Robot Trading Will End in Disaster

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Today, stock markets and other markets such as bonds and currencies can best be described as “automated automation.” Here’s what I mean.

There are two stages in stock investing. The first is coming up with a preferred allocation among stocks, cash, bonds, etc. This stage also includes deciding how much to put in index products or exchange-traded funds (ETFs, which are a kind of mini-index) and how much active management to use.

The second stage involves the actual buy and sell decisions — when to get out, when to get in and when to go to the sidelines with safe-haven assets such as Treasury notes or gold.

What investors may not realize is the extent to which both of these decisions are now left entirely to computers. I’m not talking about automated trade matching where I’m a buyer and you’re a seller and a computer matches our orders and executes the trade. That kind of trading has been around since the 1990s.

I’m talking about computers making the portfolio allocation and buy/sell decisions in the first place, based on algorithms, with no human involvement at all. This is now the norm.

Eighty percent of stock trading is now automated in the form of either index funds (60%) or quantitative models (20%). This means that “active investing,” where you pick the allocation and the timing, is down to 20% of the market. Although even active investors receive automated execution.

In all, the amount of human “market making” in the traditional sense is down to about 5% of total trading. This trend is the result of two intellectual fallacies.

The first is the idea that “You can’t beat the market.” This drives investors to index funds that match the market. The truth is you can beat the market with good models, but it’s not easy.

The second fallacy is that the future will resemble the past over a long horizon, so “traditional” allocations of, say, 60% stocks, 30% bonds and 10% cash (with fewer stocks as you get older) will serve you well.

But Wall Street doesn’t tell you that a 50% or greater stock market crash — as happened in 1929, 2000 and 2008 — just before your retirement date will wipe you out.

But this is an even greater threat that’s rarely considered…

In a bull market, this type of passive investing amplifies the upside as indexers pile into hot stocks like, for example, Google and Apple have been. But a small sell-off can turn into a stampede as passive investors head for the exits all at once without regard to the fundamentals of a particular stock.

Index funds would stampede out of stocks. Passive investors would look for active investors to “step up” and buy. The problem is there wouldn’t be any active investors left, or at least not enough to make a difference. There would be no active investors left to risk capital by trying to catch a falling knife.

Stocks will go straight down with no bid. The market crash will be like a runaway train with no brakes.

It comes back to complexity, and the market is an example of a complex system.

One formal property of complex systems is that the size of the worst event that can happen is an exponential function of the system scale. This means that when a complex system’s scale is doubled, the systemic risk does not double; it may increase by a factor of 10 or more.

This kind of sudden, unexpected crash that seems to emerge from nowhere is entirely consistent with the predictions of complexity theory. Increasing market scale correlates with exponentially larger market collapses.

Welcome to the world of automated investing. It will end in disaster.

Regards,

Jim Rickards
for The Daily Reckoning

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New Multi-year Gold Rally Has Emerged

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The dollar price of gold has been on a roller-coaster ride for the past six years. But the past six weeks have been a turbocharged version of that. Investors should expect more of the same for reasons explained below.

The six-year story is the more important for investors and also the more frustrating. Gold staged an historic bull market rally from 1999 to 2011, going from about $250 per ounce to $1,900 per ounce, a 650% gain.

Then, gold nose-dived into a bear market from 2011 to 2015, falling to $1,050 per ounce in December 2015, a 45% crash from the peak and a 51% retracement of the 1999-2011 bull market. (Renowned investor Jim Rogers once told me that no commodity goes from a base price to the stratosphere without a 50% retracement along the way. Mission accomplished!)

During that precipitous decline after 2011, gold hit a level of $1,417 per ounce in August 2013. It was the last time gold would see a $1,400 per ounce handle until last month when gold briefly hit $1,440 per ounce on an intra-day basis. At last, the six-year trading range was broken. Better yet, gold hit $1,400 on the way up, not on the way down.

