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Read this.  Please.  It’s the annual report from the Social Security and Medicare trustees, and it has bad news for anyone who doesn’t already have one foot in the grave.

If you pay taxes, you will be paying more - a lot more - sometime soon.  The annual report contains all the numbers in black and white, and all that money has to come from somewhere. 

Medicare will pay out more than it brings in starting this year.  For 2008, Medicare is only projected to be $8 billion in the red, but that translates to a $16 billion increase in the deficit.  Why?  I’m glad you asked!

For years the government has been taking the “excess” revenues from Social Security and Medicare and “investing” them “in special non-marketable securities of the U.S. Government on which a market rate of interest is credited.” 

In other words, the government takes the money, writes an IOU (promising to pay it back with interest) to Social Security and Medicare, and spends it as part of general revenue.

That’s your trust fund.  There’s no money in a bank account drawing interest, there’s no gold in a vault, there’s no stock certificates.  There’s just a huge pile of government bonds (IOU’s) in the administration building.

Maybe that doesn’t make it clear so let me try explaining it this way….  You deposit $500 into an account (let’s call it a trust fund just for the hell of it) then - promising to pay yourself back - you transfer it to another account and spend it. 

You could even print out your IOU to yourself and stick it in a pretty box.  You do the same thing the next month.  And the next.  And the next….

After a year, how much money is in your trust fund?  Exactly nadda, nothing, zip, zilch, squat. 

You can’t take money out of one pocket, put it into the other pocket, and spend it.  Well, technically you can, but you haven’t saved anything.  And there’s no money left (you spent it on other things) to put back into the first pocket.

I hope that clears up the mystery of the Social Security and Medicare trust funds.  To put it bluntly, there’s no money in them.  Zip.

But the government stills owes that money to itself - or more accurately, they owe it to the designated recipients who have paid into the “trust fund.”  That’s you and me.

So where do they have to go to get the money they’ve promised to pay?  There are only three ways for the government to get money; taxes, borrowing, or printing more money - or a combination of these. 

Which one should they use?  Let’s take a quick look at the choices:

1) Taxes.  The government can raise taxes to cover their expenses.  Since we’ve run a deficit for years, I don’t think they’ll do this - which is actually the option which would cause the least pain for all. 

2) Borrow: This simply means they sell more bonds to foreigners.  We get to use their money and simply make payments on our national interest only loan.  Hey, it’s working out great for homeowners!  Right?

3)  Print more money:  Sounds, good - after all, the government makes a profit on each dollar they print.  It costs less than a cent to print a dollar bill, and it’s worth $1 - before inflation anyway.

See, there’s this little thing called supply and demand that refuses to go away.   When you make more of something without a corresponding rise in demand, each one of them is worth less.  Make too many, and each one is worthless.

That’s why we have inflation - we print dollars with nothing standing behind them.  The money supply (the supply part) rises faster than the economy grows - the demand side.   Rising prices for “real” stuff like oil, gold, wheat, and milk don’t cause inflation - they’re caused by inflation.

Read that paragraph again, it’s important.  Most people (even bankers and some of the fed board) don’t “get” this basic fact of life.

Anyway, the government will need to get the money to pay Social Security and Medicare benefits from somewhere, so my bet is that taxes, deficits, and inflation will all be a big part of the years to come. 

And if you think the deficit is big now, you ain’t seen nothing yet.  You can ignore those “pull the numbers out my ass” deficit projections from the government - because they actually assume that the money from the Social Security and Medicare trust funds are there!

I don’t know what “real” stuff will be worth in a week or a month, but gold, oil and silver will be a lot higher 10 years from now.  That’s where my money is.

gk

As regular readers know, I think that the price of “stuff” will go up long term as the dollar continues to fall - and the dollar will continue to fall long term, as our governemnt prints more pretty green pieces of paper.   So why have commodities (gold, silver, oil, wheat, etc.) dropped so much over the past 2 days?

