The End Of The World As We Know It… Just Not Yet!

Why You Should Be Cautiously Optimistic About Stocks And Commodities Through December

As we go to press, legions of economists are picking apart two days’ worth of congressional testimony by Federal Reserve chief Ben Bernanke — trying to divine clues about what the Fed will do next.
Frank Shostak is not one of them. “I’m paying attention to what they’re doing, not what they’re saying,” he tells us.
“What they’re doing” is revealed by a tool most economists overlook. With this tool, Dr. Shostak believes the United States is not on the verge of an economic catastrophe. Not yet, anyway. In fact, this tool forecasts a rally in both stocks and commodities for the rest of this year.
The tool is called Austrian Money Supply, or AMS.

“Artificial Forms of Life”: How Central Banks Warp Your Portfolio

Chances are you’re already familiar, if only in passing, with “Austrian School” economics.
The central insight delivered by its leading lights — Ludwig von Mises and Friedrich von Hayek — is that central bank tinkering fuels the boom-and-bust cycle. The machinations of the Federal Reserve pump up bubbles in the U.S. economy. These bubbles inevitably collapse… and if the Fed pumps up a new one, it too is destined for collapse.
Little wonder that in the wake of the dot-com crash, followed by the housing crash, Austrian economics has been turning heads in recent years — with considerable help from the two presidential campaigns of Rep. Ron Paul.
“When central banks start to push money into the system,” explains Dr. Shostak, “the money gives rise to what I call ‘artificial forms of life’:

The GDP rate of growth goes up; industrial production’s rate of growth goes up. The growth momentum of key economic indicators starts to go up, with a time lag. Whenever central bankers reverse their stance, the reversal takes place not just because of a tightening of interest rates, but merely because the money supply growth starts to decline.

Once you see the money supply rate of growth start to decelerate, you know the support for various artificial forms of life is starting to slow down.

That’s the theory… but what’s the practice? How do you track the money supply and its rate of growth? The Federal Reserve has several preferred measures that you’ve likely heard of — M1 and M2. You might even remember there was once a measure called M3, which the Fed stopped publishing in 2006 — prompting many a conspiracy theory about what the Fed was trying to cover up.
For a small cadre of Austrian School economists, all of these measures were found wanting. In the 1970s and ’80s, the late Murray Rothbard led the charge to find something more reliable. The measure he developed came to be known as Austrian Money Supply.
Over the decades, Dr. Shostak has refined Rothbard’s work, as a strategist for a major Australian brokerage; a professor at two universities in South Africa; and as the proprietor of his own forecasting firm, Applied Austrian School Economics.
Austrian Money Supply as defined by Dr. Shostak includes three major components:

• Cash
• Demand deposits (i.e., checking accounts) at banks and savings and loans
• Government deposits at banks and the Federal Reserve.

Essentially, “We take the figures published by the Federal Reserve and remove some items that shouldn’t be there and add some items that should,” he explains. “For instance, if you look at M2, they include money market funds.” A money market fund is an investment in income-paying securities; it’s not really money in the sense that money sitting in your checking account is.

“What we’re doing is rem-oving all the transactions of lending and credit, and we only add those items that are pure money, which are claim transactions, like demand deposits.”
The rate of change in Austrian Money Supply has gyrated more than Elvis Presley’s hips since the financial crisis hit full force in the autumn of 2008.
“By looking at money supply,” says Dr. Shostak, “I can ascertain the pace of damage [central bankers] can inflict. I can also establish whether we will go down or up in terms of so-called boom or bust cycles.”
So how does he use AMS to forecast movements in financial markets? “We know that financial markets are driven by liquidity,” he says. “The early beneficiaries of newly created money are financial markets. So when liquidity is starting to rise, the effect on the stock market after three or four months is there.”
Liquidity as calculated by Dr. Shostak has also seen wild swings in the last four years.