The range-bound trading from 2013 to 2019 was long and tiring for long-term gold investors. Gold had rallied to $1,380 per ounce in May 2014, $1,300 per ounce in January 2015, and $1,363 per ounce in July 2016 (a post-Brexit bounce).

But, for every rally there was a trough. Gold fell to $1,087 per ounce in August 2015 and $1,050 per ounce in December 2015. The bigger picture was that gold was trading in a range. The range was approximately $1,365 per ounce at the top and $1,050 per ounce at the bottom, with lots of ups and downs in between. Yet, nothing seemed capable of breaking gold out of that range.

The good news is that gold has now broken out to the upside. The $1,440 per ounce level is well within reach and the $1,400 per ounce level seems like a solid floor, despite occasional dips into $1,390 per ounce territory. Gold’s trading at $1,416 today.

More importantly, a new multi-year bull market has now emerged. Turning points from bear to bull markets (and vice versa) are not always recognized in real time because investors and analysts are too wedded to the old story to see that the new story has already started.

But, looking back it’s clear that the bear market ended in December 2015 at the $1,050 per ounce level and a new bull market, now in its fourth year, is solidly intact. The recent break-out to the $1,440 per ounce level is a strong 37% gain for the new bull market. This price break-out has far to run. (The 1971 – 1980 bull market gained over 2,100%, and the 1999 – 2011 bull market gained over 650%).

The price action over the past six weeks has been even wilder than the price action over the past six years. As late as May 29, 2019, gold was languishing at $1,280 per ounce. Then it took off like a rocket to $1,420 per ounce by June 25, 2019, an 11% gain in just four weeks.

Gold just as quickly backed-down to $1,382 per ounce on July 1, rallied back to $1,418 per ounce on July 3, and fell again to $1,398 per ounce on July 5. These daily price swings of 1.5% are the new normal in gold. Again, the good news is that the $1,400 per ounce floor seems intact.

What’s driving the new gold bull market?

From both a long-term and short-term perspective, there are three principal drivers: geopolitics, supply and demand, and Fed interest rate policy; (the dollar price of gold is just the inverse of dollar strength. A strong dollar = a lower dollar price of gold, and a weak dollar = a higher dollar price of gold. Fed rate policy determines if the dollar is strong or weak).

The first two factors have been driving the price of gold higher since 2015 and will continue to do so. Geopolitical hot spots (Korea, Crimea, Iran, Venezuela, China and Syria) remain unresolved and most are getting worse. Each flare-up drives a flight-to-safety that boosts gold along with Treasury notes.

The supply/demand situation remains favorable with Russia and China buying over 50 tons per month to build up their reserves while global mining output has been flat for five years.

The third factor, Fed policy, is the hardest to forecast and the most powerful on a day-to-day basis. The Fed has a policy rate-setting meeting on July 31. There is almost no chance the Fed will raise rates. The issue is whether they will cut rates or stand pat.

The case for cutting rates is strong. U.S. growth slowed in the second-quarter to 1.3% (according to the most recent estimate) from an annualized 3.1% in the first-quarter of 2019. Inflation continues to miss the Fed’s target of 2.0% year-over-year and has been declining recently. Trade war fears are adding to a global growth slowdown.

On the other hand, the June employment report showed strong job creation, continued wage gains, and increase labor force participation. All of those indicators correspond to higher future inflation under Fed models. The G20 summit between President Trump and President Xi of China led to a truce in the U.S.-China trade war and the prospect of continued talks to end the trade war.

In short, there’s plenty of data to support rate cuts or no cuts in July. The Fed is biding its time. Meanwhile, the market is highly uncertain. A good headline on trade results in a stronger dollar and weaker gold. The next day, a bad headline on growth results in a weaker dollar and stronger gold.

This dynamic explains the erratic up-and-down price movements of the past week. The dynamic is likely to continue right up until the July 31 Fed meeting in two weeks.

With so much uncertainty and volatility in the dollar price of gold lately, what is the prospect for a rally in precious metals prices and stocks that track them?