The short answer is that I don’t know.  How’s that for sticking my neck out? 

From what I’ve read and heard, it’s a combination of two distinct factors:

1) The market had priced in a 1% drop in interest rates, and the Fed only dropped 3/4%.  So traders think that the Fed is now hawkish on inflation.  (Yup, I think it’s weird too.)

2) The US is definitely going into a recession.  That means that demand for commodities will drop as consumers spend less. 

Of the two reason given for the drop, I’m inclined to think that #2 has more validity than #1.   Not that I think that’s a bad thing!  The US needs to spend less.  The average US consumer is in over their head with debt.  Collectively we need to stop spending more than we earn - and the same goes for the US Government.  If the dollar is to rise long term, we need to stop spending more than we make.

We need to pay off old debt and stop taking on new debt for awhile.  We need to accumulate capital so that our banks don’t have to drop their trousers and bend over for money from Sovereign Wealth Funds in order to stay in business.  A little actual capital would have prevented Bear Stearns from being bought out for $2/share.  Of course, that was us (the US) doing the “buying”, but now we’re all on the hook for $30 billion of Bear Stearns’ over-valued mortgages.

I don’t know what the next shoe to drop will be - or how the markets will react to it.  In spite of the fact that CIT Group (not to be confused with CitiGroup as I did at first!) today announced that they didn’t have any money on hand and needed to borrow $7.3 billion to stay afloat, the US stock markets all went up today.  And the commodities all dropped. 

Side note:  I like the headline on the CNN article I linked to - “CIT Borrows $7.3 Billion to Repay Debt“  I’m still trying to figure out how borrowing money to repay debt works….

Anyway, despite the news of yet another financial company having problems, the stock market shrugged it off and the DJIA soared 261 points.  XLF (an ETF that tracks all the financial stocks in the S&P 500) was up an astounding 6%!  But I think that we’ll see this sector plumet at some point as this mortgage inspired credit crisis unfolds.

Remember that very few of the ARM’s and Option ARM’s that were handed out at the peak of the housing bubble (2005 through 2007) have reset to higher rates yet.  A lot of those mortgage holders are making minimum payments on their interest only loans.  This is far from over, and I’m hanging on to my gold ETF.  I’m also buying silver when I find it cheap on eBay.

In other words, I’m using this drop in commodities as a buying opportunity.  I don’t know about oil, wheat, or corn (they depend too much on the economy) but I expect to see a big rebound in precious metals sometime soon.  And when that happens, I’m betting that the rebound in precious metals will coincide with a drop in the financials.

gk

From the 400 point rally today in the stock market, you’d think that the bulls are running rampant in Pamplona.  And you may be right, however….

Stocks are still down over 10% for the year.  The highly leveraged banks and Wall Street firms are still highly leveraged.  Massive amounts of mortgage backed securities - and their higher default rates coming this year and next - are looming.  When a CDO takes a 10% loss because the home owners can’t make the payments, that translates to a 300% loss on a 30 to 1 leveraged portfolio such as Bear Stearns and Lehman Brothers.  (Citigroup is also highly leveraged.)  The $2/share Fed ”take it or leave it” financed JPM buyout of Bear Stearns still needs to be approved by shareholders.  Hmmm…. How would you vote if you owned BSC?

As I’ve written before, this unwinding of the leverage in the financial markets will take quite awhile.  The longer the Fed props up failing companies, the longer it will take to hit bottom.   JP Morgan is getting a deal only because the Fed is guaranteeing $30 billion of BSC’s “assets.”  They’re not really worth $30 billion, but the Fed took that much risk away from JP Morgan.   That’s $30 billion that US taxpayers will end up spending to finance this bailout - because the underlying securities are “riskier assets.”

 A couple of weeks ago, I thought we were headed for a repeat of the Carter years and stagflation, but it’s beginning to look more and more like we’re repeating Japan’s mistakes of the 1990’s.  Low interest rates, keeping bad debt on the books (instead of recognizing the loss and getting it over with) propping up banks with fake assets on their books, etc. 

