The FOMC Decision – Some Advance Kremlinology

We have tried to get an idea of what to expect from the FOMC on Wednesday, but must admit we couldn't really make up our mind. One line of argument  goes 'Ben Bernanke will try to shock the markets by doing much more than most people currently expect'.

This line of thinking has been ably laid out by David Rosenberg of Gluskin Sheff (the details are available at Zerohedge) and Bill Fleckenstein (details at MSN Money).

Both Rosenberg and Fleckenstein are quite capable analysts of the economy and financial markets, so it is certainly worth considering what they are saying.  Here is what we like about their idea, aside from the reasons they have laid out themselves: First of all, it is notable for being a minority view at the moment. This is at least our opinion from observing anecdotal evidence and a recent Bloomberg survey confirms that the vast majority of economists expects 'only' a variation of 'Operation Twist' ('OT') to be announced, whereby the Fed will simply alter the term structure of its balance sheet by selling shorter term and buying longer term debt. The aim would be to lower long term interest rates (this is to say, the operation would tend to flatten the yield curve).  

The Bloomberg article relating the result of the survey begins with an unintentionally funny statement – it declares the expected Operation Twist 'dead on arrival' as far as the likelihood is concerned that it might actually help the economy. Very true, but it's still funny. It seems the Fed is losing its nimbus as an omnipotent entity that can 'jump-start the economy' at will.

Federal Reserve officials tomorrow will probably announce a program for monetary easing that will do little to help 14 million unemployed Americans find work, according to economists in a Bloomberg News survey.

The Federal Open Market Committee will decide to replace short-term Treasuries in its $1.65 trillion portfolio with long- term bonds, according to 71 percent of 42 surveyed economists. The move, known as “Operation Twist” for its goal to bend the yield curve, will probably fail to reduce the 9.1 percent unemployment rate, 61 percent of the economists said. Among those, 15 percent predict it will be “somewhat harmful.” [we don't know about you dear readers, but we found this lough-out-loud funny, ed.]

Operation Twist is among a few untested policy tools that Chairman Ben S. Bernanke has said the Fed could use as risks to the U.S. recovery rise and unprecedented easing falls short of fulfilling the Fed’s mandate for full employment. The yield on the 10-year Treasury note already fell to a record low this month on concerns global growth is flagging and Europe’s sovereign-debt crisis will intensify.

“It’s better than nothing but it’s obviously not going to be a knockout blow or a game changer for the economy,” said Michael Feroli, chief U.S. economist for JPMorgan Chase & Co. in New York. The FOMC began its meeting at around 10:30 a.m. in Washington and plans to release a policy statement tomorrow at about 2:15 p.m.

Feroli estimates the Fed will reduce longer-term yields by about 0.1 percentage point by announcing a swap of $300 billion to $400 billion in Treasuries, selling securities with one to three years remaining maturity, and purchasing mostly those with seven to 12-year maturity. [another knee-slapper; how exactly is this 'better than nothing'? ed.]


(emphasis added)

There are several things one must consider here. The Fed has evidently prepared the ground through its various mouth-pieces to tweak expectations in the direction the survey reveals. The chief leaker Jon Hilsenrath at the WSJ has mentioned 'Operation Twist', the cutting of the interest rate paid on excess bank reserves (namely, to zero), and 'explicit targets' as the things likely to be discussed. What the 'explicit targets' refer to are targets for the unemployment rate and 'inflation' (i.e., the rate of change of CPI) that would trigger a change in policy – in short, it would be a 'guarantee' of loose policy until one or both of these targets were met. We can call this one the non-chess version of the 'Evans gambit'. Moreover, Hilsenrath's latest article downplays the 'palace revolt' by the three dissenters Plosser, Fisher and Kocherlakota. 

It follows from the survey that if the Fed wanted to get a big reaction out of the stock market and other 'risk assets', it would have to do more than just 'OT'. As David Rosenberg relates, it is well known that Ben Bernanke is a big believer in manipulating the stock market  – on the mistaken idea that rising stock prices somehow 'increase wealth' and induce people to spend more, which is held to be good for the economy. Spending, it must be remembered, is the be-all and end-all in Bernanke's view of the economy. He is of course not outside of the mainstream with that view. Seriously, most of today's mainstream economists believe that we can consume ourselves back to prosperity.

Production is not given much consideration in this view of the  world – it is simply assumed that the means of production are so to speak 'lying in wait' and will swing into action as soon as there is 'enough spending'.