Right now, my models are telling us that the gold rally will continue regardless of the Fed’s action on July 31.

Expectations today are that the Fed will cut rates at the next FOMC meeting, but the probabilities are far from a sure thing. If the Fed cuts rates, the market will simply move its expectations of further rate cuts to the next FOMC meeting (September 18). The weak dollar/strong gold rally will continue.

If the Fed does not cut rates, gold may suffer a short-term drawdown, but markets will assume the Fed made a mistake. Expectations for a 50bp (0.5%) rate cut in September will start to build.

That new forward expectation will power gold higher just as surely as the missed July rate cut. That covers gold. But what about silver?

Many investors assume there is a baseline silver/gold price ratio of 16:1. They look at the actual silver/gold price ratio of 100:1 and assume that silver is poised for a 600% rally to restore the 16:1 ratio. These same investors tend to blame “manipulation” for silver’s underperformance.

That analysis is almost entirely nonsense. There is no baseline silver/gold ratio. (The “16:1 ratio” is an historical legacy from silver mining lobbying in the late 19th century, a time of deflation, when farmers and miners were trying to ease the money supply by inflating the price of silver with a legislative link to gold.

The result was “bimetallism,” an early form of QE. The ratio had nothing to do with supply/demand, geology, or any other fundamental factor. Bimetallism failed and was replaced with a strict gold standard in 1900).

This does not mean there is no correlation between gold and silver prices. As Chart 1 below reveals, there is a moderately strong correlation between the two. The coefficient of determination (expressed as r2) is 0.9.

This means that over 80% of the movement in the price of silver can be explained by movements in the price of gold. The remaining silver price factors involve industrial demand unrelated to gold prices.

Chart 1

Read more here.

Recently, a huge gap has opened up between the rally in gold prices (shown in blue on Chart 1 with a right-hand scale) compared to silver prices (shown in orange on Chart 1 with a left-hand scale).

Given the historically high correlation between gold and silver price movements, and the recent lag in the silver rally, the analysis suggests that either gold will fall sharply or silver will rally sharply.

Since I have articulated the case for continued strength in gold prices, my expectation is that gold will continue to outpace silver.

Either way, both metals are heading higher.

Regards,

Jim Rickards
for The Daily Reckoning

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The Perfect Storm

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What are the three elements of the perfect political and market storm I see coming together this fall?

The first is an effort by the Democratic House of Representatives to impeach President Trump. The second is the socialist-progressive tilt in the 2020 presidential election field. The third is the fallout from the Mueller report and the Russia collusion hoax — what I and others called “Spygate.”

These components are independent of each other but are at high risk of convergence in the coming months.  Let’s look more closely at the individual elements of impeachment, electoral chaos and Spygate that comprise this new storm with no name.

The first storm is impeachment. Impeachment of a president by the House of Representatives is just the first step in removing a president from office. The second step is a trial in the Senate requiring a two-thirds majority (67 votes) to remove the president. Two presidents have been impeached, but neither was removed. Nixon resigned before he could be impeached.

If the House impeaches Trump, the outcome will be the same. The Senate is firmly under Republican control (53 votes) and there’s no way Democrats can get 20 Republicans to defect to get the needed 67 votes needed. So House impeachment proceedings are just for show.

But it can be a very damaging show and create huge uncertainty for markets. There are powerful progressive forces in Congress and among top Democratic donors who are fanatical about impeaching Trump and will not be satisfied with anything less. One poll shows that 75% of Democratic voters favor impeachment (including almost 100% of the activist progressive base).

Speaker of the House Nancy Pelosi and House Majority Leader Steny Hoyer have both poured cold water on impeachment talk. They feel it’s a distraction from Democratic efforts to enact their legislative agenda. But some of the party’s biggest private money donors, including Tom Steyer, are also demanding impeachment.

If Steyer does not get an impeachment process, he looks to support primary challenges to sitting Democrats who don’t join the impeachment effort. This could jeopardize Pelosi’s speakership in a new Congress. So Pelosi could come under heavy pressure to go along with impeachment.

