Category Archives: Case Study


Oswaldo Lairet – Sequoian Financial Group Research


Since our start in 2005, we have sought to keep reports entertaining, even while including the charts, links, mathematical proofs or documentation supporting our opinions.  Like our 2006 and 2007 reports, this one is meant to warn you in advance of potential market trouble. This time, however, we set up a hedging structure that may help you protect your current investments from such a possibility. 

Foxy Loxy:”How do you know the sky is falling?”

Chicken Little: “Well, if you look at Chart 1, since Dec.11, the total amount in OTC (Over The Counter) Derivatives Notional (Notional), as published by the BIS (Bank for International Settlements) has been hovering near $650 trillion, the level it reached, heading into the Jul.08 market collapse!”.

Chart 1.

Foxy Loxy: “Actually, if you had included all contracts in your slightly-outdated chart, the figure would be closer to $700 trillion by Jun.12 and that´s not counting the $300 trillion that were effectively subtracted from pre-2010 aggregates through “Notional Compression” in IRS (Interest Rate Swaps) and CDS (Credit Default Swaps).”

Chicken Little: “Are you saying that, in terms of pre-2010 Notional, the Jun.12, BIS aggregate was really One Quadrillion Dollars (one thousand trillion USD)? That would be almost twice the level of Notional at the start of theHousing Credit Crisis ($586 trillion), marked by Dec.07 in Chart 1″

Foxy Loxy
: “Yes, but Notional itself doesn’t represent ON or OFF balance-sheet risk, it´s a nominal value upon which derivative-market participants compute a percentage to settle periodically, among themselves. AND …of course, it´s also “the living proof” for every fantastic legend out there, whether it´s planetary hyperinflation, gold´s inevitable rise to $5,000/oz or the “end of (take your pick) …the US dollar” …all fiat currencies” …the financial system” …modern civilization”, etc. What these sources never mention is that next to Notional, the BIS table shows GMV (Gross Market Value) and quite explicitly, the actual balance-sheet risk: GCE (Gross Credit Exposure). In fact, using the same BIS table you used to draw Chart 1, I drew Chart 2. But, note that from Dec.08 to Jun.12, while Notional hits $6 to $7 hundred trillion in Chart 1, GCE actually drops from $5 to $3.7 trillion.” 

   Chart 2.

Chicken Little: “Funny you´d mention that 25% drop in GCE, having just acknowledged that 30% of Notional magically disappeared from the aggregate after 2010! Also, while referring to the $5 trillion top in GCE, you forgot to mention howthe world´s financial system spiraled “like a headless chicken” into that amount! Oh well, I´ll fill you in: When markets were collapsing in 2008 and net settlement obligations had reached $5 trillion, banking giants had only $3.1 trillion in collateral (at market price) plus $1.2 trillion of net worth (tangible equity as opposed to Tier 1 capital). In case you want to keep as a secret “who put up the missing $700 billion” or want the whole episode to remain unreported, as themedia did “not to scare anyone”; just have one of your high-placed, furry friends reap page 20 from this sobering OECD recount.”

Henny Penny: “Sorry to interrupt Chicky pie! But, you forgot telling Foxy dearest, that Notional Compression is a lovely, but rather sumptuous manner of saying “Netting”, which in our last brush with systemic meltdown, didn’t quite work as advertised by those charming young fellows at “Sacs of Gold”! Had the Fed not intervened to save the bottoms of our beloved “netters“, just the CDS blowup at AIG (American International Group) on its own, would have many of them, furry critters from around the planet, still “netting” in bankruptcy court! Again, my apologies and heartfelt thanks for accommodating my disruption.”

Chicken Little: “Much obliged! Henny Bunch! I am glad; all of us birds are keeping track of Foxy´s unintentional slips of memory! I was about to say that if Notional is irrelevant, then: why did rollovers from Dec.07 to Jul.10 in Fed letter-soup, liquidity-programs credits reached over $16 trillion for the banks listed on page 131 of the GAO Report to Congress? And why then, is Reserve Bank Credit (short-term liquidity assistance) still rising in Chart 3, having already jumped 600% since Aug.08?”

Chart 3

Foxy Loxy:”You really are …the ultimate Chicken Little! Why would anyone add up the nominal size of rollovers? Theonly conceivably useful information from that report page is the relative amount of assistance received by each of those banks! Regarding Chart 3´s significance, just answer one question for me: Has any of you birds, experienced anything close to a 600% increase in Real Economy prices since Aug.08? By the same token, take a good look at Chart 4 and note that not even doubling public debt to $16 trillion (in red) since Aug.08, has kept Money Velocity (in green) from falling to a 67-year low! Oh, and BTW, notice how the banks you criticize so much, have actually slashed $3 trillion of their own debt over the same period (in blue).”   

Chart 4.

Turkey Lurkey: “Foxy dear, you really need to get out of the woods more often! Banks didn’t stop borrowing out of self-restraint! What keeps decimating the aggregate balance of US financial debt is brutal interbank-lending attrition! Remember that following the world´s “Lehman Momentthe TED spread spiked 500% because banks worldwide stopped lending to each other and didn’t budge until central banks intervened? Well, from that point on, interbank lending has continued to implode as much of the maturing bank debt is being repaid by central banks. That´s why Chart 4’s $3 trillion drop in financial debt, coincides with Chart 3’s $3 trillion top in Reserve Bank Credit.”

Foxy Loxy
: “Darling, you obviously skipped the chapter on Fisher´s equations in your Econ.101 elective! But, never mind, just Google up “MV=PQ=GDP” and be sure to check what each letter means! If you still don’t get it, here is what´s really happening: Banks have generally trimmed down on interbank borrowing, not only to diminish their dependence on wholesale funding, but also, because they can’t start lending massively to unqualified borrowers a la “pre-housing crisis” style, while qualified borrowers have been repaying debt and decreasing new borrowings. So, while money turnover (lending) decreases and Monetary Base (M) increases, Money Velocity (V), which is the quotient betweenthe two (turnover as dividend and M as divisor), must drop in value! In effect, what´s behind the drop in interbank lending is a drop in Economic Demand, which in turn, affects Output (Q) and Price (P) and thus, GDP.”

Chicken Little: “Wow Foxy, that´s quackery only Ducky Lucky would understand! That is…until Chart 5 confirms to him, that domestic orders (green) and imports (red) are up 26% and 29%, respectively, over their 2009 lows! So, your argument that “demand contraction” is behind the drop in Money Velocity is probably unfounded! Regarding Fisher´s monetary interpretation of Mill’s equation of exchange, you should know that it’s meaningless in the absence of interbank lending. Again, I’ll fill you in: In the centuries after the arrival of central banking, most observers had posited that fractional banking had a measurable effect on M and therefore on GDP. By the time Fisher formalized that relationship, using Mill´s formula, he realized that although you can control M, through central banking, V needs to be an unbound (independent) variable. That is possible, only if “fractional lenders” (private banks) have “unconstrained” access to funding from other fractional lenders (the interbank market).”

Chart 5.

Turkey Lurkey: “That might explain why $3 trillion of incremental Fed liquidity plus $8 trillion of incremental public debt have not been enough to outweigh $3 trillion in financial debt reduction. Obviously, public debt has none of the“fractional banking” power of financial debt, but the Fed’s money printing does! If the power of fractional banking is not working for the Fed, could it be, because much of its newly-created liquidity assistance has gone to repay the creditors of undercapitalized banks? If so, then a substantial part of incremental Fed liquidity is not available for bank lending.”

Foxy Loxy: “WHAT? What do you mean?”

Turkey Lurkey: “Well, Foxy, let’s say Bank ABC lost its capital during the credit crisis, as the value of its assets dropped below the sum total of its capital plus liabilities. But, then Lehman happened and regulators decided that, to avoid “financial catastrophe”, banking system losses should go temporarily unrecognized (A la Japan circa 1990). Since ABC’s debt was mostly short-term and from wholesale lenders, it needed to borrow funds quickly against the registered-value of its value-impaired assets. Since only the Fed can create money from thin air, this was the only entity that could lend against ABC’s assets at registered-value. Next, the Fed took ABC’s assets onto its balance sheet and lent itthe funds to repay its creditors in full.”

Ducky Lucky: “It gets even worse Foxy! By lending against the registered value of ABC´s credit portfolio, the Fed not only extinguishes interbank lending (which could still occur at some price below registered value), but eliminates thepossibility of negotiated renewals, which would preserve some of the interbank debt outstanding. Over time, as each new dollar of repayment, unwinds a geometric multiple of credit-dollars created over three decades of unconstrained interbank lending, Money Velocity approaches its historical minimum.”

Foxy Loxy: “So there is no bank hoarding of excess reserves, as much of the 600% increase in short-term liquidity assistance provided by the Fed since 2008, has gone to repay pre-crisis debt on the books of bank-creditors! In theprocess, capital markets have not been allowed to clear prices for pre-crisis financial assets, effectively suspending interbank lending and with it, the astonishing amount of leverage that fractional banking could be providing to theunderlying growth potential of the US economy.”

Chicken Little: “Exactly why THE SKY IS FALLING!”


  • Why central bank “assistance” and not inflationary expectations, is the reason behind the post-2008, price-rise in Currencies, Commodities, Stocks and all other types of “Marginable Securities”. 
  • Why Inflation and Deflation are determined by Central Banks.  
  • How RWA (Risk Weighted Assets) and other Tier 1 Capital allowances are promoting “London Whales”. 
  • The launching date for Systemic Risk Averse Fund of Funds (SRAFOF), developed after years of research on which are the key strategic, operational and legal systemic issues to hedge for.


This month, investors absorbed some important news announcements, among them: the nationalization of the last four oil fields, a 35% drop in Central Bank Reserves, the IMF-withdrawal statement and the threat to nationalize the banking industry. Below we will try to figuratively deconstruct what these messages may mean for all “three” sides of the fence.


Suppose you are subsidizing several economies at once, including yours, but their demands keep increasing every month. Unfortunately, last July your economy’s gross monthly income suddenly stopped growing and has actually been decreasing since then. In effect, you have been running an escalating deficit that only became publicly visible when you had to pull out 35% from savings, even after issuing the largest one-day debt obligation in history. Yet, you tell creditors (especially those holding your currency) you are merely switching pockets and… they believe you. But, there is another problem, in the past few years, although you repurchased every external-debt bond submitting you to SEC surveillance, you still belong to a guild you must regularly open your financial books to. How do you get them out of your hair? Simply drop out. Foreign creditors may be a bit flabbergasted at first, but not to worry, they always come around. Finally, there is the issue of how to prevent local creditors from eventually deciding to cash in their chips and try their luck elsewhere. Easy, tell them that the tellers are just part of the casino and as such they can be nationalized anytime, together with the chips. At least you forewarned them!


All this time, no matter how obvious the direction we are going, there has been little you could do. In fact as time has passed, you have accumulated the largest amount of chips you ever had, because even after it became legal to exchange chips [through negotiable securities]; converting them would cause an accounting loss. By now the size of that potential loss is so huge; it leaves you no choice but to let balances grow and accept the puny interest rates they pay you locally. To top it all, the nationalization threat just complicated things further, because, no matter how big, well-known or international your local chip-holder is, as long as your account with him is under local jurisdiction, it just became an immeasurable risk.


Not everything is bad news though, until recently, no mechanism existed that allowed you to maintain your assets free from the risk of devaluation and/or nationalization, while keeping them in local currency. Last November, our parent company unveiled a Money Market Fund whose shares are local currency denominated, but as shown in the Bloomberg price-history graph below, they track exactly the movements of the parallel rate (shown in the next graph).  This price behavior allows you to hedge against devaluation without converting your chips to foreign currency (to avoid conversion losses). But the best feature of the fund is that it completely shields your assets from intervention: No matter what laws are changed or how many banks get nationalized, they have no jurisdiction over the fund. Additionally, as in any Money Market Fund, shares are 100% redeemable and can be liquidated every Friday in any currency you want.