Japan still hasn’t fully recovered from the 1990’s.  I sincerely hope that we don’t continue making the same mistakes, but today’s 3/4% drop in both the discount and Fed funds rates isn’t helping.  That only serves to drive up long term inflation, and that (rather than deflation that I’m reading about) is my long term worry.

As regular readers know, I don’t try to predict short term market swings, I simply try to stay on the right side of the market during long term trends.  I don’t know if today’s action signals a turnaround or not; my gut says no - because of the reasons listed above - but my gut doesn’t make the market move.

Regardless, I don’t see any fundamental change in the long term trends of the dollar going down, commodities (especially gold, silver, corn, and oil) going up, and the broad market (especially financials) going lower.

My feeling is that the majority on the street think that the worst news is behind us; that most people are looking for a reason to buy.  They’ve discounted all the bad news and they’re ready for another bull market.  I don’t think they’ll get it just yet.

Too many firms have too much debt.  Too many firms are leveraged enough so that a small change in the base assets (mortgages in most cases) results in a huge change to their balance sheets.  One little piece of unexpected bad news will be enough to cause a dramatic sell off.  I’m talking about a sell off big enough to trigger a halt to trading. 

I think the coming upswing in the foreclosure rate (because of all the ARM’s taken out in 2005 through 2007) hasn’t been fully factored in to the stock prices of the companies that are using these mortgages as collateral on their loans. 

When people realize how little capital is propping up these companies, share prices will drop.  The dollar will drop, and commodities will rise.  Again, I have no clue what the market will be at in a week or a month.  I don’t know if commodities will be higher a month from now or not.  But I’m betting that 10 years from now, you’ll be glad you bought gold at $1000/oz, silver at $20/oz, oil at $105/barrel, etc. 

If we really are following the deflationary path Japan took in the 90’s, the Dow may well be at 7000 10 years from now.  As it stands, buy and hold investors are down from where they were 8 years ago….  How much longer do we need to prolong the agony? Take the losses now, write off the sub prime and alt-a loans, get it over with!

Of course that’s just my opinion, I could be wrong.  :-) 

gk

Given the posts I made earlier tonight, I’ve been thinking that instead of just outlining the problems of today (and how much worse it’s going to get) I should talk a bit about what to do with your money to allow you to keep more if it during this downturn - or worse - of the economy.  So shooting from the hip, here are my thoughts.

1) Pay down debt.  If you’re one of the idiots who bought more house than you could afford, or who took out HELOC’s and second mortgages to “access your home equity” this doesn’t apply to you.  You’re toast.  You’re the problem.  For anyone who has a reasonable amount of debt - which I’ll arbitrarily define as totaling no more than 50% of your gross annual pay - I suggest paying it down as fast as possible.

When the shit hits the fan, you need to be able to live as long as possible on your savings.  Just imagine how much money you’d have each month if you didn’t have any payments!  If you’ve got a car payment, sell the freaking car to get rid of the debt and payments.  Buy a cheap car that runs good. Build up a small emergency fund by making minimum payments on everything and saving every dime you can.  You need at least one month’s worth of expenses saved up. 

Then (as Dave Ramsey would say) “act your wage”.  Live on less than you make so you can start paying off the debts.  Stop eating out, stop renting movies, get rid of your cable or satellite service, collect coupons, etc.  Cut your bills to a minimum and get out of debt.

2) Pile up cash.  Continue your frugal budget and save at least 6 months worth of expenses.  This money needs to be in your local FDIC insured bank in a simple savings account.  I don’t care about the interest rate - the object here is to save money, not grow it.  It needs to be easily accessible, so that means no CD’s or other investments.  This is your cushion for the dismal day when you don’t have a job.

That 6 months of expenses you save gives you time to plan, to look for a better job, to avoid despair, if and when you don’t have an income.