Here it’s important to make some distinctions. Money supply to an economy is like heroin to an addict: A new “fix” feels great and creates a sense of euphoria. But inevitably, the euphoria wears off, requiring an even bigger fix the next time.
“If I see the balance sheet of the Fed is actually falling right now, I think that’s good,” says Dr. Shostak, as an Austrian purist. “But from the boom-bust cycle perspective, whether it can perpetuate bubble activities, it’s very, very bad. I know that bubble activities will come under pressure because the supply of oxygen is slowing down.”

A Proven Track Record

Dr. Shostak has put these insights to good use for decades: He was among the elite class who called the crash of 1987.
In that year, “liquidity had started to fall,” he says. “And it preceded the crash quite significantly. There was quite a big fall in momentum in liquidity. Based on this, I said there’s a strong possibility that we’ll have a big fall in the Dow. This is what liquidity was showing.”
More recently, he stood nearly alone in August of last year — when Standard & Poor’s had downgraded the United States’ AAA credit rating, eurozone troubles were making daily headlines and “double-dip recession” was on many a lip.
“For the time being, the pace of pumping by the Fed remains buoyant,” he wrote. “The massive amount of money pumped by the Fed since 2008 (over $2 trillion) is starting to be funneled into to the economy by the banks.” It had the desired effect: The economy/addict got another fix and a double dip was averted.

So where do we stand now, with nearly half of 2012 remaining?

“We May Still Be OK for This Year”

As you can see from the AMS chart on Page 2, the yearly rate of growth has accelerated a bit of late — from 11% in May to 11.8% in June.
Meanwhile, liquidity growth as shown on Page 4 is also picking up pace — from a yearly 4.6% in May to 5.8% in June.
“The Fed can pump money,” Dr. Shostak explains, “but if it doesn’t go straight into the money supply, then it won’t have the effect that the Fed really wants. And this, indeed, was the case when they pumped $2 trillion, but it didn’t affect money supply that much, because you need cooperation from banks.
“Until recently, banks were quite tight in terms of lending because they burned their fingers during 2008–09. But we’re gradually noticing them start to push a little bit more money.” That’s why Dr. Shostak believes the Fed has been in no rush to implement a third round of “quantitative easing.”
“The banks could take the trillions that were pumped into the system and start lending them. If this were to happen, we could have a massive explosion in money. But at the moment, we don’t see it, only very early signs. So we will not see a collapse in the money supply rate of growth.
“Given the time lag, various measures of activity will hold up, like GDP and industrial production. We may still be OK for this year, and even a little bit next year. But from the second quarter next year, I envisage if the money supply won’t start growing faster, then we could have a relapse in activity.”
With that in mind, it’s time to dive in and see what AMS reveals about what’s in store for your portfolio for the rest of this year.

The Music Hasn’t Stopped Yet

What Austrian Money Supply Says About Your Investments During the Rest of 2012

One of the most infamous quotations from the financial crisis of 2007–09 came from Citigroup CEO Chuck Prince: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
Mr. Prince, oblivious to signs the music was about to stop, was out the door less than four months later. But in his own fatuous way, he made a valid point: As long as liquidity is coursing through the system, it’s good news for asset prices — even if the assets in question are subprime mortgage-backed securities.
Frank Shostak, in applying Austrian Money Supply to the major asset classes, sees liquidity flowing freely through year-end 2012 — pumping up stocks and commodities. For the moment, the music plays on… and if you’re feeling adventurous, there are two dance moves that could deliver handsome short-term gains.
Outlook for stocks: A steady climb up. When it comes to forecasting the movement of stocks, it’s all about watching liquidity. As of June, the annual rate of increase was 5.8%. Dr. Shostak expects that to fall for the remainder of the summer, and then reverse course through year-end 2012.

“I reckon we may still have enough liquidity to provide support through year-end,” he tells us. “So I would retain a certain optimistic note on the stock market for the time being — not for any good fundamentals, but purely from a monetary liquidity perspective.”
Using a proprietary model that incorporates this liquidity figure and several other factors — everything from industrial production to the ratio of the S&P 500 to its 12-month moving average — Dr. Shostak comes up with a remarkably bullish outlook.
It projects the S&P rising to 1,531 by December 2012 — close to its October 2007 record. And the index would rise further to 1,944 by December 2013.