If you would like to know more about the fund and why the financial service providers behind it are as large and trustworthy as your local provider, just send us a note to




Collateralized Debt Obligations, or CDOs for short can be created from many types of collateral, but the most popular lately are CDOs from MBS (Mortgage Backed Securities). The idea is to create some higher risk assets and some much safer ones, slicing up the MBS into what are called equity, mezzanine and investment-grade bonds. The equity takes the higher risk, and so it earns the higher return if things go well. But if things start to go wrong, the equity is lost first…and then the mezzanine. However, even if there’s quite a high rate of failure in the higher risk end, the investment-grade bonds still get fully paid out. In this way the bankers might, for example, convert a large package of MBS into perhaps 70% investment grade bonds, 15% mezzanine, and 15% equity. It is relatively easy to sell the high-grade investment bonds. Stamped with an investment-grade rating, these bonds are sold off to mostly respectable investment institutions. But the mezzanine, and particularly the equity, are harder to sell. In effect the 30% of the mortgages in the original MBS which were deemed on a statistical basis to be likely to fail, are concentrated into what investment insiders call “Toxic Waste”.  Enter the case of the Bear Stearns hedge funds:

Last week, increasing losses and redemptions induced the lenders of two highly leveraged (at least 10 to 1) hedge funds in “structured” instruments (Toxic Waste) to hit The Street with bid lists of CDO collateral loaded with subprime exposure.  The dearth of buyers willing to pay anything close to their “marked” prices forced the sponsor, Bear Stearns to step up and loan the hedge funds $3.2 billion. However, the specter of downgrades of similar securities and a possible contagion de-leveraging of CDO exposures throughout the market initiated a stock market plunges that is continuing today.

On the other hand, we keep telling you that 10-year US Treasuries is the only investment we believe in, no matter how much of them the Chinese may be selling. Last Friday, for the first time since the 10-year treasury yield started rising from a low of 4.602% on May 11th to a high of 5.316% on June 15th, it rose as equities dropped. This is quite significant in that it confirms a new top from which 10-year treasury yields will probably drop as they have over the past 20 years. You can check this behavior in Chart1 below. Notice that the RSI Readings over 70 (se dotted line) have marked peaks in interest rates and the current reading near 90 hints at either a pause or a pullback in rates.

CHART 1. Source:

In the meantime, the slowdown in retail sales is quite visible after peaking in early 2006, and has turned south sharply following the bursting of the housing bubble. This trend will likely continue heading if retail sales follow its historical relation to the yield curve as it has in the past, as the yield curve leads the trend in retail sales by roughly two years (advanced in chart 2 below).

CHART 2. Source: Moody’s Economy.comimage002

With such a negative housing backdrop, it’s understandable why retail sales are falling and consumers are putting off their plans to purchase big ticket items. Business equipment industrial production has clearly peaked on a year-over-year (YOY) basis and lags the shape of the yield curve by one year, indicating continued weakness for the rest of 2007.

CHART 3. Source: Moody’s

Finally, if you are going to keep some Treasury securities in your portfolio, you can either buy them from us or consider buying them yourself. It is quite easy to buy Treasury securities with a broker. Just go to the Treasury Direct web site ( and follow directions. The purchases are paid for by direct debit to your current bank account.


Tuesday, when markets were down huge, Bloomberg Television inquired what we thought of the PDVSA bond plunge of the past few weeks. We pointed out that PDVSA bonds had done nothing but follow the rest of Venezuela’s external debt bonds down in price. If you look at the first graph below, you will notice that since late march, when PDVSA bonds were issued, until yesterday, Global 34´s, for instance, plunged 15% compared to PDVSA 37´s which dropped a bit less. We told Bloomberg TV there were two reasons why PDVSA bonds performed a bit better. First, from issuance these bonds were arbitraged against Global 18s, 27s and 34s on the basis of “better yield, same debtor and similar period”. Secondly, we believe the bonds have performed better because Venezuelan institutions and individuals (who are still a majority of the holders) are historically prone to hold paper losses instead of realizing them. WHAT NEXT ON PDVSA As we mentioned last Thursday, there was a great chance we would see an overall market rebound. However, the fact that your PDVSA bonds were helped by the rally doesn’t mean you are of out the woods, but we expect that good core PPI figures today and possibly good core CPI numbers tomorrow could inject additional energy to the rebound and hopefully get your bonds higher. Just don’t wait too long after that to start exiting your positions. WHAT WITH TREASURIES China may be the reason behind the swoon in Treasuries of the past two weeks. As you can confirm in the chart below, at least $12.5 billion in 10-year Treasury notes were dumped by “Fgn Official & Intl Accts” during the first week of the plunge. I am sure this week an even larger figure will be reported. In our view, these sellers are Chinese because “they have got motive”. Increasing US rates revalue the dollar, devalue the Yuan and keep the Chinese BoP growing, especially now that China’s yuan rose to a record high against the U.S. dollar after U.S. lawmakers brought up pressure on Beijing to adjust its foreign-exchange policy. Our conclusion: let’s keep checking the weekly updates of the second chart below over the next few weeks. In the meantime, we have been buyers of 10-yr Treasuries this week. As you know, we think Fed rates this year are ultimately going down, not up.


US stocks

We are probable witnessing the last stage of a major bull market in US stocks. However, knowing if this stage will take a few weeks or a few months is what matters and that information is not yet evident to us. On the other hand, there has been a pickup in economic indicators that sent the 10-year Treasury note’s yield on Friday to a nine-month high of 4.986% (from 4.857% a week earlier). Barrons this weekend mentions that China’s central bank may be shifting some of its enormous Treasury holdings from notes to bills. The other explanation, that the market is betting on a second quarter rebound of US GDP, we tackle first under our usual report format below.


Real GDP grew only 0.6% in the first quarter, but the consensus is that capital spending will bring 3% growth back, partly on expectations that corporate profits will lift capital spending. However, corporate profits, (up 6.4% in the first quarter) are sharply trending down after five quarters of double-digit growth (see first chart below). On the other hand, consumer demand has been decelerating since the third quarter of 2006 (see next chart), so neither trend supports the pickup in capital spending argument.

With respect to the May jobs number (157k up), it is being questioned not just by perma-bear economists like Roubini, Ritholtz or Kasriel, but by everyone who cared to look deeper, as shown by Justin Lahart´s excellent analysis attached below. Finally, with respect to the strong pick up in manufacturing this quarter, it is obvious this is not in response to new demand from consumers but a natural consequence of companies throttling back production after wiping out 2006´s inventories in the first quarter. As consumer spending may be about to slow significantly (as real estate and credit-card credit taps out), manufacturers may have second thoughts, but for now, stock investors can enjoy the ride, probably until July, when everyone may realize that 3% growth level is not coming back in the second half.


As shown by Mayela Armas´report below, during the first quarter of this year, we spent $1.2 billion more than we earned during each month. We covered that deficit by issuing new debt and by using up our reserve savings. To be sure, we are not overspending on investment; we are merely financing our monthly public payroll. This partly explains why our reserves are starting to decrease so rapidly, the rest hast to do with the new arrangement whereby the Central Bank never gets to see PDVSA´s dollars before they get spent by the Treasury (also noted in Mayela´s article). In another key economic analysis, Victor Salmeron shows how, not even by boosting imports ($9.1 billion during the first quarter) to a 10-year high have we been able to stop inflation (30.2% in food prices). It looks like if we were able to reach the $40 billion import figure for 2007 (projected from the first quarter), it would have to come from consuming every cent from our liquid Central Bank reserves (some $18 billion –since about $7 billion are gold) and everything we get from PDVSA this year. Yet, even then, our inflation numbers will keep growing together with the incredible growth of our monetary base (60% over the pats 12 months). As pointed out in Salmeron´s article it doesn’t look like our economy is sustainable unless oil prices rocket up miraculously, but soon, because otherwise, it might come to be like the man says: “All this aggravation ain’t satisfactioning me”

In our opinion, there are three main factors behind future parallel rates, one is positive and the other two are negative:

From the minister’s announcement last week, Venezuela is about to issue $500 million in external bonds (Bolivian), together with $500 million in TICC before month’s end. He also announced that at some point during the second quarter, then country will issue another Bono-Sur package with at least $750 million in external bonds (Argentinean and Ecuadorian) plus $750 million in TICC.

The Central Bank´s Monetary Base stands at Bs. 116.899.747 million (see, which added to Central Bank CD´s outstanding of Bs. 48.950.964,00 (see, comprises a total of Bs. 165.850.711 million that can be converted into foreign currency. Simultaneously, Central bank reserves stand at $25.156 million (see, to which we cannot add FONDEN balances, because they are spent or in the process of being spent and thus cannot sustain currency conversion. Finally, if we divide Bs. 165.850.711 million into $25.156 million, we obtained that the currency’s Implicit FX rate amounts today to Bs. 6.603/$.

As pointed out above, US real consumer spending would at the heart of the coming recessionary process and if it gets confirmed over the next few weeks or months, it will trigger a stock market sell-off as both always precede recessions. A bursting stock market will bring down with it the prices of all commodities, including oil. If oil falls, the fragile state of our LOCALY GROWN economics, as pointed out above would begin a serious downward cycle.




Given the busy circumstances posed by the last two bond issues from the government, we haven’t been able to present our economic reports as often as usual. In order to correct this, going forward, we will publish a short weekly or biweekly report with a minimum of three sections initially: THE MATRIX, analyzing the US economic scene; LOCALLY GROWN, reviewing local economic developments and PARALLEL UNIVERSE, surveying local FX tendencies. Yet, as we did in the past, every so often we will publish long reports providing historical context to help you understand present events. Without further ado, here is our first report under the new format:


The Friday Dow Jones record doesn’t bode well for our original call in November 2006 to stay away from equities. But, hang on! Take a look at the chart below. In it, Paul L. Kasriel, our favorite economist, shows why the LEI (Leading Economic Indicators Ratio) is already signaling a US economic recession, note how it (red line) has already gone below the level attained in the 2001 recession.

Thus, what you are looking at today in the Dow, S&P and NASDAQ must be the typical “Suckers’ Rally” so many times announced by Nouriel Roubini in his broken but incredibly accurate English dissertations. As claimed by Roubini, since the appearance of soft-hearted central bankers (the Greenspan era), every time the Fed is about to cut the Fed Funds rate (because of a slowing economy), equity markets go wild as they envision consumer consumption doubling or tripling as rates recede. Instead, by the time the Fed eases, things are so bad that equity markets have usually dived into a whirlwind funk they cannot recover from until the economy finally improves (two to three years later).


So if you are short, all we can say is: Short people got more reason to live!


In reference to our economy, please keep in mind that if US equities plunge, so will oil prices and commodity prices in general (yes, including gold!). Yet, this time around, we are in even worst shape than usual. For the fist time in history, we have indebted our nation by $74 Billion (see table below), while sinking our reserves to less than half that amount ($30 billion going on to $25 billion when PDVSA settles). If oil prices do drop in the next 3 to 6 months, as we envisioned they will, our economy will be the most vulnerable it has ever been since 1958, when we became oil-rent dependant and started drifting towards an increasingly unviable economic model.



Fortunately for some, Emerging Market bonds move in tandem with the US equity markets, so for now your PDVSA bonds are enjoying a good ride as the Dow reaches another historical record. Technically, that could improve even further as we get closer to the 45-day quarantine (last week of May). However, if before that time, US equities suddenly start discounting the coming recession, not only will the Dow and all other indices plunge savagely, but all emerging market bonds will follow them down, just as viciously. Thus, keep an eye out!


Finally, with respect to the FX scene, we can’t seem to get across the following historical observation: The parallel rate GOES UP after each and every government dollar-bond placement, no exceptions. Whether you call them Global bonds, “Unidades de Inversión”, “Bono Sur” or PDVSA bonds, there has never been one instance so far, when the parallel rate went down AFTER the final placement of the bonds. Thus, rather than asking the question one more time, please sit down and watch the rate soar, as always!