In addition to all  of the above, we must consider that normally, the September FOMC meeting is a routine one day meeting, but not this time. The lengthier meeting may be due to a perceived need to bring the dissenters on board, but Hilsenrath's remarks seem to rule that out (apparently the only firmly committed opponent of Bernanke's policies was Thomas Hoenig, who is about to abscond into retirement and won't even take part in the debate). In short, the most likely reason for the two day meeting is that the FOMC will discuss all sorts of interventions, in order to finally come up with a cocktail that is deemed potent enough to 'work'.

Lastly, so far Ben Bernanke has done everything he promised he would do in his famous 2002 'anti-deflation' speech. It is actually quite amazing that we still don't simply take him at his word and are looking for reasons why he might do anything different. :)

To summarize, Messrs. Rosenberg and Fleckenstein may well turn out to be correct.

The consensus view on the other hand also has some arguments going for it. An article in the NYT looks at why 'The Fed Runs The Risk of Doing Less Than Expected' (the NYT would of course see this is a risk…).  It lists all the well known reasons arguing for relative monetary chastity at the present moment, from the political headwinds the Fed is  facing due to the obvious failure of the 'QE's' to achieve any tangible results, to the objections of the dissenters, to  the idea that the 'Fed will want to milk the announcement effect' for as long as possible (this latter point has the most merit in our view, because we know Bernanke believes strongly in the 'announcement effect').

As we have noted many times before, we are beginning to think that the structural damage the last credit boom has wrought may well have been so grave that the economy's pool of real funding is now in serious trouble. Putting it differently, the degree of discoordination in the economy's productive structure, the amount of capital malinvestment and the amount of capital consumption that have attended the last iteration of the boom may have severely impaired the economy's capacity to create real wealth. If this is in fact the case, then it won't matter how much more monetary pumping is thrown at the depression. The effects will simply be weaker and weaker with every new round, with seeming recoveries becoming ever more fleeting.

Alas, what interest us ahead of the FOMC is the likely short term market reaction (days to weeks), mainly for tactical reasons. Considering the possibilities discussed above, we would think that 'OT' has been fully priced in by now. It seems likely that 'OT' alone would actually be dismissed as 'not enough' by traders of so-called 'risk assets' such as stocks and commodities. On the other hand, if Messrs. Rosenberg and Fleckenstein are correct, then we can probably expect a fairly sizable short term rally in said risk assets. If that were to happen, then we think the bigger such a rally turns out to be in the very short term, the more likely it will be nothing but yet another wiggle in an ongoing bear market.

As an aside to this, we would like to point readers to a post at 'Reformed Broker' where the narrowness of the recent stock market advances is discussed. We have mentioned this phenomenon in the past in the context of the 2007 top – when rallies are driven by only a handful of big cap momentum stocks, they must be considered highly suspect –  however we should add that we think that this may characterize what happened at the July top better than the current situation, since the 'momentum leaders' have failed to mask the broader market's weakness this time. Too many of them have fallen by the wayside since July (see NFLX or GOOG as pertinent examples).

Still, we thought it was worth passing these thoughts on, since they describe a phenomenon that we think investors should be aware of.

Should the FOMC 'disappoint', it seems likely that the ensuing sell-off could be quite steep and 'force its hand' a short while later – with regards to this, we certainly agree with Bill Fleckenstein. A further sell-off would leave the market severely oversold, which would make it more likely for new inflationary measures to have a large positive effect on prices. From the point of view of bulls this outcome should actually be preferred, while bears would probably be better served by a rally that  leaves the market closer to an 'overbought' state (unless it just crashes, which remains a possibility, even though it is one with a very low probability. One should however not dismiss it out of hand).



The SPX finds itself poised just below the 50 day moving average ahead of the FOMC decision. We should note here that we still don't like the looks of this chart. Both our 'possible paths' remain in the contest, see this chart – click for higher resolution.



On Monday we commented on  industrial commodities, specifically copper and crude oil and their ominous looking charts. In the meantime, both markets have indeed broken to lower levels, with copper showing more alacrity in falling (like Falstaff). Crude Oil may actually still be said to have held within its wedge, but only barely. Perhaps the slight divergences between stocks, copper and crude oil will turn out to be short term meaningful. We would note though that at the summer 2010 low, copper diverged from stocks by making a higher low, while at present it seems to be busy diverging to the downside.



Copper waves good-bye to another lateral support level – click for higher resolution.



Crude oil weakens as well, but it's only a tentative breakdown from the wedge so far. Here is Monday's annotated chart – click for higher resolution.