The final outcome is irrelevant; what matters is the process itself. Impeachment fever is not likely to last long into 2020, because at that point the election will not be far away. Voters will turn their backs on impeachment and insist that disputes about Donald Trump be settled at the ballot box. That’s why you can expect impeachment fever to come to a head by the fall of 2019. And that will create a lot of uncertainty for markets.

The second storm is the 2020 election.

Trump is on track to win reelection in 2020. My models estimate his chance of victory is 63% today and it will get higher as Election Day approaches. The only occurrence that will derail Trump is a recession.

The odds of a recession before the 2020 election are below 40% in my view and will get smaller with time. Meanwhile, Trump will keep up the pressure on the Fed not to raise interest rates and will ensure that the U.S.-China trade war comes in for a soft landing.

This may sound like a rosy scenario for the economy. But it’s not so rosy for the Democrats. Every piece of good economic news will cause Democrats to dial up their political hit jobs on Trump. Each one will try to outdo the next.

There are now 24 declared candidates for the 2020 Democratic presidential nomination. That’s more than the Democrats have ever had before. Currently Joe Biden and Bernie Sanders are out in front. Biden is considered the most moderate of the candidates.

But I don’t expect Joe Biden to stay in front for long, and I don’t believe he’ll win the nomination. But the only way for a Democrat to stay in the race is to stake out the most extreme progressive positions. This applies to reparations for slavery, free health care, free child care, free tuition, higher taxes, more regulation and the Green New Deal.

If Biden does fall away, then the choices are back to Sanders, Elizabeth Warren or maybe Kamala Harris. But one is more radical than the next. So, you could have a shock effect where all of a sudden it looks like the Democratic nominee is going to be a real socialist. And that would rattle markets.

This toxic combination of infighting among candidates and bitter partisanship aimed at Trump will be another source of market uncertainty and volatility until Election Day in 2020 and perhaps beyond.

But the third storm is the most dangerous and unpredictable storm of all: Spygate. It involves accountability for those involved in an attempted coup d’état aimed at President Trump.

The Mueller report lays to rest any allegations of collusion, conspiracy or obstruction of justice involving Trump and the Russians. There is simply no evidence to support the collusion and conspiracy theories and insufficient evidence to support an obstruction theory. The case against Trump is closed.

Now Trump moves from defense to offense, and the real investigation begins.

Who authorized a counterintelligence investigation of the Trump campaign to begin with? Did surveillance of the Trump campaign by the U.S. intelligence community (CIA, NSA and FBI) begin before search warrants were obtained? On what basis? Was this surveillance legal or illegal?

These are just a few of the many questions that will be investigated and answered in the coming months.

These criminal referrals will be taken seriously by Attorney General William Barr along with other criminal referrals coming from Congress. Barr will take a hard look at possible criminal acts by John Brennan (CIA director), James Comey (FBI director) and James Clapper (director of national intelligence) among many others.

At the same time Lindsey Graham, Republican senator from South Carolina, will hold hearings in the Senate Judiciary Committee about the origins of spying on the Trump campaign and lies to the FISA court. These may be the most important hearings of their kind since Watergate.

Trump will be running for reelection against this backdrop of revelations of wrongdoing by his political opponents in the last election. Actual indictments and arrests of former FBI or CIA officials will cause immense political turmoil. Such charges may be fully justified (and needed to restore credibility). They will certainly energize the Trump base.

But they are just as likely to infuriate the Democratic base. Cries of “revenge” and “witch hunt” will be coming from the Democrats this time instead of Republicans. Markets will be caught in the crossfire.

How do these three storms — impeachment, the 2020 election and Spygate — converge to create the perfect storm?

By November 2019, the impeachment process should be well underway in the form of targeted House hearings. The 2020 Democratic debates (starting in June 2019) will be red-hot. Trump’s counterattacks on the FBI and CIA should be reaching a fever pitch based on real revelations and actual indictments.