THE MATRIX The 88,000 jobs added in April is the smallest increase since November 2004 and a factor in lowering year-to-date average monthly increase in jobs to 129,000 versus 2006´s 189,000. This untimely trend comes at a time when falling home prices prevent US households from cashing any more home equity via mortgage debt or reaching into their a negative savings (-0.7% so far in 2007) to keep spending. As a result, the average consumer is turning to his last available option: credit cards. This would explain why U.S. Consumer Credit increased $13.5 Bln (versus $4.5 Bln expected) in March and why MasterCard´s first-quarter profits surged 70% to a record $214.9 million following a 19% jump in transactions. However, since credit card debt carries much higher interest rates than mortgage debt and is not tax deductible, it is far more expensive to finance. So even as consumers “charged” their credit card for things that until recently they could pay for in cash, they bought less of them and so major retailers such as Target and Circuit City still got disappointing March sales. What this all means is that the US could be getting closer to recession as Consumer Spending which drives 70% of the US GDP may be approaching a “cliff” as consumer credit taps out and jobs trend down.

As for the frothiness of the current stock market, please take a look at the chart below and notice that over the last fifty years, the S&P 500 has reached its peak (red arrows) 1 to 12 months ahead (7 months average) of each economic-cycle peak (recessions are in grey). So the bullishness you are seeing is typical of the last stage of all bull markets. How long will this stage last, no one knows. For instance, today we may see the S&P 500 topple its year 2000 high of 1527, if the Fed changes its tightening bias to neutral, but if the Fed stays firm, this bull market’s days are probably over.

LOCALLY GROWN As pointed out by Gustavo García in the article below, by issuing $7.5 billion in PDVSA notes and loosing $7.5 Billion (Bs. 16 Trillion) in Central Bank Deposits, the administration only managed to exchange 28-day Bolivar obligations of the Central Bank for 10,20 and 30-year Dollar obligations of PDVSA. This means that May Monetary Mass (M3) of Bs. 117 Trillion is the same as January’s but Central Bank Reserves came down from $36.6 Billion to $24.6 Billion. Dividing 117 into 24.6 yields an implicit FX rate of Bs. 4.756/$. If you add the other Bs. 18 Trillion left in Central Bank Deposits (which would be drawn upon any new issues being placed), you obtain a truer portrait of how many Bolivars are really available per dollar: 5.487

An interesting item the administration announced last week is the country’s pullout from the IMF. Analysts throughout the world take it just as a threat. Only Venezuelans can understand the announcement is for real. We have learned, the hard way, that legal and economic considerations are secondary to the administration’s long-term interests. So, yes any of the Republic’s external debt trading below par will soon enjoy a free, permanent put at 100% and all that will be required to execute it is that 25% of the debt holders (in each note) vote in favor, once Venezuela draws out of the IMF.

PARALLEL UNIVERSE Given the failure of the new dollar issues to solve the excess-liquidity problem (explained above) and thus to lower the parallel rate, the administration seems to be embarking on a new tactic: Drawing most if not all of the public sector’s deposits from private banks whenever they become due. As everything else tried before, this initiative may work to lower the parallel rate only at the beginning. In a month or two, private banks will be compelled to increase their yield rates in order to attract whatever funds are left in the wake of the public sector pullout. Such a rate increase may start a negative dynamic in both the financial and the real sectors of the economy that will be hard to pull back from, once it begins and in the end the parallel rate will rebound to considerably higher grounds.



Some of our PORTAFOLIO VITAL* clients have asked us why we keep invested in dollars (10-year US Treasuries at a 4.64% yield) in preparation for the coming US recession. Even as we explain in detail that log-term US treasuries generally escalate in price when recessions take hold, these customers wonder why we won’t take cover by purchasing Euros (German 10-year bunds at 4.22% yield) or Yen (Japanese 10-year JGBs at 1.62% yield). Their logic is sound; apart from the incredibly large US trade and fiscal deficits, the prospect of a US recession is currently devaluing the dollar. For instance, last week as real US GDP reached its lowest reading in four years (1.3%), the TWEX (The Federal Reserve’s Trade Weighted Major Currency Index) pierced 80%, its lowest reading since the index was started in the early seventies. However, while the whole world is predicting the dollar’s demise, we believe that once the US recession starts, the dollar will reach a bottom and all other currencies will start devaluing.

If you study the major-trend lines in the St. Louis Fed chart below, you will note that the TWEX moves in sync but countercyclical to the Fed Funds rate (FF). For instance, if you picked 1977 as the major first move for the FF curve (point 1in red), you can see that the TWEX doesn’t match that move until 3 years later (point 1in blue). From thereon, subsequent turns in the FF curve are matched countercyclically by the TWEX curve with the same time lag. In fact, if you follow the largest downturns of the FF rate versus the TWEX as pointed by the black-arrow pairs (2-3, 6-7 and 10-11) you will notice that dollar devaluation essentially takes 3 to 4 years to discount lower FF rates. Conversely, dollar revaluation takes about the same time to kick in after higher FF rates are set. Thus, no matter how big the US trade and fiscal deficits are now, point 11 red in the chart (June 2004) indicates that we are about to see point 11 blue at some point from June 2007 to June 2008. Point 11 blue will be the bottom from which dollar revaluation (the broken blue line to point 12) should come. Another thing to notice from the chart is that dollar revaluations (blue segments 1-2, 3-4, 5-6, 7-8, 9-10 and imminently 11-12) means that as US recessions (or slowdowns) pass on to the economies of the rest of the world, their currencies and commodity prices devalue.

On the other hand, “Cool economists” believe the dollar is holding its value only because foreign central bankers (meaning Asian CBs) continue propping it up so that American consumers keep buying their exports. However, the reality is that since 2002 (blue point 10), the dollar has fallen 36 percent against all the major currencies, yet, until recently, US consumer spending (financed by the housing boom) had sucked in goods, services, oil imports and investments from other parts of the world as if higher prices didn’t matter. Only now, after the housing bust, US consumers are about to start behaving as anyone whose buying power just evaporated by 36% and unfortunately, the first who are going to understand the difference this summer (versus the past 3 summers) are oil exporters like ourselves.

Furthermore, regardless of the housing boom, the 36% dollar downfall has already narrowed the US trade gap by making imports more expensive and exports cheaper: For the first two months of 2007, the deficit with the European Union was less than $13 billion, down 28% from a year earlier. With Canada, the deficit fell to below $12 billion from more than $16 billion and in February, the U.S. posted a surplus with Britain for the first time since 2001. China, of course, is a different story; by continuing to exchange their hard goods for 36% less value (the yuan is pegged to the dollar) they are basically subsidizing US consumers: A dynamic that creates Chinese growth and jobs, but inflates Chinese asset prices and diminishes their consumer purchasing power. However, now that US consumer spending is about to implode as a consequence of the housing bust, not even the Chinese subsidy may help. That will put a temporary halt to Chinese economic expansion at some point by the end of this year or the beginning of next, but its severity will depend on how long it takes for the US economy to recover from the coming recession.

*PORTAFOLIO VITAL is one of Sequoian´s most complete investment products. It allows customers to invest their long-term funds in a conservative but well-informed manner with a view to benefit from our team’s market experience and financial knowledge. If you would like more information please call Nelly Parra at 212-276-4862 or write to



Ben Shalom Bernanke is probably one of the smartest people on earth. A summa cum laude from Harvard, PhD from MIT and ex-full time professorship form Stanford, prepared him well to sort out the economic mess inherited from another summa cum laude economist, Alan Greenspan. However, no matter how bright or knowledgeable he may be, today he is a prisoner of history and can only watch as events unfold on his watch. In our public presentations (the next one is tomorrow), we spend time explaining why this is the case. One of the key findings we show is how the combination of Paul Volcker and Alan Greenspan may have largely determined the economic fate of the world over the last 20 years and a few more to come. Let’s try to summarize why as briefly as possible:

After the US suspended gold convertibility in 1971 (incidentally, Nixon imposed this one exactly like Chavez did on January 8th –completely on his own), which resulted in the collapse of the Bretton Woods system, the US economy entered a severe inflationary spiral that kept growing until Paul Volcker, appointed Fed chairman in 1979, started one of the longest and harshest campaigns ever seen to reduce inflation by sending the Fed Funds (FF) rate as high as 20%. After two recessions, one of them quite nasty (1982-83), Volcker turned the Fed to Greenspan with an economy that had become incredibly more efficient, generating higher GDP on much less liquidity.

However, barely 2 months after Greenspan took over the Fed in 1987, the stock market in its rush to discount the good times to come, grew extremely high and crashed by 22%. The steepness of the fall brought the US economy near systemic collapse, so in addition to reducing the FF rate, Greenspan was forced to bail out the largest US stock market intermediaries and to publicly stand behind them. After markets completely recovered, Greenspan started increasing rates again, perhaps causing the 1991 recession. That’s when he must have said “No more” and over the following 15 years proceeded to bring about the largest increase in absolute liquidity the world has ever seen.

From August 1990 until he left the Fed in 2006, Greenspan kept the FF rate on average at 4.2%, 50% lower than the 8.8% average that was necessary to transform the inflationary, post gold-standard US economy into a lean growth engine (from Aug. 71 to Aug. 87). The low rates brought a mountain of liquidity to finance the massive consumer demand that luckily found a timely counterpart in China, India, Eastern Europe and the rest of the economies whose exports to the US, whether manufactured or extracted, rose astonishingly high over the past 15 years. To top it all off, currency carry trades, financial derivatives and other intricate leverage schemes multiplied Greenspan-fed liquidity, leading to the asymptotic price behavior we have seen over the last four years in all commodity charts, from oil to cooper, to iron, to gold, etc.

However, by dropping rates to 3% by April 1992 and to 1% by June 2003, Greenspan sowed both the technology bubble and the housing bubble. The first one eventually wiped out 70% of NASDAQ capitalization, but these huge losses were quickly reversed by the second one. Now that the housing bubble is exploding, it will eventually wipe out multiple times the amount of capital originally saved, but the larger problem is: this time a precipitous FF rate drop won’t save the American economy from crashing. In fact, if Bernanke doesn’t wait until markets endure a large enough correction before he starts cutting the FF rate, dollar purchasing power WILL implode. For a taste of what would happen, just consider how fast the Yen has strengthened since Feb. 27 (5% up) as Yen-Carry trades unwind. Soon, Bernanke will have no choice but to watch personal consumption erode and unemployment climb, just as he watched production fall apart without even telegraphing the possibility of a rate cut to the markets.

This week, the world’s eyes will be fixed on the February employment numbers (Friday at 8:30 AM). As you know, since December, we have been waiting for unemployment to start rising sharply at some point this quarter or next as confirmation of the start of the recession. Well, so has everyone else, especially since last week’s Initial claims for unemployment benefits rose to 338K and the four-week average rose to 2.547 million, a sure sign of creeping employment weakness. Should February Nonfarm Payrolls decrease sharply below 100K, all hell will break loose. Should they not, we may see a steep rebound from the losses being experienced at the moment.

In the meantime, quite a few numbers are coming out this week that will keep volatility rising. As you can see on the SPX chart below, after the market broke through the top green line last fall, 1360 became support, but as the market broke that green line again last week at 1400, 1360 became support again (top dotted red line). However, if news surprises keep popping up like today’s announcement on New Century’s federal criminal probe and HSBC massive charges (old news), the SPX may drop straight through 1360, but hopefully rebound at 1330 (mid dotted red line).

Finally, this week, if no major hedge fund blows up or more bad news comes out, the SPX should stay between 1330 and 1400. Yet, should we get bad employment numbers on Friday or should the Yen-Carry Trade continue to unwind, the SPX correction could take us below support at 1270 (the bottom green line). In any event, we doubt the SPX reaches below 1150 (bottom dotted red line), that would represent a 20% correction or what is called, the start of a bear market.

If you are one of our Portfolio Vital clients or have been following our bulletin’s advice, your 10-year and 30-year treasuries have just returned some very handsome profits. Last week, the price of the 4 5/8 percent treasury due February 2017 rose 1 12/32 to 101, or $13,750 per million of face value. Last night long-term treasuries went up even further and yields are presently at 4.45%, but we believe they may drop further in the weeks to come, so If you haven’t done it yet, consider switching a good part or your portfolio by to long-term treasuries now.