The Greek Debt Can

It is actually a bit tiresome that Greece won't just go away, but it remains a potential trigger for upcoming short term market moves as well. It appears from the latest news that the telephone conference with the 'troika' went well enough to entice it to send a delegation back to Athens for further discussions, while Greek finance minister Evangelos Venizelos in turn is going to visit the IMF in Washington.  From this we conclude that the Greek debt can is readied for one more kick down the road.

To our mind throwing the money into the super-massive black hole thought to reside at the center of the Milky Way galaxy may actually be slightly more productive. The markets are no longer trying to guess whether Greece will default – they are trying to guess what the post default recoveries will be.

The only reason we can discern for releasing yet another bailout tranche is an attempt to buy more time in order to prepare for the post-default contingencies.

Note by the way that several of the smaller euro area nations could still bring the entire plan to grief. It appears for instance that Slovakia's government will have a hard time to get parliament to ratify the latest bailout agreement. Slovakia resents the Greek bailout, as the country has overcome considerable economic and fiscal problems in the past on its own. Moreover, we would note that Slovakia has consistently erred in the direction of pro-free market reforms and has established one of the most unhampered economies in the entire EU (for instance, it has a 19% flat tax, which speaks volumes about economic freedom). Since Slovakia's economy is highly dependent on the car industry, it has a tough time at the moment as well, and Slovakian citizens who have borne many sacrifices when the country was in trouble previously don't see why they should now bear even more sacrifices in support of spendthrift Greeks. While this is bemoaned as a 'lack of solidarity' elsewhere in the EU, we sympathize with the position. After all, the Greek government first lied about its deficit, then got a giant bailout the conditions of which it consistently failed to meet and now it is supposed to receive yet another bailout even though the financial markets have evidently consulted their collective abacus and come to the conclusion that paying back its debt has become an arithmetical impossibility.

It is of course true that in reality, the bailout is aimed at bailing out Greece's creditors rather than Greece itself, but that hardly makes the situation any better. On the contrary, this propping up of unsound credit is a colossal waste of resources  in favor of those who took risks they should have thought twice about. 

Be that as it may, it appears from what we have seen thus far that any news of further can-kicking will be regarded as 'positive' by the financial markets (yes, we know, it's not logical), while conversely, the uncertainties over the manner in which an outright default may redound on the euro area's banking system keeps markets on edge every time the can kicking exercise threatens to be terminated.



Greece's  economic data are actually 'improving' in that the rate of change of the regression is slowing. Alas, the public debtberg is too big relative to this economic performance, and always has been – click for higher resolution.



There is tragically quite a lot of human suffering that accompanies these ugly economic data, which is all the more reason to bring the debt back to a manageable level via a default. As a recent example of the desperation that is finding expression behind the bleak numbers, consider this article in the WSJ on the sharp rise of suicides in Greece.


Italy's Government  Miffed

'Italy rejects S&P downgrade!', the NYT informs us. We find this tendency to anthropomorphize entire cities or countries quite funny. It sounds almost as though  'Italy' were some gal who's cross with her boyfriend, S.P. Downgrade. In reality, it is of course a real person that 'rejects' the downgrade, namely Silvio Berlusconi, the 'locust hunter'.  We can be reasonably certain that S&P won't lose any sleep over it. However, we are by now well acquainted with how such things tend to progress. Next in line is Moody's, which was hitherto thought to be the first ratings agency likely to downgrade Italy's government debt further. For now, Moody's is merely lying in wait, but one of these days it will strike. Now, apart from the danger that Uncle Silvio's righteous wrath may become more intense when that happens, there are many investors that have to abide by certain rules as to what kind of debt they may hold. Usually when the credit rating agencies disagree, the decisive point is which rating the majority of them have dispensed (i.e., what two out of the three are saying is what counts).

So the next downgrade will be a bigger deal than this one is, as it may result in some forced selling (the extent is hard to gauge – it may not be significant, as   Italy's debt isn't in any danger of becoming 'junk' just yet).


Accounting Delusions

More importantly though, the euro area's banks and insurers are stuffed to the gills with Italian debt, simply because there is so much of it. In spite of a 'risk on' day in euro-land on Tuesday, Italian debt actually kept selling off.

We may rest assured that such adverse moves in the value of the banks' portfolios will utterly escape accounting recognition, i.e. there won't be any marking to market. Alas, this is precisely the banking system's biggest problem, a problem which we have highlighted on account of the EBA's famed 'stress test', which managed to destroy any remnant of confidence there may once have been by merely lifting the rug a little bit and allowing us a glimpse  of what's underneath.