The impeachment process and Trump’s revenge represent diametrically opposing views of what happened in 2016. The Democrats will continue to call Trump “unfit for office.” Trump will continue to complain that the Obama administration and the deep state conspired to derail and delegitimize him.

The 2020 candidates will have to take a stand (even though they may prefer to discuss policy issues). There will be nowhere to hide. The bitterness, rancor and leaking will be out of control.

Any one of these storms would create enough uncertainty for investors to sell stocks, raise cash and move to the sidelines. The combination of all three will make them run for the hills. That’s my warning to investors.

The next six months will present unprecedented challenges for investors. Markets will have to wrestle with fights over impeachment, election attacks and Spygate. Trump will be trying to improve his odds with Fed appointments and an end to the trade wars. Democrats will be trying to derail Trump with investigations, accusations and leaks.

Some of this will be normal political crossfire, but some of it will be deadly serious, including arrests of former senior government officials and revelations of an attempted coup aimed at the president.

A perfect storm with no name is coming. The only safe harbors will be gold, cash and Treasury notes. And make sure you have a life preserver handy.

Regards,

Jim Rickards
for The Daily Reckoning

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Rickards: “Perfect Storm” Is Coming

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People often refer to the “perfect storm.” A perfect storm is generally understood as two or more events that are independent but converge to produce an outcome much worse than either event alone.

The term is an overused cliché, and as a writer I avoid clichés whenever possible. But though rare, perfect storms do exist. The most common example is the devastating 1991 storm popularized by the book and movie of the same name, although it was initially known as the “Halloween storm.”

In that case, three separate weather dynamics all converged in one place on one day to produce a perfect storm. The odds of all three coming together at once were less than one in 100,000. That’s less than once in 270 years. That’s a perfect storm.

Do metaphorical perfect storms happen in politics and capital markets?

The answer is yes, provided the conditions of the perfect storm definition are satisfied. The multiple events that make up the true perfect storm must be independent and rare and come to converge in an almost impossible way.

Unfortunately, a political and market perfect storm is now on the way and may strike as early as Halloween 2019, marking a new “Halloween storm.” Get ready.

Today I’ll be discussing the components making up this perfect storm, and how I see them all coming together at the same time.

In my 40-plus years in banking and capital markets, I have lived through a number of financial fiascos that arguably qualify as perfect storms. Here’s a partial list:

  • 1970: Penn Central bankruptcy, the largest in history at that time
  • 1973–74: Arab oil embargo
  • 1977–80: U.S. hyperinflation
  • 1982–85: Latin American debt crisis
  • 1987: One-day 22% stock market crash
  • 1988–92: Savings and loan (S&L) crisis
  • 1994: Mexican tequila crisis
  • 1997: Asian financial crisis
  • 1998: Russia/Long Term Capital Management (LTCM) crisis
  • 2000:Dot-com crash
  • 2007: Mortgage market collapse
  • 2008: Lehman Bros./AIG financial panic.

I was not just a bystander at these events. From 1977–85, I worked at Citibank and dealt with inflation, currencies and Latin America from a front-row seat.

From 1985–93 I worked for a major government bond dealer that financed S&Ls and traded their mortgages.

From 1994–99, I was at LTCM and dealt in all the major international markets. I negotiated the LTCM rescue by Wall Street in September 1998.

In 1999–2000 I ran a tech startup, and in 2007–08 I was an investment banker and financial threat adviser to the CIA.

That’s a lot of action for one career, but it also makes the point that financial perfect storms happen more frequently than standard models expect.

Here’s what I learned: Every one of these episodes was preceded by mass complacency or euphoria.

Before the Arab oil embargo, we expected cheap oil forever. Before the Latin American debt crisis, countries like Brazil and Argentina were “the land of the future.”

No one worried about a stock market crash in 1987 because we had “portfolio insurance.” The S&Ls could not get in trouble because they had FSLIC (Federal Savings and Loan Insurance Corp.) insurance.