In a few months, once a majority of the bad news has been discounted, we will start switching out of long-term treasuries and back into the markets. If you are one of our clients by then, your investments will benefit from our timing, operational precision and low costs. We believe diversification can only become optimal if besides choosing the right asset classes, you choose the right time to enter them. In other words, diversification without market knowledge doesn’t work or works very slowly at getting you were you want to be financially before you are too old to enjoy it. If you have any questions, please bring them to Hotel Tamanaco presentation tomorrow. Hope to see you then!





That’s the question many of our clients are asking since they need to decide whether to cover their FX exposure now or wait to see if the parallel rate drops further. Sadly, the answer is: Yes, 3500 is coming back. Not only for the seasonal reasons presented in last week’s report, but mainly because this years phenomenal growth in Bolivar Monetary Mass already duplicated the amount of international reserves in Central Bank. This is the fundamental difference between this November’s 3500 and the last time the parallel market reached 3500 in March 2004.

The graph below shows the behavior of four key variables over the past 30 years: Bolivar Monetary Mass (Red) in dollar terms, International Reserves (Green), The Implicit FX rate (Yellow) and the Official FX rate (blue). The Implicit FX rate is the result of dividing Bolivar Monetary Mass into International Reserves. The theory behind this number is that the only dollars truly backing Bolivars are those available at Central Bank. Any stories you hear about FONDEM´s supposedly colossal reserves and how they must be added to Central Bank reserves in order to compute the “true” amount of reserves is bogus.

The fundamental difference between Central Bank reserves and any monies held by FONDEM is that Central Bank is constitutionally bound not to spend them, whereas FONDEM can and does what it wants with its monies. In fact, up until today no one knows how FONDEM spends its money and how much of it is still available. This crucial difference is what motivates the government to transfer Central Bank reserves to FONDEM repetitively. Hence their announcement last month that before year end another $5 to $6 billion will be taken from Central Bank reserves and transferred to FONDEM, on top of the $6 billion transferred in 2005 and the $4 billion transferred early this year.

Having cleared that concept, let’s dive into the chart. As you can see there, in March 2004, the Implicit FX rate (yellow line) was way below the Official FX rate (blue line). That meant that however high the parallel market went, it was destined to retreat down to a level consonant with the underlying stability of the monetary system. That stability was founded on the fact that Bolivar Monetary Mass (red line) was growing below the growth rate of International Reserves (green line). However, as you can see on the chart, since late 2005, Bolivar Monetary growth started exceeding the growth of International Reserves, up to the point that today the Implicit FX rate has become twice as large as the Official FX rate. The other two times this occurred is shown on the chart where the blue line was forced to converge upwards to the yellow line (1983 and 1996).

So that’s where we are at now, and this is partly the reason why this week the parallel market already went Bs. 120/$ higher than last week. In conclusion, if you compare this November’s 3500 to March 2004´s 3500, the difference is the laws of physics and every retreat will be met with an upward bounce, as economic agents recognize the underlying imbalances in monetary stocks.



Please do remind us strongly, if we ever utter those four words. This phrase is the curse of all wishful thinkers. It’s the ultimate hideaway used by optimists trying to sell you a story. They will always find an argument and an audience to discredit the past and “prove” why the historical norm doesn’t apply “this time”.

In our public presentations and in these reports, we are keen on showing historical records for whatever assertions we make. The reason for that is that after 25 years in the financial arena we have come to respect the law of the patterns. This is why we retrace 30, 50 and even 500 years to look for the patterns that prove the norm rather than the exception.

This is why we review the last 30 years of Venezuelan FX rates and come up with the recurring 10-12 year cycle of revaluation & devaluation that is coincident with the cycle of world oil prices. And the, we stubbornly trace back the oil price cycle since it was “discovered” in 1859, and note that it has been largely determined by the U.S. economic cycle, which itself has always been preceded by several irrefutable statistic events: among them an inverted yield curve and a plummeting “New Housing Units” curve.

The chart below, taken from the St. Louis Fed, traces the behavior of these two stats since 1962 in juxtaposition with oil prices (black line). Notice how the red line (new housing units) plummets ahead of every recession of the last 40 years (grey columns). Simultaneous with every drop of the red line, notice how the green line (3-month bond yields) topples the blue line (10-year bond yields) ahead of every recession –the toppling is indicative of an inverted yield curve-. Also note that the only exception to the rule occurred in 1966. The year after Lyndon B. Johnson’s decided to escalate the Vietnam war from 20,000 troops in 1964 to an eventual half million (by 1968). The corresponding increase in defense spending after 1965 stopped the imminent recession from materializing in 1966. Now that is quite an exception. Why would anyone think the inverted yield curve event that’s been happening since July 17th this year and the plummeting New Housing Curve that’s been occurring since October 2005 until today would equal the 1966 circumstances? If anything, it would be the opposite, the US seems to be getting ready to decrease its military presence in Iraq, not escalate it, thus military spending should trend down. Just by reading yesterday’s bipartisan road map “The Iraq Study”, you can tell what is coming is military reduction, not escalation.

Also with respect to our FX hedging advice of yesterday, we base our readings on the same historical principles as above: Every one of the years we have been under FX controls has encountered the same December-January behavior: parallel FX rates go up significantly. Additionally, every post-electoral February since 1983´s historical devaluation has been met with increasing fiscal deficits that have always been “cured” with some form of devaluation.



Several readers have asked us for a strategy regarding their currency exposure. As always, rather than making predictions, we let the charts teach us their history lessons. If you visit, you will find CADIVI´s monthly summary of daily average dollar amounts “authorized” and “delivered” at the Official FX rate (2150) since January 2005. We took their figures at face value and drew the red line in the chart below. Then, we plotted the month-end closing FX rate for both the Official and the parallel FX rates from January 2005 and drew the green lines on that chart. However, to plot the FX rates we decided to invert the right axes (instead of going from 2000 to 3000, it goes from 3000 to 2000), in order to see if the green lines would move in synch with the red line. In other words, we wanted to see if the parallel FX rate goes up (Bolivar revalues) when CADIVI authorizations increase, or if it goes down (Bolivar devalues) when authorizations decrease.


As you can see, the lines don’t correlate very well. For instance, notice how, from January to March 2005, the parallel rate stayed near 2800, although CADIVI approvals doubled from $41 million to $81 million during that period. You must remember that at the time, CADIVI had practically frozen approvals since December 2004 and everyone knew the Official rate would be devalued because the outgoing minister of finance had announced it. Well, in April 2005 the government issued yet another dollar bond (Global 2025) on top of the one it had  issued, in December 2004 (Global 2034-part 2), and that’s when the parallel rate finally retreated to 2600. Notice that afterwards, CADIVI kept pumping over $80 million in daily authorizations, which kept the parallel market improving until June 2005, when CADIVI approvals went down.

From August to October 2005, Venezuelan importers launched their seasonal dollars-at-any-cost chase to fill their expected December-demand. In the graph, you can see how this massive yearly episode pushes both the parallel market and CADIVI in opposite directions. This is exactly what is happening now. The only difference this year is that we haven’t had dollar bond auctions. Instead the administration started a new scheme that allows it to assign dollar bonds discretionarily. In 2006, the ministry has been assigning Argentinean and other bonds weekly to a chosen group of banks that were supposed to automatically sell them to the rest of us. However, as it usually happens when distributing any priced item without an auction process, this year’s methodology seems to be causing hoarding. In turn, importers had no choice but to turn in mass to the parallel market and bided it up to the levels seen on the chart, so they could fill their December orders.

The importers cycle is highest from August to October but it continues, at a lower pace, until the last week of December. For instance, on the chart, notice that last year, due to the extra-seasonal demand for dollars, the parallel market jumped when the November bonds (Global 2016 & 2020) were announced but it immediately started crashing a day later. This year, the November through December dollar-demand will be much higher than 2005´s for two reasons: First, the historical uncertainty posed by every post-electoral “February” in Venezuela, and second, the extremely sharp oil-price drop currently affecting Venezuela’s future dollar income. Hopefully, before December, the authorities may recognize the gravity of the situation and come up with another dollar bond auction. Otherwise, in spite of their weekly discretionary bond sales, we may see much higher parallel rates in November.

Since importers demand is starting to pass its peak, parallel rates are slowly coming down this week and upon seing that, Argentinean-bond hoarders are starting to sell. Since no one, but government insiders knows if a dollar bond will in fact be issued, this may be the time to start covering part of your currency risk: nothing higher than 10-20% of the total amount you intend to convert. Then, if by the last week of October, the FX rate keeps on dropping, try to cover another 10-20%. If not, you should think of converting a larger amount, but not larger than 50% of the total. Finally, with the rest of your funds do the following:

  1. Wait for a dollar bond announcement, if it occurs, convert everything on the same day of the announcement.
  2. Prepare for the no-bond alternative by picking a rate level now (together with your senior decision makers) over which you wouldn’t want to convert. Then tell your broker to automatically convert your funds at that level if the market hits it.

Above all, we recommend caution; it won’t hurt you to hedge and then wait to see how things develop.  This course of action is even more relevant now that we developed a conversion alternative that allows you to hedge without holding foreign currency, without paying hedge costs and without loosing weekly access to 100% of your funds plus interests. Please contact us at if you would like to know more.


We developed the combo-chart below from data published by the St. Louis Fed ( Both charts in the combination represent US economic history since 1962, including recessions (grey spouts). The bottom chart shows that since 1962, each US recession was preceded by the toppling of the 10-year treasury yield (blue line) by the 3-month treasury yield (green line) and by drastic falls in either housing starts (red line) and/or oil prices (black line). Please note also that right now, the green line is again toppling the blue line, while both the red and black lines are dropping sharply. Upon seeing this, you probably agree there is a high probability we will have another US recession. How soon? Based on the average time lags shown by the charts, the US recession should start by the first or second quarter of 2007.

Yet, no matter how irrefutable historical facts are, you still see a multitude of analysts and journalists arguing against them. Unfortunately, once again, they will convince many of you as thy did in Q3, 2000, when, despite a severe crash in the NASDAQ and an inverted yield curve, investors intently bid up the S&P 500 to all-time closing highs. Today, despite a severe home builder crash and an inverted yield curve, it is the Dow Jones Industrial Average that is reaching new all-time highs.

Soft-landing advocates and their followers will have you believe the recent drop in oil prices and in long-term interest rates is promoting a rebound in consumer spending, when in fact it is a continued drop in spending that is causing these variables to plunge. Oil prices at $60 are so high that their inflationary after-effects are still trickling through the economy and causing the Fed to worry about inflation. Together with a busting housing market and the delayed effects of the increase in the Fed Funds rate, high oil prices will continue to push US consumers to spend less, not more.

Lacking the simple knowledge written by history in the charts below will keep feeding new clients to the marketing machine of the world’s many financial service providers. They are in good company though, every OPEC minister who believes that by cutting oil production, he will reverse the direction of oil prices, doesn’t realize his actions guarantee a harder and longer recession.


In order to understand what may happen to FX rates in 2007, below, we attempt to abbreviate Venezuela’s last 30 years of monetary history through three graphs. Figure 1 points to the perpetual reality behind our economic performance: oil prices. In turn, Figure 2 shows how oil prices have affected Bolivar monetary mass (M3), and finally, Figure 3 shows what happened each time M3 grew unconstrained as oil prices climbed. Please refer to the description under each graph for exact details.

Even if you superficially review these graphs, you can see that, just like the years 1983 or 1996 were nothing like the “increasing-oil-price” years that preceded them, 2007 will be nothing like the past three years. From the first graph, you can tell the Negative Spread (explained underneath it) taking place now is essentially heralding a downturn in US economic activity that may turn into a full recession as GM, Ford, Delphi and other transport-sector companies continue massively laying off workers as they always have before or during previous recessions. From that same graph, you can see that oil prices most probably will return to the $25-35 per barrel level they had before starting their latest foray to the high seventies.

On the second graph, we are confronted with the stark reality that, as oil prices drop, we will be producing 1 million barrels less per day (-30%) than we did ten years ago, but our population is nearly 5 million people (+20%) larger. From that graph, you can also tell that our propensity to convert every oil-revenue dollar into Bolivars is what fires up our monetary supply every time oil prices soar.