The selling wave in euro-land bank stocks accelerated shortly after the publication of the stress test results on July 17, as can be seen below:



The EuroStoxx Bank Index. In mid July the EBA stress test led to a confused 'hope' bounce, followed by an accelerated crash after people actually found the time to go through all  the details – click for higher resolution.



The method of allowing banks to sweep unrealized losses on assets under the rug has the obvious advantage that they don't all have to declare themselves insolvent at once, but it also increases uncertainty over the ticking time bombs that are hidden from the prying eyes of investors (actually, ever since the stress test results were published, they are slightly less hidden, but that has proved to be only a marginal improvement compared to the status quo ante). The fact of the a priori insolvency of a fully lent up fractionally reserved banking system has so to speak been thrown into somewhat starker relief by the sovereign debt crisis in Europe, even if current accounting practices are not up to the task of fully disclosing this state of affairs.

Jonathan Weil has written an excellent article at Bloomberg that discusses the mess pliable accounting standards boards (like FASB and IASB) have created by moving away from the demand that stricter accounting principles be adhered to. It is entitled 'European Bank Blowups Hidden With Shell Games' and well worth reading in its entirety. Says Weil:

“The last time the world had a major banking crisis, fair-value accounting rules were near the top of the list of scapegoats most likely to be denounced by government and industry leaders. Not so this go-around.

Today many of Europe’s largest financial institutions are seemingly on the brink again, driven by fears of pent-up losses stemming from the sovereign-debt debacle. Only you don’t hear much criticism of fair-value reporting anymore. That’s probably because the accounting mandarins gutted many of their fair-value rules in response to the financial system’s near-meltdown three years ago. This hasn’t made banks safer. It has given politicians and bankers one less culprit to blame, though.

Fair-value accounting – or the notion that financial instruments should be recorded at market value on companies’ books rather than at historical cost – made for a popular whipping boy in 2008, both before and after the collapses of Fannie Mae, Freddie Mac, Lehman Brothers Holdings Inc. and American International Group Inc.

Companies supposedly were being forced to write down their assets to temporarily irrational prices, or so the story went. Critics said the practice exacerbated market downturns. The boards that write accounting standards for Europe and the U.S. responded by passing emergency amendments to their rules to give the world’s banks and insurance companies a break. Predictably this has only made matters worse in the long run, by hurting investor confidence in some of the numbers financial companies are reporting now.”


(emphasis added)

We would add here that truly conservative accounting rules would stipulate that bank assets should be recorded at either fair market value or their historical cost, whichever is lower. This should be so because if there is anything truly worth criticizing about 'pure' fair value accounting it is the illusionary profits that are recorded on unrealized paper gains when things go well during an inflationary boom.

These profit delusions have been used to create a giant Potemkin village of ruddy bank health prior to the crisis, not to mention that they were used as the basis for calculating banker bonuses (the latter may seem like a minor quibble compared to the systemic risk that was created, but it was a major motivate in the abandonment of conservative accounting principles).

In other words, we would go one step further than Weil, who says that “the problem with fair-value accounting now is investors don’t get enough of it. Those banks that are destined to blow up will do so regardless.”   

We would say it is not merely fair value accounting investors don't get enough of. It is truly conservative, prudent accounting that investors don't get enough of. Book values should neither be inflated when assets have fallen in price, nor when they have risen. Only realized profits should be booked as such. 

Let us not forget that in a fractionally reserved system, the commercial banks are able to create loans and deposits from thin air, i.e. their own inflationary activities create illusionary profits for themselves that are invariably given back in their entirety once a debt-deflationary bust strikes. A return to prudent accounting rules would without a doubt make bank officers far more circumspect about the risks they are willing to take – something which we all should actually regard as a de minimus requirement for banks operating with fractional reserves, especially when tax payers are regularly required to bail them out and pay for their losses.


Euro Area Credit Market Charts

Below is our usual collection of charts of CDS spreads, bond yields,  euro basis swaps and a few other charts. Prices in basis points, with both prices and price scales color-coded where applicable. The most notable development on Tuesday was the continued rise in Italian yields, otherwise most markets remain stuck in a high level nervous holding pattern.



5 year CDS on Portugal, Italy, Greece and Spain – note, CDS on Italy's, Spain's and Portugal's debt continued to increase on Tuesday – click for higher resolution.



5 year CDS on Bulgaria, Croatia, Hungary and Austria – only small moves here – click for higher resolution.



