Why Stock Prices Can Rise in Phase Three Even as the Economy Languishes

by Kevin D. Freeman on May 1, 2012

The economic recovery is anemic at best with unemployment remaining over 8% and GDP growth closer to 2%. Much of Europe has already fallen back into recession. Even China appears sluggish. yet, the Dow Jones Industrial Average reached its highest level since December 2007, essentially wiping out all the losses of 2008-09. One big question is WHY?

First, it is important to understand that this was not totally unexpected. In fact, even at the lows in early 2009 we predicted that the Dow would regain 80% of its losses within two years. It did so by April of last year. In addition, corporate earnings have been very strong and can justify the gains. Still, most people wonder how the market could gain so much in light of such a tenuous recovery. The Dow Average has more than doubled in a little over three years.

From our perspective, the answer is actually fairly simple. It is all about money. The Federal Reserve has provided so much stimulus and it had to go somewhere. Estimated Federal Reserve monetary injections include $2.3 trillion in quantitative easing since the crisis. And that is just a portion of Fed activity and does not include the massive bailout and government stimulus packages. One estimate at the end of last year was that, in one form or another (much of which was very temporary), the Fed used almost $30 trillion to keep the economy alive. In terms of total longer-term commitment (ignoring overnight and very short-term funding), the tab calculated by The New York Times through one year ago was $12.2 trillion. Given the fact that our total annual Gross Domestic Product is only about $15 trillion (roughly the same size as our total Federal Debt), $12 trillion is a huge amount.

So, the government has provided a massive stimulus. And, yet the economy has responded very poorly. So where has the money gone? It has gone into the stock market, into gold, and into the prices of raw materials and energy. All of these have increased sharply since the crash. A huge amount has also gone into government bonds as a safe haven, much of it directly from the Fed. [It has been reported that the Federal Reserve is now buying something like 61% of all Federal Debt being issued. With a $1.5 trillion annual deficit rate, that is close to $1 trillion dollars each year on top of the other stimulus and bailout money.]

This is part of what we were concerned about in the original report, Economic Warfare; Risks and Responses presented to the Department of Defense in June 2009. In 2009, we suggested that there would be a $12.8 trillion Federal response which was right on the money. The DoD report explained how this would make us vulnerable to a Phase Three attack:

The concern is that the response to the recent collapse by itself will strain available economic resources for some time with large budget deficits and high inflation risks. The situation would be made significantly worse in the event of further economic attack. It is in this vein that a potential Phase Three must be considered.

Based on the assumed nature of Phase One and Phase Two, a Phase Three attack would likely involve dumping of U.S. Treasuries and a trashing of the dollar, removing it from reserve currency status. This is clearly foreseeable as a risk and even could float under the cover of a natural outcome in much the same way that Phases One and Two potentially have been hidden.

The implications are extremely serious. If the dollar were not the reserve currency, there would be a mass dumping of Treasury instruments by foreign holders. Treasury interest rates would skyrocket, further worsening the annual deficits due to sharply higher interest payments on expanding debts. The Treasury would have to raise taxes dramatically, further dampening growth or the Federal Reserve would be forced to monetize the debt, worsening inflation concerns. Pushed to the limit, could the U.S. dollar would follow the path of the German currency in Weimar Germany following defeat in World War I.

The report went on to share that U.S. Treasury debt would likely lose its Triple-A credit rating (which happened last August). It clearly stated that the major oil producers and BRIC nations would call for an end to the dollar’s reign as reserve currency. This was the “checkmate” scenario that would result in the most devastating economic warfare attack in history. We explained the process and implications in great detail in Chapter Nine of Secret Weapon. In Chapter Ten, we discussed general thoughts on protecting assets during a Phase Three attack.

Among those thoughts is the suggestion of diversification. Keep in mind that this Blog does not provide investment advice. Any reader should consider his or her personal financial situation and/or consult a professional advisor. But, it does provide general ideas in regard to Economic Warfare and Financial Terrorism. In regard to Phase Three, it discusses the need for diversification and possible ways to protect against a currency collapse. Some readers of the book were surprised to learn that stocks actually could do well, at least for a while, with a collapsing currency. The reason is that share prices of real and productive companies with pricing power (meaning they can raise prices for goods and services they sell along with inflation) can actually gain ground against a falling paper currency. If the dollar loses half its value, theoretically, the price of stocks will at least double in dollar terms.