In the last graph, you can see how it is that Venezuela ultimately corrects its monetary excesses. As international reserves are the only real backing Bolivars have, when the dollar value of Bolivar monetary mass (M3) doubles or triples over the dollars in reserve, the implicit FX rate (M3 divided by reserves) skyrockets over the value of the official FX rate. Eventually, as oil prices descend, monetary authorities have no choice but to align the official FX rate to an equal or higher rate than the implicit rate. For next year, the graph projects that implicit FX rate to be near Bs, 5000/$. However, should the authorities choose not to align the official FX rates to that level, there probably won’t be many dollars available at the official rate. In that circumstance, most of the private economy will be forced to access the “permuta” market and consequently bid its rate up to the level of the implicit rate.

We believe that an exceptionally large portion of the $22 billion excess trapped in Bolivars in the Venezuelan banking system (roughly equal to the Bs. 47 trillion in CDs issued by the BCV in August) will be caught by the next maxi-devaluation. Our opinion is that it will be very hard, if not impossible for corporate managers to believe the story told by the historical graphs below, given the rather easy availability of preferential dollars obtained by them since 2003 (only affordable through high oil prices). In the mean time, monetary authorities take advantage of their self-created, excess-liquidity conditions by selling Bolivar bonds at yields of 6% p.a, fixed for up to 14 years (TIF 2020). Similarly, private issuers are racing to come to market over the next 3 months with over Bs. 600 billion in 3 to 5 year issues. You are welcome to join the party! Besides being specialists on hedging currency risk, we are experts at issuing securities.


Fig. 1. From 1969 until 2001, the yield of the 3mth Treasury (red) exceeded the 10yr Treasury’s (blue) in six occasions (the occurrence is called a Negative Spread). In each instance, the Negative Spread preceded a US recession by six to 18 months. Coincidentally, each recession brought international oil prices (black) down to the levels they started climbing from before the recession. Since July 17th of this year, the Negative Spread has reappeared for the seventh time over 37 years (see arrow). If a recessionary period follows, Venezuelan oil prices may drop to the levels where they started from in 2004 ($25-$35/ barrel)


Fig. 2. Over the past 30 years, Venezuela’s oil production (gray) reached a maximum of 3.4 million BPD in Dec-97, but it’s down today to 2.4 million BPD. However, monthly oil revenues (green) tripled since 2004 as oil prices tripled, but since we converted them all into local currency, our monetary mass (red) more than quadrupled since 2004 (includes BCV absorption).


Fig. 3. Over the past 30 years, Venezuela’s monetary mass (red) has experienced three periods of extremely high acceleration that took it outrageously beyond its hard currency backing (green). In each instance, the Official FX rate (blue) has been deliberately kept below the implicit FX rate (yellow) for political reasons, until eventually allowing the former to match up with the latter


A paper titled “The Yield Curve and Predicting Recessions”, by Jonathan Wright, research economist at the Federal Reserve, describes the probability of an economic recession as a function of the spread between the yields on 10-year and 3-month U.S. Treasury securities (see However, Wright and other researchers suggest that in addition to the spread it is helpful to look at the overall level of short term interest rates. Wright’s Model uses both the spread (S) and the funds rate (R) to calculate the probability, where F denotes the cumulative distribution function for a standard Normal variable, so: Prob = F(-2.17 – 0.76 x S + 0.35 x R). The probabilities implied by different values of S are summarized in the table below:

Probability of recession within the next 4 quarters (in percent) as a function of both the spread between 10-year and 3-month yields and the level of the fed funds rate.

Spread FF = 3.5 FF = 4.0 FF = 4.5 FF = 5.0 FF = 5.5
1.00 4% 6% 9% 12% 16%
0.75 6% 9% 12% 16% 21%
0.50 9% 13% 16% 21% 27%
0.25 13% 17% 22% 27% 33%
0.00 17% 22% 28% 34% 40%
-0.25 23% 28% 34% 41% 48%
-0.50 29% 35% 41% 48% 55%
-0.75 35% 42% 49% 56% 63%
-1.00 43% 50% 57% 63% 70%

Thus, right now, it would seem that the probability for recession in the US is less than 48% (if you look at the graph below, S is between -0.25 and 0.0). But, if you go back forty years on this measurement, you will notice that every time the spread has dropped below zero or by more than 3 percent from its previous high, there has been a recession (gray line).


In our opinion, it is likely that we are getting to the point where a recession may be in the cards. This would add influence to the argument, first posted in our “NEWS FROM DUBAI” article of July 6th, that oil maybe about to start an important correction. Based on the graph posted then (DSE moves precede oil-prices by 2-3 months), we might see oil prices dropping substantially.  As expressed in today’s WSJ (article below) by Mr. Philip Verleger, an independent energy economist who heads PK Verleger LLC, “If the economy slows and demand for petroleum eases, investors will scramble for the exits.” Medium term, though, we do not agree with Mr. Verleger, we think 2007-2008 may be years to reposition in oil, once the markets correct as expected.


Single-Digit or $100 Barrels?

The Answer Probably Depends

On Impact of Investment Flows


August 21, 2006; Page C1

A nearly 8% decline in crude-oil prices in the past two weeks, and the market’s flirtation Friday with prices below $70 a barrel, is reigniting a debate: Is there an oil-price bubble, and could it burst?

Underlying the question is an argument about what has been a bigger factor buoying oil prices in the first place: record investor inflows into commodities or supply-and-demand fundamentals.

The answer will go a way toward setting the tone for broader financial markets and the economy. High oil prices have affected everything from consumer spending, to the stock and bond markets, to interest-rate increases by the Federal Reserve to curb inflation.

If oil continues to slide even as international tensions flare, “it is going to be much more difficult to argue that crude oil remains a bull market and that all dips are buying opportunities,” says Tim Evans, a futures analyst with Citigroup Inc.

Crude-oil futures contracts for near-month settlement on the New York Mercantile Exchange surged more than 33% over nearly six months, hitting $76.98 a barrel on Aug. 7 before falling to a two-month low Thursday of $70.06. After an intraday low of $69.60 Friday, near-month crude-oil prices bounced back to settle at $71.14 a barrel on news of a storm developing in the Gulf of Mexico.

As prices soared earlier in the summer, oil analysts and economists argued that global economic growth, tight refining capacity to process crude oil into usable products like gasoline, and geopolitical tensions could push crude beyond $80 a barrel, even as oil inventories remained high in the U.S.

These specialists dismiss the notion that crude’s recent pullback is a turning point. Instead, they point to short-term factors that have pushed oil lower, including a move by Goldman Sachs Group Inc. this month to reduce its exposure to gasoline in the widely watched Goldman Sachs Commodity Index.

In addition, they say BP PLC’s Alaska pipeline shutdown had less of an impact on oil supplies than initially feared. Seasonal factors also play a role, including a lighter-than-expected hurricane season, the ending of the summer driving season and the expected drop in demand for crude from refineries as they shift operations for winter-grade fuels.

“Until I see massive spare capacity in Saudi Arabia or new refining capacity in Asia or the Middle East, the world will still be susceptible to the same exogenous shocks as it has been in the last three years, whether the shocks are from civil strife, geopolitics or weather,” says Edward Morse, chief energy economist for Lehman Brothers Holdings Inc. He says global demand remains robust.

Still, an increasing number of analysts and traders predict that oil prices are poised for further decline. They say the market has become somewhat inured to geopolitical uncertainty — reacting to the news of another kidnapping of oil workers in Nigeria, for example, with a 25-cent jump, when the price used to move $2 on such events.

Traders say prices are high considering some key supply-and-demand indicators. Mark Vonderheide, global head of oil trading for Deutsche Bank AG, points to a large buildup in world inventories. Traders are “balancing the fundamental weakness of this market against the probability of some global event or continuation of global events in Nigeria, Iran or Venezuela….Barring an event, it’s very likely we’re headed for much lower oil prices.”

Oil prices may at least level off a bit, some energy researchers say. Larry Goldstein, president of the Petroleum Industry Research Foundation, calls the recent slide in prices “a move to a new equilibrium level, not the start of a major selloff.”

Some increasingly vocal bears are making stark forecasts. Sanford C. Bernstein & Co. energy analyst Ben Dell is calling for $50 crude in early 2007. Philip Verleger, an independent energy economist who heads PK Verleger LLC, predicts in an interview that oil could hit the single digits in the next three years.

In particular, they say, the market hasn’t fully grasped the import of investment flows into oil futures and the danger that a slowdown in those investments could cause a lull or even a panic in the oil markets. Institutional money managers have $100 billion to $120 billion in commodities, at least double the amount three years ago and up from $6 billion in 1999, says Barclays Capital, the securities unit of Barclays PLC. Mr. Dell estimates such investors have $40 billion invested in crude alone.

“Too much money has been chasing too few commodities futures,” Mr. Verleger argues. He says that as long as economic growth continues, oil could climb as high as $100 a barrel in the fourth quarter of 2007. If the economy slows and demand for petroleum eases, investors will scramble for the exits. “There is no floor. The price could fall to single digits. It won’t stay there for very long, but it could fall.”

Mr. Verleger’s dramatic forecast isn’t shared by most analysts. Still, the impact of investment flows into commodities has taken some in the oil establishment off guard. As oil prices steadily rose to triple their levels three year ago, ministers from the Organization of Petroleum Exporting Countries, oil-company executives and others have periodically argued that the fundamentals of supply and demand didn’t justify the increase.

Deutsche Bank’s Mr. Vonderheide says the inflows into index-related oil investments are a big-enough factor that, if they slow, the market could fall further.

In the days leading up to and just after Goldman’s Aug. 9 announcement that it was reducing its allocation to gasoline contracts in its index, gasoline futures took a dive.

Write to Ann Davis at and Bhushan Bahree at


As WTI rose over $72/barrell this morning on Norwegian strike fears and tightness in US gasoline summer supplies (see first article below), you may recall that our last analysis regarding oil carried a graph evidencing that while prices are reaching their historical high in nominal terms, oil suppliers seem unable to increase production. Our first reaction then was to think that suppliers are facing a production limitation of some kind. However, if you look at the facts, the opposite picture could emerge:


  1. The World SPR (Strategic petroleum reserve) is currently close to its highest value over the past 20 years: 1.4 billion barrels
  2. The physical (“wet barrel”) market is awash in oil. Saudi Arabia, the world’s top exporter, had to cut production from 9.5Mbpd down to 9.1Mbpd (-400,000 barrels per day) since April-06 (see second article below and
  3. OPEC monotonously insists that supply is plentiful at every meeting since 2004: 05-28-06 05:05 PM EST. CARACAS -(Dow Jones)- OPEC’s acting secretary general, Mohammed Barkindo, said Sunday that the global oil market is well supplied. “This market is very well supplied both in terms of crude and products,” Barkindo said upon arriving in Venezuela for an OPEC ministerial meeting. Ministers of the Organization of Petroleum Exporting Countries will hold a formal meeting in Caracas on Thursday-


Since the late 1980s, there are two distinct markets for oil: an illiquid spot market for “wet barrels” and 2 liquid derivatives markets for so-called “paper barrels” of oil: NYMEX and ICE. Theoretically, “wet barrel” and “paper barrel” prices should be tied together by arbitrage as it happens in most commodity and stock index futures markets, but apparently not in the oil market. This is probably due to the fact that the types of crude oil traded in derivatives (West Texas Intermediate and UK Brent) represent a very small % of world’s daily oil production, e.g. WTI represents the most expensive 1% of all oil sold in the world, while Brent represents 0.4% of the world’s total oil production. Thus, paper barrel oil prices keep rising and at the same time oil producers can’t find buyers for all their oil, including light sweet crude. So, at least in the short-term, maybe the run-up in oil prices is not an indication of shortages in the physical market, but a financial phenomenon.


With the above, we are saying that maybe in the short-term, oil prices (and commodities in general) may be due for a correction. However, if this correction in fact happens, one should be prepared to acquire a position in both oil and gold, once both markets start to recover. I cannot pinpoint a date for any of this, but as a general guideline, I would follow the “8-year cycle” posed by Clif Droke (, who claims that we will be see all investment markets bottom in September. Take a serious look at the link provided; Droke´s explanations make a lot of sense, especially, his presidential cycle theory that revolves around the fact that US presidents must take all the hard medicine (Fed Rate increases) during their first two years in office, so they can enjoy the benefits over the last two years of their term. If oil and other commodities continue to rally during July, then I would expect Droke to be right on the money by Sepetember.