The caveat here is that if policy changes, the outlook changes… and the near-term forecast has more certainty than the long-term. But while the numbers have varied week to week, the model has put out consistently bullish numbers since early June.
Outlook for Treasuries: Yields will rise… but not much. The benchmark 10-year Treasury rate hit an all-time low of 1.47% as we went to press in mid-July. Except for two brief intervals, the rate has been below 2% ever since Ben Bernanke announced “QE2” at the Fed’s annual gathering in Jackson Hole, Wyo., in August 2010.
“I reckon that yields on Treasury bonds are far too low, mostly on the notion of the ‘safe haven’,” Dr. Shostak tells us. “It’s been overdone. We should see some upward correction in terms of yield.”
But don’t look for a reversion to pre-2008 rates of 5–6%. After evaluating monetary liquidity, U.S. economic activity and the level of the national debt… the AMS model says we’re staying below 2% for the next 18 months.

Outlook for gold: $2,000 will wait. “Gold probably will retain its strength,” Dr. Shostak tells us. “If anything, it may go much higher than what we see right now, given all the turmoil in the world and also from the shift to the safety trade.”
In sussing out the future gold price, Dr. Shostak applies a proprietary model incorporating U.S. monetary liquidity, economic activity in the United States and China and the world supply of gold. This model has proven quite accurate throughout gold’s bull run the last decade… and before.

As of late June, the model pointed to a short-term spike in the gold price later this summer — close to the $1,925 record set in September of last year. That would be a big move from the price as we go to press, a little below $1,600.

Beyond this summer, the model projects considerable swings between $1,700 and $1,900 during the rest of 2012. But for now, the magic $2,000 level remains elusive.
Outlook for commodities: The bottom is in. Commodities have taken investors on a roller-coaster ride since mid-2010. The benchmark CRB index bottomed near 250 at that time… zooming above 360 in early 2011.
From that high, the index climbed down steadily to 267 on June 21 of this year. Applying AMS, combined with various measures of economic activity in the United States and China, Dr. Shostak thinks the bottom is in. Like his gold model, the CRB model has proven quite accurate going back to 1995.
As we go to press, the CRB has recovered to 299. Dr. Shostak sees the index oscillating around that level through the rest of July and August, and then jumping to 365 by December.

From there, the model projects a rise to 415 by July 2013 — a new post-2008 high. Then weakening U.S. industrial production will drag it back to 342 by the end of next year.
The AMS model can also be used to tease out the prospects for oil prices. “The key driving variables of the model,”
Dr. Shostak writes, “are the state of the U.S. monetary liquidity, the state of U.S. and Chinese economic activity and the world production of oil.”
Looking at those variables, he concludes oil prices bottomed in late June at $78 a barrel. As we go to press, it’s already back up to $88. Shostak sees West Texas Intermediate rising to $95 a barrel in December as world oil production tapers off slightly. For the first half of 2013, the model projects an oil price oscillating between $95–100.

The Long-term Outlook: Grim

Don’t be fooled by the sunny outlook Dr. Shostak has through year-end.^* The economy and the markets are like an addict. They can suffer a terrible withdrawal and become healthy again… or the Federal Reserve can keep supplying fixes until it kills the addict.
“Since the big crisis of 2008, the fundamentals have gotten much worse,” he explains. “They’re aggressively pushing money into the system. We’ve reached a stage where even Bernanke and others are saying what we’re doing doesn’t produce any effect. He said himself we lowered interest rates to zero and almost nothing is happening in the real economy. Why? Because lowering interest rates and pushing more money does not create real ‘stuff.’”
That is, monetary machinations don’t create new wealth that’s grown from the soil, mined from the Earth or manufactured into something new and useful. “Nobody talks about real stuff anymore. They talk about how to pump more money with the view that if you pump more money, you somehow create so-called economic growth.”
“To the extent that monetary printing is not effective,” says Dr. Shostak, “that shows the bottom line is getting thinner and thinner. In order to create the illusion of economic growth, you have to have something ‘real’ also. But once the ‘real’ is no longer there, we’re all doomed.”