5 year CDS on Latvia, Lithuania, Slovenia and Slovakia – still triangulating, but CDS on Slovenia are beginning to break out from the triangle – click for higher resolution.



5 year CDS on Saudi Arabia, Bahrain, Morocco and Turkey – all still drifting higher – click for higher resolution.



10 year government bond yields of Ireland, Greece, Portugal and Spain – all yields inching higher once again – click for higher resolution.



10 year government bond yields of Italy and Austria, UK Gilts and the Greek 2 year note. We can issue a 'red alert' on Italy again – 5.72% is uncomfortably high – click for higher resolution.


Three month, one year and five year euro basis swaps – the euro-doom indicators are taking another small step into the abyss – click for higher resolution.




Our proprietary index of euro-area bank CDS (an unweighted index of 5 year CDS  on the senior debt of BBVA, Deutsche Bank, Societe Generale, BNP Paribas, Intesa Sanpaolo, Unicredito, and Monte dei Paschi di Siena) – another 11 basis points were added on Tuesday. This is our new 'most scary chart in the world' – click for higher resolution.



A long term (weekly) chart of our euro-land bank CDS index – on a weekly basis it's at a new high (the high just above 400 basis points was made intra-week) – click for higher resolution.



Inflation adjusted yields – down in Europe, up in the US. This is as it should be, as the Bernank is about to pump again – click for higher resolution.



5 year CDS on the 'Big Four' Australian banks. Still triangulating, but this strikes us as a bullish chart – which by implication is bearish for 'risk' – click for higher resolution.




Charts by: Bloomberg,, Greek Governmrnt



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4 Responses to “Waiting for a Trigger And the Illusions of Bank Accounting”

  • Andrew Judd:

    Unfortunately all of those people with money savings also took risks. If everybody was prepared to share the pain – and they obviously are not – things would be simpler. Instead they are complicated.

    Bailing out the banks is also bailing out the savers.

    • Hi Andrew,

      I actually must disagree with that. It may appear so on the surface, but in reality the losses could be fully absorbed by shareholders and bondholders in the vast majority of cases. Savers, depositors and even counterparties need not truly fear such bankruptcies. The assets that are still valuable would merely change hands, and the new owners and managers would likely prove better stewards of them than the current ones.
      I would of course agree that depositors SHOULD be aware that giving a bank money is risky. That risk has however been completely obviated by modern-day deposit insurance schemes, which have contributed heavily to the moral hazard that mars our financial system. Note here that even in the case that share capital and capital provided by bondholders should not suffice to cover the losses of a bank insolvency and even though deposit insurance schemes like the FDIC may be overwhelmed by several big bankruptcies, there is always the Fed, which will simply print up the difference.
      John Hussman has written extensively on bank insolvencies and what they would involve – if you are interested in learning more on the topic, I would recommend browsing through the archives of his weekly commentary at:
      In 2009 and 2010 he has written on the topic several times.

  • amun1:

    Bernanke may not need to do any more actual QE style bond purchases for a while. He’s taken care of that by promising to keep short term rates at zero, thereby passing the baton to big banks that can borrow for free and lend to the US government at two percent. That’s a nice risk free carry trade and I’d do it too if the fed would lend to me at zero percent. There is the minor issue of unwinding the carry trade at some point in the future, but that’s a boondoggle whether the fed or commercial banks hold the bonds. I presume there is some implicit promise that the fed stands ready as a buyer of last resort in the future if their banker friends need to sell.

    As for the stock market, I’m not so sure the fed has to do more RIGHT NOW to keep the market buoyant. This manic run higher (the nasdaq 100 is poised to shove through to new 10 year highs with just a little nudge) is probably a sign of another strong earnings season. Logically, it’s not hard to understand strong corporate earnings in this environment. Companies have trimmed the fat from their payrolls, but consumption is holding steady because government stepped in with transfer payments, in this case meaning transfer from savers to spenders since the fed is now the source of deficit funding.

    Henry Ford paid his workers well so they could afford to buy one of his cars. In the modern era, government funding facilitates the consumption, so corporations can operate on a very lean basis. It’s the ideal form of economic subterfuge, because consumption apparently doesn’t use any capital at all, at least it doesn’t become apparent until future years when all that high powered money starts sloshing out of the tank.

    • If they wanted to give the markets a shot in the arm, then they have miscalculated – of course this is something we only know with hindsight.
      Your point on earnings is well taken, but I think in a globally syncnchronized recession – which may well have begun – earnings at many companies will suffer significant setbacks.

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