No matter what happens over the next three months, we think the long-term potential for oil prices is drastically up. Just like Burgan (the world’s second largest field) and Cantarell (the second largest producer) peaked last November and December, respectively, we believe Ghawar, the world largest oil field is due to peak this year or next. Ghawar, found in 1948, accounts for about 60 per cent of Saudi Arabia’s oil production. 90 per cent of Saudi Arabia’s oil comes from seven super giant fields discovered between 1940 and 1972 (see 5 of them in the list below), the other 10% comes from about 300 smaller oil fields. According to Mathew Simmons (see his impressive presentation at, aquifers are being drained to pump oil out from ever deepening wells (9 million barrels of water/day in Ghawar); a sign that oil near the surface is exhausted in all of these fields. In fact, most of the fields listed below have already peaked and are now in depletion phase. Since they comprise over 60% of current world light-crude reserves, their peaking means the world’s peaking.

However, since Ghawar´s weight among them is so large, its own official peaking will determine the world’s peak. In other words, the only variable we need to follow from here on is Ghawar´s daily production. As you may know, this figure is heavily guarded by Saudi Arabia and will not be revealed willingly. The only thing we know for sure is that the 68 year-old gusher has already produced more than 90% of its original 1970’s estimated URR (ultimate recoverable reserves).Thus, we won’t know for sure when peak oil occurs until after the fact.  In his presentation, Simmons envisions Middle East oil production to drop by 25% by 2012 and by 50% by 2018 (see slide 44 in the above presentation link). If this were the case, we may only have the rest of 2006 to make up our mind and buy as much oil as we can safely afford before the coming spike.





Saudi Arabia Ghawar 1948 4,500
Mexico Cantarell 1976 1,211
Kuwait Burgan 1938 1,200
China Daquig 1959 1,108
Iraq Kirkuk 1927 900
Iraq Rumailia N. 1958 700
Saudi Arabia Abqaiq 1940 600
Saudi Arabia Shayba 1975 600
U.S.A. Prudhoe Bay 1968 550
China Shengli 1962 547
Brazil Marlim 1985 530
Iraq Rumailia S. 1953 500
Saudi Arabia Safaniyah 1951 500
Saudi Arabia Zuluf 1965 500



Supply concerns for summer period send oil prices higher

By Kevin Morrison

Published: June 24 2006 03:00 | Last updated: June 24 2006 03:00

Oil prices rose this week, while metal prices fell, continuing a trend that has been in place since the sector began to fall from its highs in early May.

IPE Brent for August delivery fell 2 cents to close at $69.93 a barrel in London trade yesterday, and was up 2 per cent on the week. August West Texas Intermediate added 3 cents to settle at $70.87 a barrel in trade on the New York Mercantile Exchange, leaving it up about 1.7 per cent on the week.

Oil prices were pushed up this week mainly on concerns about tightness in US petrol supplies during the summer period when demand reaches a seasonal peak. This pushed up US gasoline futures by 4 per cent this week.

The Atlantic hurricane season also kept the market nervous with the US National Hurricane Center saying this week that a tropical storm could develop north of the Bahamas. But it added that it was unlikely to turn into a cyclone and predicted it would avoid the oil and natural gas fields in the Gulf of Mexico.

Another factor that helped support oil prices was the threat of a strike by oilfield service workers in Norway, the world’s third largest oil exporter, that could startto affect production next week.

Gold fell $4 to $577.70/$578.00 a troy ounce in late afternoon London trade. The fall was enough to stop the metal price from recording its first weekly rise in six weeks. The gold price has fallen 20 per cent since reaching a 25-year peak of $730 a troy ounce on May 12.

The gold market ignored comments this week by officials at China’s central bank that China should allocate more of its foreign exchange reserves, which are the largest in the world, to gold.

Copper prices were up $91 to $6,709 a tonne yesterday on the London Metal Exchange, but down $180 on the week. The fall in copper prices came in spite of copper inventories at warehouses registered with the LME suffering their steepest weekly drop since last October, to 95,000 tonnes, or two days of world consumption – and threats to supply in Mexico and Chile.

Striking workers at two of Grupo Mexico’s copper facilities have forced the company to forfeit supplies, while in Chile unions at BHP Billiton’s Escondida are pushing for a pay rise of up to 10 per cent.

The three-month LME aluminium contract dropped $37 to $2,448 a tonne yesterday, and was down about $120 on the week. Zinc prices dropped $80 to $2,860 a tonne, and were down 7 per cent on the week as inventories in LME warehouses recorded some rare increases this week.

The Atlantic hurricane season has also affected US orange juice futures, which mainly track the Florida orange crop. The orange juice futures for July delivery on the New York Board of Trade hit a 15 year high of $1.6615 a pound yesterday. The Florida crop was partially damaged by the hurricanes last year, and producers, consumers and investors are expecting the same to happen this year.

Saudis Cite Market Forces
For Lower Crude Output

Kingdom Denies Any Effort
To Curb Global Oil Supply;
Stores Are Near Capacity
June 5, 2006; Page A3

CARACAS, Venezuela — Saudi Arabia’s oil minister confirmed that his country’s massive crude-oil output has declined in recent months, but he attributed the trend to a drop in demand and denied the kingdom is aiming to limit supply.

In an interview after a meeting here of the Organization of Petroleum Exporting Countries, Ali Naimi said other cartel members are having trouble finding buyers for all the crude they are producing, at a time when global stores are near full and many refiners have closed facilities for routine maintenance. One Saudi official said an estimated three million barrels a day of refining capacity is out of action and unable to process crude, at a time when the world is using some 84 million barrels a day of oil products like gasoline and jet fuel.

“It’s not just heavy oil. Even light oil is having problems” finding buyers, Mr. Naimi said, referring to premium grades of crude known as light crude that are highly prized by refiners because they have high gasoline yields.

Asked if the kingdom was easing up on supply because of concern about the buildup of inventories in the U.S. and other importing countries, Mr. Naimi rejected such a motive, replying: “At $70 a barrel?” Mr. Naimi suggested that producers will sell all the oil they can at such high prices.

The implication of Mr. Naimi’s remarks is that Saudi Arabia would again open its oil spigots when buyers ask for more oil. For the past two years, the Saudis say, their policy has been to sell as much oil as buyers want, to the limit of the kingdom’s production capacity.

U.S. benchmark crude for July delivery settled at $72.33 a barrel, up $1.99, on the New York Mercantile Exchange Friday. So far in 2006, crude oil is up $11.29 a barrel, or 18%, and the price has more than doubled since the end of 2003 due to rising global demand and supply constraints.

The Saudi minister said the kingdom’s oil output fell to 9.1 million barrels a day in April, the most recent figures available. Saudi output averaged nearly 9.5 million barrels a day in the first quarter, according to data compiled by the International Energy Agency.

The Saudi oil czar shrugged off concerns about large inventories, a trend that some in OPEC have cited as warranting a cutback in production. Mr. Naimi said producers must focus not only on stockpiles but also on spare oil-pumping capacity world-wide. Because there is little extra oil that exporters can produce, oil held in inventories can act as a cushion against supply disruptions.

But he ruled out the idea of Saudi Arabia discounting its oil to sell more barrels. “We will not leave money on the table” for others, Mr. Naimi said.

Saudi Arabia prices its oil according to a formula that takes into account prevailing prices on futures markets and on refinery margins — or the difference between the price of crude and the price of crude-based fuels — in different regions. It adjusts prices monthly for America, Europe and Asia. Many other exporting countries follow the kingdom’s lead. OPEC’s members assert that by basing prices on futures markets and on refining margins, they in effect let markets set the price of their oil.

With prices near a nominal high — though still shy of highs reached in the early 1980s when adjusted for inflation — OPEC’s ministers on Thursday brushed aside a proposal by Venezuela to trim output and decided to maintain current output quotas totaling 28 million barrels a day, excluding Iraq.

OPEC and industry officials say the cartel’s output is currently below that. In part that is because of supply shortfalls in Nigeria, whose production has been hobbled by political violence. But cartel officials say the production shortfall is also because Saudi Arabia and others in the cartel are encountering problems selling oil. Buyers have cut back purchases from other exporters, including Iran and the United Arab Emirates.

Iran’s response has been to keep pumping oil and storing it, some of it in tankers, while it looks for buyers on the spot market. Some industry estimates put the oil Iran has stored in the past six weeks or so at more than 20 million barrels.

A senior Iranian oil official attending the OPEC meeting confirmed that his country, OPEC’s second-largest oil producer after Saudi Arabia, was having trouble selling heavy oil and was storing it. But he didn’t specify the volumes involved.

In contrast, Saudi Arabia has reduced output to match demand for its crude. Saudi Arabia sells oil exclusively under long-term contracts with buyers that have some latitude in deciding how much crude to take every month at the prices specified by the kingdom. “We don’t sell on the spot market,” Mr. Naimi said.

Write to Bhushan Bahree at


“Take your protein pills and put your helmet on”. David Bowie

Two weeks ago we pointed out that come next quarter; even if GDP starts crumbling, Bernanke will have to stay firm. The main reason being that at the first sign of easing, the US economy’s current pro-inflationary structure would entice a nasty dollar sell-off and possibly an inflationary spiral. On the other hand, once a recession begins, deflation expectations will break the back of asset prices and enable the Fed to ease. However, as always, we can’t have our cake and eat it too: by staying firm ahead of recessionary expectations, the Fed will cause a hard landing. This means that once recession starts, no matter what the Fed does, the unemployment rate will rise almost vertically (see chart below) as it always does.

In this context, it is easy to understand why tomorrow’s FOMC policy statement (at 14:15) and last Friday’s job figures are so meaningful to the markets. As charted below, for the past 60 years, every recession started with a brutal rise in unemployment. Thus, we are all on the watch for even minor rises of the UNRATE and what the Fed has to say about it. For instance, if next month, Friday’s 0.01% increase gets followed by a higher number, the markets may interpret October’s 4.4% unemployment rate as the top of the economic cycle.  If such were the case, expect the stock and commodity markets to begin crashing. By then, the next question that bears revisiting will be: how long to the bottom? Here is one answer:


As seen in our St, Louis Fed chart last week, housing starts fell, on average, 50% from peak-to-trough in the past seven US recessions. Given they have dropped 34% since this January, just to match the average, they must plunge another 20% over the next several months. On the other hand, with respect to housing prices you must consider Yale Professor Robert Shiller’s index which tracks Existing House prices, adjusted for inflation, since 1890: After seeing the chart from his book “Irrational Exuberance” (below), you won’t have any more doubts about the US housing bubble and what comes afterwards.  Now, to answer the question about the bottom, we need to compare Shiller’s chart to that of another famous real estate bubble, Japan:


The 83% price rise you see from 1997 to 2005 in Shiller’s chart is similar in size and length to that of Japan’s real estate price froth of 1980 to 1991 (next chart). Two notable differences between these charts: 1. Regression to the mean in US house prices is starting 2 years early with respect to Japan’s. 2. Those 2 extra years took Japanese real estate prices up 110% from 1980, 32% higher than in the US bubble. Let’s hope that makes a difference, otherwise we may be signing up for a 13 year trip down the tube. That would be three times longer than the IMF’s four year average shown in one of our earlier bulletins (“A THREE DOG NIGHT”).



As mentioned last week, this is our last bulletin. If you would like to receive future bulletins please follow the instructions at the end of this report.

Today, we are revisiting two issues: Peak Oil and Bolivar FX Strategy. On the first subject, we found the one picture that says more than one thousand words. On the second subject we are suggesting you execute your 2006 and 2007 Bolivar FX strategies together.