3) Fund your retirement.  Save at least 10% (and you’re much better off if you can save 15 or 20%) of your gross pay in an IRA.  Use your 401k at work if you have one.  Most employers have some sort of matching program, so be sure to contribute enough to get the full employer match.  Put the rest into a self funded IRA - you can open an account online with for as little as $50.  I use Scottrade and TD Ameritrade, but there are dozens of others.  Just do it!

I think a Roth IRA is best - taxes WILL be going up over the coming decades.  A Roth IRA is funded with after tax dollars, and the earnings are tax free.  That might not be much difference right now, but it will when tax rates hit 50 and 60%.  (If that seems extreme and alarmist to you, just wait.  I’ll have more to say later!)

If you’re putting in a big pile of money, be sure to spread it out among various large funds.  Be sure to include international funds (to take advantage of the tanking dollar) and I don’t think you can go wrong in the long run by putting a decent chunk (say 10%) into a gold or silver fund.  10 years from now you’ll be glad you did. 

Personally, I’d stay away from Asia, as the tightly regulated economy (and zero transparency in the numbers the governments provide) will eventually drag them down.  The China bubble may be popping now - although most “experts” say that the Chinese government will keep things propped up through the Olympic games later this year.

If you’re just starting out, pick a few good index funds and contribute each month.  You’ll be automatically dollar cost averaging, which in effect allows you to buy at a lower average price.

4)  Invest in staples.  No, not the office supply company (I don’t have an opinion on them) I mean consumer staples - the things everyone needs regardless of the economy or job situation.  This is stuff like food and clothing.  As times get tougher, people will spend as little as possible on everything - but they have to eat. 

Where’s the cheapest place to buy food and clothing?  Wal Mart.  As sales go down at the Gap, Dillards, Kroger, etc, look for them to go up at Wal Mart.  Target might be ok as well, but I think Wal Mart sales will grow faster - so the stock price should rise more over time.  McDonalds and other cheap fast food should also do better than average.

5)  Stuff.  I don’t have time to get into this in the detail it deserves right now, but “stuff” will become more valuable as the dollar is inflated away.  By stuff I mean things like farm land, apartment buildings, and rental property.  We’re nowhere near the bottom yet in the real estate market, so there’s no hurry on this one.  But in a year or two you should be able (if you’ve saved and invested) to pick up valuable property for 50 to 60% off today’s prices.

Look for property in retirement areas, such as Florida, southern California, and Arizona.  Look for farm land in Nebraska and Kansas - possibly areas of Texas and Oklahoma that receive adequate rain.  If it’s in a windy area, so much the better, as you may be able to lease small sections to energy companies for wind turbines.  It may sound crazy right now, but there will be fortunes made in wind energy over the next 20 years.  There’s too much to go into here, but Google “peak oil” sometime.  We’ll need energy, and wind is relatively cheap.

6) Tin foil hat stuff.  I don’t know what the price of gold or silver will be next month or next year.  But in my opinion, we are watching an epic devaluation of the dollar.  Until we stop spending more than we make (at the personal, local, state, and federal levels) the dollar will continue to lose value.  Conversely, things priced in dollars will continue to rise long term.  Things like gold and silver and oil.  It’ll be a bumpy ride, but 20 years from now, all of these will be much higher than they are today.

1/10 oz gold coins on eBay are going for about $100, while 1 oz silver coins are about $20.  Pick one and buy a coin or two every month.  This isn’t something to turn around for a quick profit - this is your insurance against a 1930’s type depression, or (more likely IMHO) hyperinflation like 1930’s Germany, or Argentina in the 1980’s.  We’re inflating the money supply faster than ever, and the law of supply and demand hasn’t been repealed. 

Remind me to talk more about inflation, deflation, and peak oil sometime.  It involves M3 and the huge unfunded Social Security and Medicare mandates - which are the major reasons the dollar will continue down.  Deficit?  You ain’t seen nothing yet!

gk