July Strategy Meeting

At Arbor Capital Management, Inc. we’ve never been ‘perma bulls’, ‘perma bears’, or even ‘gold bugs’. That’s because we make the best effort possible to invest in ways that are appropriate considering the preponderance of information. So, for example, in December 2008 we began building precious metals positions for the majority of our clients. The reasons for this and other somewhat related positions can be complex but the decision is frequently not difficult. This month’s Strategy Meeting provides background to our December 2008 gold purchase decision as well as addresses other ‘portfolio protector’ efforts that are ongoing. We apologize in advance for the lack of eye resting charts in this issue. The material is a lot to cover in two pages.


The cover of the June Strategy Meeting shows an example of a Roman ‘denarius’ silver coin which was first minted in the 3rd century BC. By the beginning of the 3rd century AD (~215 AD), the coin had been diluted by the inclusion of more than 50% base metals in the minting process. When folks speak of the ‘debasement’ of a currency this is where the term comes from. While the dilution of silver in the coin occurred slowly over many years, Roman treasury officials apparently had a loose understanding of the long term ramifications. However, they did know what they were doing. They were creating money with lower and lower intrinsic value – but that was not known until the people began to assay their coins! While in the short term they preserved what silver the treasury had left, the long term saw a sustained and irretrievable decline in the currency and their country.

Interestingly, this ‘debasement’ of currency gained a more familiar ring when in 1400AD merchants began arriving en mass on the shores of present day China. What they found defied logic. Incredible quantities of silk, porcelain, spices and other goods were available for a relative pittance in silver or gold. What these merchants had ‘discovered’ and profited exponentially from was not due to their expert trading capabilities, but rather was the first example of the collapse of a fiat, or paper, money system. The merchants had stumbled into China when there was an ongoing race for precious metals due to a government driven devaluation of ‘paper stings’, which was the world’s first consistently and broadly used paper money. Many present day fortunes were made by being on the correct side of this seemingly random interaction between two remarkably different worlds.
In 1832 a terrific little play by Johann Goethe entitled Faust drew wide acclaim. The second part presents the emperor Faust requesting Mephistopheles (the devil) to multiply his money. The devil complies by creating a paper note and handing it over to magicians where they multiply it a thousand times overnight. The play is often referenced to explain lucidly what happened to the German economy in the 1930s.

While it’s hard to resist comparisons between these three examples and our present day systems, that is not the point. In fact Charles de Gaulle probably said it best “He who bets on governments and government money, bets against 6,000 years of recorded human history.” What is of particular interest here is why and when do systems such as these tip into oblivion.

Confusing a Liquidity Crisis With a Solvency Crisis

Since 2002 there has been a virtual debasement of the US dollar. Historically governments have made the most egregious mistakes when trying to apply a ‘known’ solution to the wrong problem. As it stands now the expansion of debt and the monetary base are being applied to a solvency crisis. These tools are known to work well in simple liquidity crises, but are proving disastrous in the current scenario.

The westernized system is based on paper money where profits and payrolls (income tax) are taxed at generally known rates. This paper money, which is not based on anything other than a promise to be redeemable, has been multiplied by 30-35 fold (historical norms for the past 2,000 years is 10-12 fold) in the USA and Europe in the form of interest bearing debt. The debt is serviced through the allocation of taxes generated from profits on private enterprise. Herein lies the problem. The USA and Europe are in one of the worst economic contractions of the past several hundred years of data. As businesses slow down or expire, so do the profits and ultimately tax streams to local, regional and national treasuries. Employees are often asked to take cuts in pay or are just fired. People who have less in their pockets tend to begin to bargain down prices for goods and services. The lower prices received leave less to run businesses with, which in turn lower profits, and thus taxes . . . and ultimately ends in full blown depression where debt is wiped out, many businesses are wiped out and few things retain significant value. In this is the chief reason why the hard working folks at the US Treasury and the Federal Reserve will do about anything if only to defer the process; it has reliably ended in catastrophe. Unfortunately these same folks are trying to cure a solvency crisis using tools that have been developed for the liquidity crises of the past 50 years.

So, the debt that was supposed to support the economy in a time of need has actually led the USA and Europe closer to the edge of extreme difficulty. In recent testimony, the Federal Reserve Chair has stated that we have ‘significant downside risks’, that the US economy may not recover for five or six years, and that the economy faces ‘unusually uncertain’ prospects. There just are not enough taxes to support the enormous and continuously growing debt. Not to mention the planned on regional and national budget deficits. The average US state is running a budget deficit of 30% of budget while the USA Government is running a deficit of greater than 40%. Somewhat predictably, the response has been to call for additional taxes. To which business owners are responding – ‘on what’? If taxes are not enough – you guessed it – more debt must be raised. In the case of the USA, that means that the US Treasury in some fandango with the Federal Reserve will likely arrange some really interesting auctions. While they may be initially met with buyers seeking ‘safety’ in the USA, there will be a point where the buyers strike because it will have become obvious to everyone that the debt cannot be repaid. When the strike occurs, the only option will be for the Treasury and Federal Reserve to buy that which they are issuing. This is where a deflationary environment turns to pure inflation.

Defending the Moat

What is one to do if they are concerned with one thing (deflation) that may become another (inflation) at some unidentified future time? One answer is to put together a collection of securities that have historically provided a safe harbor during times of uncertainty. These liquid investments also tend to increase in value during various difficult circumstances, yet exhibit low correlations amongst each other. A couple of these, and how they perform in different circumstances, are detailed in the accompanying chart.
Liquid Investments and How They Perform in Different Circumstances
While it will be difficult to anticipate the exact timing of a switch to a highly inflationary environment, there will be clear signals such as quick and sharp moves in the US$, a broad selloff of dollar-denominated paper assets, rapidly rising interest rates, and in the worst case, the US Treasury may even have several failed auctions. This all sounds rather apocalyptic. The good news is that if a reasonable portion of a portfolio is invested in positions such as those listed on this page, it will likely remain well protected in turbulent times.

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