The graph below shows oil production (green) and real oil prices (plum) since the beginning of 1989 until today. You can see that there were three production peaks (marked by the blue rectangles) in 1991, 1998, and 2001, before the current one. Although they were each caused by completely different market events, they were all preceded by an oil-price peak (marked by the red lines). The 1989-2001 market behavior reproduces oil markets dynamics in place since 1859, when Colonel Edwin Drake drilled the first oil well in Titusville, Pennsylvania. However, the current production plateau (2004-2006) would be unprecedented in that it is happening before oil prices peak (notice that no red line precedes the last blue rectangle).
So, unless prices are about to drop abruptly, for the first time in history, high oil prices dont incentivate suppliers to pump more oil. Could this behavior be voluntary? No! But if it isnt, why arent oil prices going wild? The explanation, as in the Butterfly Effect, may be coming from China:

As oil production plateaus, we are missing the symptoms of an oil crisis: skyrocketing oil prices; a world economy slow down, the arrival of hyper inflation, etc. One possible explanation for this is coal. Believe it or not, Chinese coal has been literally the engine of the world economy for the past three years. Chinese total energy production growth has supplied almost half of the growth in world energy supply from 2002 to 2005 (450 Mtoe of 1010 Mtoe growth). Chinas average electricity generation grew 44% from 2002 to 200, and Chinese coal consumption grew from 67% of primary energy in 2002 to 70% in 2005. At this pace, by 2010 the Chinese will produce more electricity than the US, while the Chinese industry sector will consume as much energy as the US and the EU industrial sectors put together.

All this time, we thought low wages were the main reason for production moving to China, but the industrial growth there would have been impossible without the huge growth in domestic energy production. This Is probably one of the biggest “energy surges” in world history. However, China is starting to meet the physical limits to carbon production growth.  As pointed out by the first article below, atmospheric contamination has become one of Chinas major social issues, both domestically and internationally. What will happen when the growth engine of the world economy stops? One possible outcome is that you will see oil prices skyrocket to where they would have been, where it not for the role Chinese coal has played in the worlds energy growth over the past 4 years.

I have included below an article from the WSJ on how rising domestic consumption at the oil-exporting countries works against net exports. The article implies that net export capacity is disappearing at a rapid rate, while demand in energy importing areas like India and China continues to grow. As pointed out in TO LEAVE OR NOT LEAVE, this all works in favor of the oil-exporting countries. We are probably going to see a worldwide population shift to areas that have surplus energy to export. Not only will this change the economic balance of power between OECD countries and oil exporters, but it will definitely make owning a piece of the real economy (real estate, businesses, fixed assets, etc.) in any oil exporter a very valuable possession. In other words, dont sell your Caracas house yet, buy another one!

Based on the news article below confirming that PDVSA will issue dollar-denominated bonds payable in Bolivars, we designed an FX strategy to help you hedge 2007 Bolivar Receivables from $100K up to $2million per transaction at what may be the lowest possible price attainable this year. However, to obtain this information, plus Part III of PROTECTING YOUR NEST EGG and several other market reports, you will need to follow the instructions below.

All previous and future bulletins will be available only to registered users of Sequoians website.  If you would like to register, please proceed as follows:

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In Part I of PROTECTING YOUR NEST EGG, we posted two articles that made exactly opposing arguments in front of the same economic outlook. Hopefully, you were able to pick “The Cheshire Cat” between the two. As proven by that day’s WSJ, you will encounter the same type of opposing arguments on major economic topics, almost every day in the main periodicals. However, armed with simple tools such as Evidence-Based Decision Making, Looking Glass Perception and Market Rhythm, one should be prepared to “read between the lines” among contradicting financial stories to pick who is selling you a “tidy” picture. Likewise, over the next pages, we will re-interpret the last 100 years of financial history trends using these three analytical tools. You will be surprised to confirm that: consuming investment market information without the proper filtering gear can distort your long-term perception of market behavior and seriously harm your financial future. On a separate note, I’d like to thank REUTERS for supplying ample access to their long-term data bases, so we could graph & cross-check some of the information presented below.



Below is the 100 year stock-chart that every stock broker worldwide has been taught to show you from the first day he attended the company’s investment seminar. This chart and the one showing the price behavior of the mutual fund he is trying to sell you today, always come together with the phrase “if you had invested $10,000.00 in such date, you would now have……..

I fact, if you visit, together with this chart, you will find this classic stock-broker observation:  “As you can see above, over the last 70 years the Dow has done quite well. There was a rather striking “adjustment” starting in 1929, with the Dow bottoming out in 1932 and not fully regaining its previous high until 1955. However, as you can see neglecting minor “blips” the Dow has been on an upward trend pretty much non-stop since 1932.”  In the words of Alice, this is a very “tidy” picture indeed. Beware, next thing we’ll see are big cat eyes, a smiling face and no cat!


Now, let’s take a look at the other side of the “Looking Glass” by comparing the same chart above with its real (adjusted for inflation) version. Notice that to obtain the real value of the stock market; we divided the Dow’s daily closing price into the closing price of gold and we drew a red line at each turning date. The reason, we used gold to get the “relevant evidence” from this chart is that Central Banks can’t print it and gold has had a specific value to human beings for about 5,000 years. When Central Banks print lots of their paper currencies, gold seems to be worth more, but when Central Banks stop their printing presses and hike interest rates, gold seems to be worth less. For instance, gold’s purchasing power increased by around 1000% during the 1970s and then fell by more than 80% between 1980 and 2001.  In other words, although its price overshoots and undershoots its fair value by wide margins, it eventually returns to ‘fair value’. Over the very long-term, gold’s fair value is determined by the total quantity of US dollars versus the total quantity of gold in existence. The average commodity, on the other hand, does not behave in this way. One reason is that the price of every commodity except gold is strongly influenced by the current year’s production and in most cases, the real cost of production falls over long periods of time due to technological improvements. But in gold’s case, the existing stock aboveground is always so much larger than the yearly new mine supply (below 2%) that changes in the cost or the quantity of annual production have almost no effect on gold prices. Also, although gold is no longer used as money, it is still accumulated as if it was money and it still trades as if it were a currency. Further proof that dividing the nominal price of stocks into the nominal price of gold is the right way to understand their nature is to use the historic price/earnings Ratio Chart (the chart immediately below the Dow/Gold Ratio Chart). Just the fact that the Dow/Gold Ratio Chart is so strikingly similar to the P/E Ratio Chart, should tell you why the “currency” you must use to understand the pricing behavior of anything is gold.


After looking at the last two charts, you probably will never again waste your time looking at nominal charts or listen to people expressing their historical performance in nominal Dollars, nominal Euros, nominal Yen or nominal paper from any country. By the same token, forget about deriving inflation-adjusted values using any Central Bank’s measure of inflation (CPI, PPI, etc.), they are so distorted; they are deceitful. To know the historical value of anything over time, you must divide its price into the price of gold. You will not only get a true picture of purchasing power, but you will begin to understand Mark Twain, when he said “History doesn’t repeat, but it sure does rhyme. Maybe Twain understood Market Rhythm, but whether he did or not, you can see from the history written in these charts why the Risk/Reward Ratio is today very much against owning stocks and in favor of owning gold or some other real asset. Just from looking at the red line breaks in the last two charts, you can tell there have been two secular bull markets and two secular bear markets in stocks since 1929 and that we have just started a third secular bear market. Since gold is the chart’s pricing divisor, you will agree that simultaneously, gold has experienced the exact opposite trends to stocks after each red line. In other words, when stocks rallied, gold dropped and when stocks dropped, gold rallied. Also, over the last leg you can tell that gold and other commodities are starting to appreciate and they will probably move up and down in sequentially higher nominal terms as investors become more and more disillusioned with owing stocks and/or bonds and more convinced that gold is the way to go.



Another way to understand what’s going on with monetary assets (stocks, bonds and cash in whatever currency you hold them) is to take a look at the growth rate of the U.S. Money Supply (M3) over the past 100 years. Notice that after 1971, M3 exploded exponentially in the U.S. (and everywhere else) when the world’s leading economies decided to scrap the gold standard -a global monetary system under which the US$ was pegged to gold at $35/ounce and all other currencies were pegged to the US$ at specific fixed rates during the Bretton Woods Conference in 1944-.

The blue line on the chart above represents the U.S. money supply as measured by M-3, from 1913 (when the Federal Reserve was created) through to May 2006. (Please note that on March 2006, the Fed stopped reporting M-3, what you see after that is Statistical Liquidity). The pink line represents the market value of gold (priced in dollars) held by the U.S. Treasury. From looking at the chart, you realize that the gold held by the U.S. Treasury is not rising in value. What is in fact happening is that the dollar, which we use to measure the price of gold, is shrinking in value. Hence we need more dollars to price the same amount of gold and other items including houses, stocks, commodities, consumer items, mutual funds, etc.

 In other words, the picture your broker has been trying to sell you as his fund’s “performance” is nothing more than the picture above, where $750 Billion in 1971 became $10.3 Trillion today, but the amount of “things” you can purchase stayed constant. He is not going to tell you that his fund increased 14 times in value because every “thing” denominated in dollars increased 14 times in value since 1971 (1.400%).  In fact, most likely his fund increased much less than 14 times in values due to fees, trading expenses, taxes, etc. But whatever X times figure he comes up with will look very good to your eyes.  The same principle applies to any nominal graph presented to you over any period of time after 1971. This is why the very first chart above, showing the Dow’s nominal growth for the past century is completely misleading, as you found out.  


Similarly, in the future, investors holding monetary assets in dollars or other currencies will eventually lose most of their purchasing power. In fact, most investors are clueless about why gold prices, along with other commodity prices are rising so quickly of late. Most think it concerns the rise in oil prices or the turbulent geopolitical U.S. tensions developing with Iraq, Iran, Venezuela, Nigeria and other oil countries since September 11, 2001. But, instead, what we are seeing is the logical outcome from Triple Deficits (see “To Leave or Not to Leave Part II”): an acceleration of the destruction of the dollar and other major currencies brought about by Central Banks speeding up their printing.



With the above analysis, we have so far debunked all of the Investment myths listed in Part I of PROTECTING YOUR NEST EGG, but, just in case this is not clear to you yet, we will now spell out each demystification, one by one:


  1. “Avoid volatility, always put your money into the safest investment you can find”:


As demonstrated above, the worst you can do now is to hold an important portion of your money in cash or bonds. However, if what you want is to deplete your future purchasing power as quickly as possible and see your retirement turn into a nightmare, you might as well sign up for a TV Reality Show and get paid for your hardship!


Low volatility doesn’t “magically” preserve your purchasing power. In fact, it’s exactly the opposite. As you may have noticed in the Ratio Charts above, apart from necessary cash holdings, if you are going to hold long-term investments, you better make sure they are either stocks or real assets, because regardless of which one has the lowest Risk/Reward Ratio at any one time, fixed-income returns will do much worse than either of them:


  1. When the Risk/Reward Ratio favors stocks, by investing in them, your returns will be exponentially higher than in fixed-income assets
  2. When the Risk/Reward Ratio favors real assets, both your fixed-income returns and your fixed-income assets will be steadily destroyed by inflation


In short, unless you are holding them to secure short-term or medium-term solvency or you depend on them for income, fixed-income assets have the highest possible Risk/Reward Ratio in any environment. Holding them as a long-term investment should require safety labeling such as: “Hazardous to Your Financial Health” or better yet: “Only Benefits Governments, Banks and Highly Leveraged Corporations” notice you are not in the list!


  1. “Over the long-term, the stock market always goes up, just buy and hold”:


Right! “Up in Smoke” I might add. As you saw in the Ratio Charts above, the “special magic” to stocks and all kinds of mutual funds is that they are all expressed in nominal terms. And, as you know nominal terms only work when inflation trends toward zero. Otherwise, monetary assets only reflect monetary inflation, so when you look the chart labeled “$10.000 invested on such date…..” your are really looking at how the Fed increased the price of “things” from about 280 Billion dollars in 1971 to about 10.3 Trillion dollars today. Since we have just entered a new bear cycle in the real value of stocks, you will probably still obtain high nominal returns through them, but they won‘t buy you more “things” in year 2016.