This is not just theory. We saw it happen in practice in the currency nightmare of Zimbabwe. Even though the economy cratered (losing half of its GDP from 2000 to 2007), the government kept stimulating and printing money. The result was hyperinflation. The government even printed $100 trillion bills (which have become nice collector’s items). Unemployment reached 80%.

With a declining economy and a collapsing currency, how did the stock market respond? It actually rose dramatically. In fact, the Zimbabwe stock Exchange was the world’s  best performing at points in late 2006 and early 2007, gaining 12,000% in the course of a year. And, these gains were well above the increase of consumer prices during the period according to reports from Mises.org. Austrian economic theory, according to the Mises website, explains all of this:

If, as the Austrian theory states, money enters the economy at certain points, it is likely that a nation’s stock market will become a prime beneficiary of any monetary expansion. Fresh money enters the economy first through banks and other financial entities who may invest it in shares, or lend it to others who buy shares. Thus stock prices rise relative to prices of things like food and clothes and will outperform as long as this monetary process is allowed to continue.

This is what we are seeing in Zimbabwe. With the country suffering from Mugabe’s catastrophic policies, increasingly the only means for the government to fund itself has been money-supply growth. This has only exacerbated the economy’s problems. The flood of new money that authorities have created has caused the existing value of money in circulation to plummet, i.e., the prices of all sorts of goods to explode, some rising more than others.

As prices become more misaligned, basic decision-making abilities of normal Zimbabweans are impaired and the day-to-day functioning of the economy deteriorates. Perversely, all of this has forced the government to issue even more currency to make up for budget shortfalls and to buy support. At last measure, the country’s consumer price index was rising (i.e., the purchasing power of currency declining), at a rate of 1,729% a year.

The ZSE is growing some three times faster than consumer prices. This relative outperformance versus general prices is a result of stocks being a chief entry point for the flood of newly created money. Keep Zimbabwean dollars in your pocket, and they’ve already lost a chunk of their value by the next day. Putting money in the bank, where rates are pithy, is not much better. Investing in government bonds is the equivalent of financial suicide. Converting wealth into foreign currency is difficult; hard currency is scarce, and strict rules limit exchangeability.

As for capital improvements, there is little incentive on the part of companies to invest in their already-losing enterprises since economic prospects look so bleak. Very few havens exist for people to hide their wealth from the evils created by Mugabe’s policies. Like compressed air looking for an exit, money is pouring into shares of ZSE-listed firms like banker Old Mutual, hotel group Meikles Africa, and mobile phone firm Econet Wireless. It is the only place to go. Thus the 12,000% year over year increase in the Zimbabwe Industrials.

Our Zimbabwe example, though extreme, demonstrates how changes in stock prices can be driven by monetary conditions, and not changes in GDP. New money gets spent or invested. In Zimbabwe’s case, because there are no alternatives, it is stocks that are benefiting.

This sort of thinking can be applied to the stock markets in the Western world too. Though western central banks have not been printing nearly as fast as their Zimbabwe counterpart, they do have a long history of increasing the money supply. It forces one to ask how much of the growth in Western stock markets over the preceding twenty-five years has been created by a vastly increasing money supply, and how much is due to actual wealth creation. Perhaps stock prices have increased faster than goods prices for the last twenty-five years because, as in Zimbabwe, Western stock markets have become one of the principal entry points for newly printed currency.

Interestingly, Zimbabwe had to abandon their own currency and is now using the U.S. dollar. This has caused further problems because they have no coins with which to make change. But at least the inflation rate has slowed.

Now consider that the Zimbabwe experience, although extreme, is illustrative for what we might expect in a Phase Three attack. A moribund economy creates a demand for economic stimulus. Nearly everyone agrees that this has been the case in the United States. Then, the Central Bank ends up buying most of the debt. Again, this is what is happening. A massive government debt builds and pressures the currency. Then, the stimulus has to escalate. This is where we are now. In the case of Zimbabwe, paper money became worthless rather quickly. That has not been the case in the United States primarily because we maintain the world’s reserve currency. If a Phase Three attack happens, however, we will be a little closer to Zimbabwe’s experience than we would like.

Now, many investors have turned to cash and Treasury bonds in these uncertain times. These have long been considered the “safest” of investments. In a Phase Three attack they won’t feel quite so safe, however. In fact, they will be the targets. Those who held currency or government debt in Zimbabwe suffered the most. Now, we are not saying that the extreme of Zimbabwe will happen here even in the event of a full-blown Phase Three. But, we would certainly feel at least a portion of that pain.

