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The Parallax Letter

Monahan AssociatesEconomic and Market CommentaryMay 2009 Issue #11

“

MYTHOLOGY

The body of a primitive people's beliefs concerning its origin, early history,heroes, deities and so forth, as distinguished from the true accounts which it invents later.”

Ambrose Bierce “The Devil’s Dictionary”

In this issue of the Parallax Letter, we will attempt to reveal one of the biggest falsehoods in themodern world of finance: the idea that the Federal Reserve (or any government institution forthat matter) is capable of bailing us out of our economic dilemma. Everything that you readbelow, while in parts rather complicated, flies in the face of modern “wisdom” and economiccheerleading, err I mean thought. Yet you will see if we can make our case clearly enough thatthe facts are irrefutable –

the government is powerless in the fight against deflation

. Stay withus, we believe that you will find this information as fascinating as we do, but first a quickrecap.

The Great Disconnect

Several years ago, while sounding the alarm of the pending credit contraction and “thepossibility of large-scale asset deflation in the US” (Parallax Letter #3 August 2004) we werelonely voices in the advisory wilderness. In fact, the only bearish voices that we could find were what we will call “Inflationist Bears”; individuals who saw the “inevitability” of a collapse in theUS Dollar, gold going to $5000/oz and commodities through the roof. Their prognostications were (and still are) that this would occur because the US government in “not allowing” theasset prices to collapse, would naturally inject so much money into the US system thatinflation would be rampant.

We could find no Financial Advisors in the entire United States who were recommending cash

and certainly none suggesting an “increase holding(s) of 90 day Treasury Bills, to account for our largest individual holding” (Parallax Letter #4 Sept 2004). Notthat we weren’t protecting ourselves against such a decline in the dollar nor being bullish onGold’s prospects. We had been holders of the metal since late 2003 and reaffirmed our positionin May 2004(Parallax Letter #1), saying “it makes sense to own the metal and miningcompanies” if for no other reason than as “an insurance policy against a decline in the value of the US Dollar.” At the time, Gold was trading at $390/oz – it is at $922/oz today. We werefortunate enough to sell it before its decline began in February 2008.What has transpired since that time is of course a decline in every index and asset class fromtheir respective highs,

except that of cash and short term US Treasuries

, with some indices (suchas the Baltic Dry Index) having fallen 90%!Median House prices peaked in September 2005, Stocks peaked in October 2007, Gold inFebruary 2008 and Oil in July 2008. We could go on, but

at this time, there is no index on earth that is in positive territory.

Well, again except cash, but who can make money selling that!? The “Inflationistas” are firm believers in the power of the governments’ tools and the partiesthat wield them; in fact it is the basis of their entire argument. They have also garnered quitean audience and are capitalizing on it, gathering fans and believers all the way to the bank, asthey hock their wares on air and TV. The mindset of inflations’ inevitability is now so pervasive,

that one cannot turn on the mainstream media without hearing about the great future of commodities, natural resource stocks and alternative energy (even though oil, having fallen-74% from its highs is sitting back where it was in October 2004!). The number of HedgeFunds, stocks, ETF’s and Mutual Funds “specializing” in this arena has ballooned

despite their performance

. You will recall our warning about this looming marketing buzz from us some timeago “…expect to hear about how we should all be invested in Commodities, hard goods, goldand silver etc. …Don’t underestimate the power of a large well funded marketing department,representing an institution that is trying to unload things it literally has to sell.” (ParallaxLetter #10 September 2008) The inflationist belief-system however still cannot explain how real estate and commodities canfall as they have.