  1. “Diversification is always good”:


Yeah! Particularly, if you don’t know what you are doing. As you may have concluded from the above analysis, there are really only two types of assets: Real and Nominal. When real assets are rising, nominal assets are dropping and vice versa. End of story. So if you really want to diversify, you can only do this by organizing your investments around:


  1. Your immediate and mediate liquidity needs and
  2. Your special knowledge


The first point requires that you keep enough short-term instruments in your portfolio to preserve a relaxed solvency, especially if you depend on interest returns for income and/or you are expecting big-item purchases. The second point requires that you invest most of your money in your own business (no one knows it better than you), the business of the company you work for (if you know what’s really going on), or your best friend’s business (if you really trust him). If none of the above applies, then put your money to work in whichever of the two sectors (real or nominal) offers you the lowest Risk/Reward Ratio.


Notice that apart from survival cash, the overwhelming theme here is “knowledge” and how it affects your Risk/Reward Ratio. Having better knowledge than others about any investment gives you the lowest possible Risk for the highest possible Reward. In the meantime, if you don’t really have a thorough understanding of what drives a business, stay out of it until you do. Diversifying among businesses you don’t really know much about is to hope that statistical error (by the rest of the market) saves the day for you. Aside from solvency risk, knowing the Risk/Reward Ratio of any investment should be your main criteria for safety. Put another way, the less you know about your current investments, the more purchasing power you will probably loose in the future.


  1. “Let your winners run”:


Run with your money, you mean! Ask the fellows that stayed put in April 2000 because their winners where really scorching! Unless you are professional trader, you don’t have the specialized knowledge and skills necessary to consistently profit from getting in and out of the investment markets. After several years of top-notch academic training in finance and 26 years of trading experience, I still take only those bets that are overwhelmingly in my favor, because the risk is practically zero or because of good knowledge of the particular situation. Yet, I wouldn’t try to “operate on myself” just because I am a good trader. So why would a doctor or a lawyer or anyone with special knowledge in his area, think they can “operate on themselves” when it comes to trading? Just ask any “Daytrader” from the late nineties (that came from a non-trading background) how much did it cost him to learn his “trade”.


  1. “The trend is your friend”:


You may have noticed that in the next-to-last paragraph in Part I of PROTECTING YOUR NEST EGG, I didn’t finished my story on the fellow that got out of the stock markets in 1998 and went into commodities, thereby missing the most extraordinary phase of the bull market and actually loosing some money until year 2000. Well, guess what happened since then? You guessed right, commodity markets (especially oil and gold), skyrocketed over the past 5 years and will probably keep on rising for another 5 to 10 years. There is just too many trillions of dollars running after a finite stock of real assets, whether they are oil reserves, gold reserves, silver reserves or any other “hard-to-print” type of asset. Thus, anyone currently looking for a long-term investment different from his special knowledge areas should be looking at entering the real assets sector* and then forgetting about his investment for the next 5 to 10 years, regardless of the trend. The reason why this should work is because at present the Risk/Reward Ratio in real assets is your “friend”. But keep in mind this also means that the Risk/Reward Ratio is the “enemy” of your stocks and particularly of your bonds (in any currency).


  1. “Currencies from Developed Economies are safer than other currencies”:


Have you ever considered why a piece of paper with the number 100 printed on it should be worth 100-times as much as a similar piece of paper with the number 1 printed on it? If you have, let me know, I always come back to the same thought! Seriously now, when you realize that the government can print as much money as it wants then you know that money must have no real value; this realization would lead to the question: why should I work so hard for something the government can produce in unlimited amounts at no cost to itself? It turns out, there is a cost and that is what makes those pieces of paper worthwhile: the fact is they can buy you “time” and since “time is money” you get adequately compensated for believing in (holding) those pieces of paper. In the end, you are willing to trade your work for paper, because holding that paper brings you immediate and real compensation in the form of interests that are higher or at least equal to expected inflation. In fact, the real short-term interest rate in any currency is one of the most important determinants of its exchange rate. This interest rate is, in turn, is determined by the nominal short-term interest rate controlled by Central Bank and by inflation expectations (the expected effects of inflation on the currency’s future purchasing power). In Venezuela, for instance, one of the main reasons why the parallel market FX rate has been stable for the past two years is the high short-term rate Central Bank pays Venezuelan banks (10% for 28-day CDs, while 6-year Bolivar bonds yield 8.35% fixed). Should Central Bank lower that rate significantly (as recommended by congress last Wednesday), Venezuelan banks would stand no chance of preserving their short-term deposits base and an immediate flight to quality (to other currencies) would begin that would probably spiral into a sudden increase of the parallel FX rate and eventually end in a banking crisis similar to 1994’s. It’s a good thing the MOF keeps those guys on a leash!


The same thing happens with the dollar and every other currency in the world. This is why last week’s commentaries by Bernanke about the possibility of rising short-term rates above 5% to avert inflationary trends, caused a quick reversal in the long-term dollar bear trend. However, once inflationary or devaluation expectations get set off, a currency will devalue no matter how high its Central Bank hikes interest rates. This is exactly what happens to Developed Country currencies when markets realize Central Banks are printing too many of them. The following chart shows how gold performed relative to the US$ for the past 35 years. Since high gold prices represent dollar devaluation, notice how it goes up significantly when confidence in the dollar falls and down when confidence in the dollar rises. However, since 1971, when the gold standard was dropped, developed nations currencies have been moving within a limited range with respect to each other because they are all subject to intense manipulation by their respective Central Banks (working in concert to devalue or revalue currencies whenever they move to the extremes of the range). Yet, when you see oil, gold, silver, metals and other prices steadily hiking up, you can bet that too many pieces of paper have already been issued.


As things stand today, the current monetary system provides governments an unlimited ability to inflate their currencies and rack up huge debts. The U.S. alone has printed over 10 trillion dollars and issued total liabilities of several times that amount. This pyramid scheme has also allowed banks to expand their balance sheets at mind-boggling growth rates. In contrast currencies from less-developed nations may be under tougher discipline; first, because they are forced to borrow in the currency of their creditors, so depreciating their country’s currency makes foreign debt unpayable (Argentina ring a bell?), and second, because their own citizens constantly curve their currency-printing appetites by converting local currency into “hard currency” (the currency of nations running a longer-term Ponzi scheme). Of course, none of this applies to Venezuela at the moment, starting with the fact that currency is not even freely convertible.



  1. . “Trading Commodities is another form of gambling”:


Even after five years enjoying a secular bull market, commodities are seen by the majority of the investing public as an investment threat or at minimum, a high-risk gamble. Gold and commodities in general were so badly discredited in their last bear cycle that during the last decade of the past century, they evoked a bad feeling among investors. Baby boomers, in particular, don’t want to hear about commodities, the story they really know something about is “stocks and bonds”. However, commodities are the quintessential anti-inflation weapon. They are real assets and as such, their pricing behavior has always counterbalanced monetary excesses. When inflation is increasing and confidence is down trending, gold will be in a bull market. Conversely, when investors regain confidence in monetary authorities and inflation trends down; gold will be in a bear market. This time around, however, western (and eastern) society may be facing an issue never seen before over the last century’s market cycles: the possibility that oil production may be peaking. Everyone knows how important oil is for our society and what rising oil prices could do to the world economy. So, is the spectacular gold bull market that started in 2001 due to Peak Oil? Or is it due to inflation?


  1. a.      Peak Oil Revisited: The first chart below shows nominal oil prices for oil and gold. Notice how they both seem to be going up at different growth rates. However, as we have already learned, this graph doesn’t tell us much more than the story of U.S. monetary inflation going from $280 Billion to $10.3 Trillion, a meaningless story since we already know it. However, if we divide the price of gold into the price of oil, thereby deriving the gold/oil ratio, we obtain the second chart below, the one that should tell us what is really going on. As shown by the second chart, real oil prices are in fact close to their lowest level over the past 35 years. How come? Didn’t every newspaper say that oil prices were skyrocketing? Yes, but as pointed by the arrows on the Ratio Chart, the gold/oil ratio just tested a 20-year low in 2000, it did it again in 2005 and after last week’s gold price correction (oil didn’t budge) it might be heading there again. What does this say about Peak Oil? It says that it might be coming. Think of it, if in fact there was really an imminent oil shortage, oil insiders who knew about it would immediately take refuge by purchasing oil instead of gold or any other commodity. So, this Ratio Chart may in fact be measuring the “real” value of oil to our energy-based society with respect to gold, to any other commodity and especially with respect to any currency, no matter how strong.    


  1. b.      It’s Probably Just Inflation: On the other hand, over 80% of all goods currently manufactured in the world are indirectly oil-related and so is the cost of food production (pesticides, fertilizers, transport, etc.), so, it would be logical to expect nominally high oil prices to generate correspondingly high inflationary pressures, but since gold merely reflects monetary inflation, it wouldn’t pick up on oil-specific inflationary expectations. Please notice in the gold/oil Ratio Chart that over the past 35 years the only other time the gold/oil ratio was lower than in 2005 was during the second half of 1976. Immediately afterwards, inflation and gold initiated an almost parabolic rise against oil for three years, dropped for one and then went asymptotic until Paul Volker took over the Fed and started aggressively raising interest rates. However, this time around, “oil inflation” seems to be going faster than monetary inflation. If that were confirmed by a new gold/oil low (lower than 1976’s), it would be significant enough to think that we may be at the start of a new era, one where oil may definitely become scarcer. If no new lows are put in place by the markets, then this time too, inflation may be the ultimate instigator. This would be supported by the fact that commodity prices today are largely being driven higher by China’s explosive growth and in turn, China’s rapid growth is really being driven by inflation: inflation exported by the US via its current account deficit, inflation resulting from China’s currency peg to the dollar and inflation resulting from China’s own credit expansion.


Thus, either because Peak Oil forces investors to take refuge in oil or gold versus major currencies or because higher nominal oil prices initiate deeper inflation on the world monetary system, over the next 5-10 years, oil and probably gold should keep rallying in nominal terms until some unknown factor ultimately changes its secular bull trend.





All this time you thought you were protecting your future purchasing power by turning your Bolivars into Dollars CDs. But for the last ten, twenty or how many years you have kept your savings in Dollar CDs (or other “hard” currency CDs); the Fed took most of your purchasing power away from you. It’s very hard to accept being deceived. You may not even recognize what we are saying here and dismiss it altogether.  But the pictures shown above are not an opinion, they tell a simple, incontrovertible story: in time, it took more units of any currency to buy the same amount of “things”. From the start, all you wanted was to store “value” not “things”. That’s why you traded out of Bolivars in the first place. But the Dollar story is exactly the same as the Bolivar story only that it gets “played out” over a longer time horizon.


Think of it this way: what has gone up 14 times since 1971 is not the value of “things” (oil, gold, silver, houses, cars, stocks, mutual funds, etc.), this stayed the same; what went up is the amount of Dollars necessary to purchase these items. But, since all “things” went up at the same time, you couldn’t notice the devaluation.  Thus regarding your present and future savings, the dilemma you have now is to decide whether to forget about all this stuff and keep on “saving” the way you have always done it or, to stop and do some research to confirm the findings on this report. What you do next is what counts.




Now that we are relatively clear on how investment markets worked in the past and where they seem to be heading, we need to define and execute a strategy to protect the nest egg. Since I have already taken a lot more space and time than initially budgeted, I must leave strategic and tactical details to my next delivery. Please try to refresh your memory regarding Monte Carlo Simulation or look it up in Google or Wilkipedia. We will be using that concept and other analytical tools in order to draw the outline of what your individual strategy should look like in the years to come. Additionally, we will show the investment instruments that exist today that allow you to execute your strategy at the lowest possible cost. With our guidance, you should be able to manage your money under the Risk/Reward Ratio principle for safety and then, turn away from watching every twist and turn the markets make as they unfold towards their ultimate intrinsic values. Only one caveat: Don’t try this on your own or to use familiar terms: Don’t try to operate on yourself, even if you are a doctor. Get at least, a second opinion!



*Those of you who have been waiting for a good opportunity to build up exposure to the gold sector may do some buying now. However, it doesn’t make sense to jump in with both feet at this time because although last week’s low may have been the ultimate price low for the current correction or within a few percent of its ultimate price low, the overall correction is likely to last until at least November of this year and might even extend into the first half of 2007.