Other investors have turned exclusively to gold. In Chapter Ten we discuss the role for gold in a Phase Three. It is important but not necessarily the only answer. As shown in the Zimbabwe example, gold was useful but not the only good performer. A diversified approach adds value. Keep in mind that gold has been subject to manipulations. Global central banks hold as much as $2 trillion worth of the shiny metal, as much as 20% of the world’s total supply. We wrote a Blog post on gold last year (http://globaleconomicwarfare.com/2011/07/all-that-glitters-why-gold-is-not-the-only-answer/):

Central Banks and governments can and do artificially manipulate the price. Based on World Gold Council figures, it is estimated that Central Banks own or control nearly 17% of the total supply in the world. We say estimated because no one really knows for sure. Central Banks can buy and sell in secret. They may even sell short. With nearly 1 billion ounces under their control, they can move the price in whatever direction they would like, at least in the short-term. Governments have even fixed the price to suit their needs.

In the book Secret Weapon (page 124), we said:

Gold prices could easily plunge if the largest holders of gold—global central banks—begin dumping their supplies. This happens periodically anyway and may become a common response as currencies come under fire. By the same token, gold will be a terrific investment if they don’t. And even in the event of a selloff by central banks, gold prices will rebound as uncertainty grows. So gold prices will probably prove highly volatile in the near future but ultimately move higher. This means gold should be a meaningful part of your investment mix, though not the whole mix.

On Monday, the price of gold temporarily plunged sharply before recovering. Here is the take from ZeroHedge:

For the first time in what may be ages, a phenomenon that has become near and dear to anyone who trades gold, and which at best elicits a casual smirk from those who observe it several times daily, we find that the WSJ has finally picked up on the topic of the endless daily gold slam down, where the seller in complete disregard for market disruption (because in a normal world one wants to sell any given lot without notifying the market that one is selling so as to get a good price on the next lot… but not in the gold market where the seller slams the bid with reckless abandon) ignores market depth and in a demonstration of nothing but brute price manipulation force, slams every bid down just to demoralize further buying. Naturally, that this simply provides buyers with a more depressed price than is “fair” is lost on the seller, but not on the buyers who promptly bid up the metal as attempt to demoralize buying end in failure after failure. Yet it is peculiar that today, for the first time, the intraday gold slam down has finally made the MSM. To wit: “The CME Group Inc.’s Comex division recorded an unusually large transaction of 7,500 gold futures during one minute of trading at 8:31 a.m. EDT. The sale took out blocks of bids as large as 84 contracts in one fell swoop and cut prices down to $1,648.80 a troy ounce. The overall transaction was worth more than $1.24 billion

From the WSJ:

One indicator that the transaction was a mistake was its size. At 750,000 troy ounces, such large trades are rarely conducted amid very thin trading volumes. Monday trading was expected to be quiet as market participants in China and Japan are out on holiday and many European traders are preparing for a holidays there

Attempts at manipulation are getting so glaringly obvious, not even the MSM pretends to believe them:

 “No one who has the account size and the money to trade thousands of gold contracts would do it in one transaction, that’s just stupid,” said one trader. The collateral required to purchase 7,500 contracts is about $75.9 million in cash that the trader would have deposited with his broker.

It appears that a substantial player was willing to risk $75.9 million in cash to keep the price of gold down.Our theory is that Central Banks have both the need and the ability to keep gold prices down to keep inflation fears minimized. But, they are willing to let stock prices advance with the hope of promoting a wealth effect to enhance the potential for an economic recovery. In a November 2010 Op-Ed, Federal Reserve Chairman Ben Bernanke argued:

“…higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending,” As for inflation worries, Bernanke said past use had little effect on the amount of currency in circulation and also didn’t result in higher inflation.

Now, can you understand why stock prices hit pre-crash levels today even as the economy remains sluggish? Can you understand why, despite massive monetary stimulus, gold can drop sharply all of a sudden? It is all about money!

ALL of this fits precisely with the Phase Three risks we outlined in the 2009 Defense Department report and elaborated upon in the book Secret Weapon. It is unfolding before our eyes. While we are making every effort to get the national leadership to address the risks of Phase Three, it is important for every American to prepare personally for the possibility. The next attack could be the worst.

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