will be less people willing to borrow, less banks willing to lend, and move savings - credit bit too many people in the ass and they'll have that memory for a while.

If you're sitting on a little bit of cash, look at USTXX ( fund from US Global Investors... They are a no-load mutual fund family... You can diversify a little bit to gold (another fund of theirs for that is USERX) if you wanna ride the gold train for a bit (I WOULD NOT BUY GOLD RIGHT NOW). Anyway.. open up an account to the USTXX and trade out some when you want. You can also setup a debit account with them. T-Bills is the safest bet you can go - the US Government would have to go T.U. for you to lose and, as said before, where are your other currencies going to go? The Yen is starting to lose strength and Germany isn't looking so good - the Euro is laughable due to geo-political issues, let along economic policy differentials...

Dollars, Gold, Guns and Ammo - seriously... look at the price of guns and ammo over the last 20 years.

My 2 cents...

2:14 PM  
Anonymous Anonymous said...

Seems like Keynesian fiscal policy is geared at avoiding phase 2.

Based on value of production the US outpaces even China (think: cars, planes, chips, entertainment). But we're the consumption kings. I don't really understand how such a transition would occur. Countries that depend on U.S. consumption aren't eager to call in their debts.

I think we're nearing the decision node: severe deflation/depression, or severe inflation. And our unwillingness to let bad decisions result in failure suggests we're aiming for severe inflation.
My struggle is to figure out what the hedge against that is. I don't believe it's foreign currency. Gold probably has some value. And, to the extent that you can survive it, acquiring debt prior to hyperinflation seems like a viable strategy.
But hyperinflation seems intrinsically linked with totalitarianism and scapegoating. One that seems to be thriving when others are suffering might fall into that scapegoated category.

I have to lay off the cold medicine.

9:15 AM  
Anonymous M. Organ said...

Hey, I'm pretty impressed, this model is quite close to mine. I think it will shock people how easily and how quickly the USA can tip into hyperinflation. Hyperinflation and inflation are different phenomena - hyperinflation is a CURRENCY event that can happen even - and in fact, because of - massive debt deflation. They are two sides of the same coin. All it takes is for China/Japan to stop buying US debt, or heaven forbid, start selling it. This is starting to happen. Janszen at iTulip has done a good job showing this with his Ka-Poom theory. Japan is not the appropriate model for the US - Argentina is. Hyperinflation in an instant.

Anonymous said that China has too many dollars for hyperinflation to occur. It's the exact opposite - hyperinflation actually starts in China and India, and eventually they will need to use their dollars to buy food and fuel on the global market. That could be the catalyst for the hyperinflationary spiral. Food riots are happening in India right now. China is buying absurd amounts of US soybeans right now, paying way over spot (USDA is hiding this with bogus statistics).

With respect to JHong's model, I think that we are already in phase 2. Phase 3 is not far off, sometime in the next 2-3 years I think. Everybody should have a significant portion of their portfolio in PHYSICAL gold (not paper gold promises, not ETFs, not even gold mining stocks). It's going to go to the moon in purchasing power terms, even without hyperinflation (see the awesome for the model of freegold).

1:31 PM  

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