The Trident

“

FAITH

Belief without evidence in what is told by one who speaks without knowledge, of things without parallel”. – Ambrose Bierce “The Devil’s Dictionary”

The US Government, through its’ agents the Federal Reserve and US Treasury have in theirarsenal a three headed weapon in the fight against what have up until now been theoverwhelming forces of deflation. It is our contention (and the markets clear reflection) thatthese tools are in fact worthless for anything other than buying time to calm a fearful populace.Let’s review those three prongs of “The Trident”:1: Increasing

the Amount

of Money Available to Lend to Banks2: Lowering

the Cost

of Money Lent to Banks3: Direct Purchase of Assets By the US Government These strategies have been used consecutively by the Federal Reserve over the last two years -implicitly stating the failure of the previous attempt. Over the course of the next few weeks, we will be sending you a brief analysis of each strategy, explaining just why these efforts haveproven to be so fruitless and why “

not Inflation

but Deflation

across all asset classes is and willremain the biggest threat” (Parallax Letter #2 June 2004) to our financial future. For thepurposes of this letter however, we will address the first and that receiving the most news time:1: Increasing

the Amount

of Money Available to Lend to Banks“As the credit contraction continues, we expect to hear that the sub-prime meltdown is nolonger just in the sub-prime market, but in fact spreading to almost all debt and bonds, taking with it

at least one large banking or financial institution

. (We) expect to also hear more talk of government and banking bailouts...” (Parallax Letter #8 August 2007) The sheer number of acronym-based bailout programs has reached the level of late-night talkshow fodder. Although the Fed actually increases it credit line to banks during times of financial strain to influence their borrowing

its’ ultimate goal is to influence public borrowing from banks

Contrary to popular understanding, the Fed first began their “liquidity injections”

before the market had even begun to fall.

Fully six weeks before the top in the Dow Jones Industrialaverage, over $131Billion dollars had already been made available “to stave off a potentialcrisis”. To make matters worse, on October 15 2007 within a day of the Dow’s all time high afurther $100 billion was promised in the form of the new “Superfund” designed to buy up all of the unwanted mortgage-backed securities. By this time, already $231 Billion dollars in thehole, we were minus -1 day into the bear market. The Dow went on to fall for 18 months thereafter losing -54% in the process. USunemployment levels have climbed to multi-decade highs, personal bankruptcies andforeclosure rates are off the charts. How could this be? How is it possible that the marketsshould experience such massive declines even though our publicly elected officials (and those who are not, such as Federal Reserve Board members) have spent, lent or pledged as much as$12.8 trillion trying to end the longest recession since the Great Depression? There are two answers to this question and both are surprisingly simple:

Liquidity and credit expansions are a function of confidence

without which they simply do not exist.

Credit is not money.

The Confidence Game

Any transaction that involves the promise of future payment is absolutely and entirelydependent on the lenders confidence in the other party’s ability to pay, as much as it is on theconfidence of the borrower to do so. Such trust and confidence only ever exist in the minds of optimistic and non-fearful people – evidenced by the recent disappearance of those qualitiesseemingly overnight and around the world and its’ resulting “Liquidity Crises.” You will havenoticed that every one of our political machines ardent support efforts have been focused on“restoring confidence to the marketplace.” What is lost on that effort is

the fact that confidence is an endogenous response occurring at the reptilian level of the human brains Limbic System, not something which can be imbued logically by an exogenous source

. If you don’t believe us, trystanding in the doorway of a theater packed with an audience

who just think

there is a fire inthe building, appealing to them for calm and talking about the buildings great fire safetysystem. You will be trampled.Ex-Federal Reserve Board Chairman Alan Greenspan knows this; he once called the notionthat the Fed can prevent recessions “puzzling” saying instead that what actually causes themis “human psychology.” He went further in August 1999 when he described the stock marketas being driven by “waves of optimism and pessimism” (this understanding forms a significantportion of our investment work and perhaps the one thing we finally agree with “Mr. Chairman”on!). A wave of pessimism, creates such a defensive credit market that it can derail the Fedsefforts to get lenders and borrowers to agree to transact at all, let alone at some magical “targetrate.” If individuals and corporations are unwilling to borrow, or unable to finance debt andbanks and investors are just as disinclined to lend, central banks cannot force them to do so – even at zero percent interest rates. People begin to fear the burden more than they believe inthe opportunity.

Credit is not Money