Mexico could not get in trouble because it had oil. Asia could not get in trouble because it had cheap labor, high growth and “fixed” exchange rates.

Russia would not go broke because it was a “nuclear power.” LTCM would not go broke because it had two Nobel Prize winners. Dot-coms would not go broke because they attracted “eyeballs.”

Mortgages were solid because we had never seen a simultaneous nationwide decline in home values. Lehman Bros. was “too big to fail.” AIG was the Rock of Gibraltar.

In short, the fiascoes I witnessed were “not supposed to happen.” They all did. The worst panics are always preceded by a sense that nothing can go wrong.

We are there again. Stocks are approaching all-time highs again. The bond bust hasn’t happened. Mortgage interest rates are near the lows of the early 1960s. Exchange rate volatility is low.

Unemployment is at 50-year lows. Real wages are rising (at least a little). There are more job openings than job seekers. ISIS is defeated. Brexit is on indefinite hold.

It’s all good. What, me worry?

I saw a recent poll asking investors when they thought a market crash might happen. Something like 80% of the respondents answered not anytime soon.

I cannot imagine a better setup for catastrophe. No one ever sees disaster coming. That’s the point.

I believe a perfect storm is coming. It’s hard to foresee the full magnitude of it, but it will likely be dramatic. It will have a major impact on markets. How it impacts you depends on how far in advance you see it coming.

What are the three specific elements of the new perfect storm I see coming for markets? Read on.

Regards,

Jim Rickards
for The Daily Reckoning

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Wall Street and the New Cold War

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The stock market seems to rise or fall almost daily based on the latest news from the front lines of the trade wars.

When Trump threatens new tariffs and China threatens to retaliate in kind, stocks fall. When Trump delays the tariffs and China agrees to resume negotiations, stocks rise. And so it goes. It has been this way since January 2018 when the trade war began.

The latest dust-up came late last week when Trump threatened tariffs against Mexico if it doesn’t do more to curb illegal immigration to the U.S. Markets sold off on Friday as a result, bringing a terrible May to an end. Largely due to the trade war, the stock market had its worst May in seven years.

From the start, Wall Street underestimated the impact of the trade war. First they said Trump was bluffing. Then the analysts said that Trump and Xi would put their differences aside and make an historic deal.

All of these analyses were wrong. The trade war was problematic from the start and is growing worse today.

China will lose the trade war. The reasons are obvious. Foreign trade is a much larger percentage of Chinese GDP than it is for the U.S., so a trade war was always bound to have more impact on China than the U.S.

And if China tries to match the U.S. in tariffs dollar for dollar, they run out of headroom at $150 billion while the U.S. can keep going up to $500 billion and inflict far more pain on China.

Other forms of Chinese retaliation are mostly nonstarters. They cannot dump U.S. Treasuries without hurting their own reserve position and risking an account freeze by the U.S. China cannot turn up the pressure by stealing intellectual property because they’re already doing that to the greatest extent possible.

China’s latest threat is to ban exports of “rare earths” to the U.S. and its allies. Rare earths are essential for the production of plasma screens, fiber optics, lasers and other high-tech applications. Electric vehicles, mobile phones and telecommunications systems would be impossible to build without them. China is responsible for 90% of global production, which makes them a potent weapon in the U.S.-China trade wars.

“Rare” earths aren’t actually that rare. They are plentiful in quantity. The problem is that they are found in extremely low concentrations. This means a huge amount of ore and expensive mining processes are needed to extract even a small amount of these vital substances.

So rare earths are one weapon China possesses.

But over time, Western powers can replace rare earths purchased from China. There could be major manufacturing disruption in the meantime, it’s true. But it would not be the end of the world.

The U.S. will win the trade war and either China will open its markets and buy more U.S. goods or the Chinese economy will slow significantly.

But while the trade war is important, it’s not the main event.

The trade war is part of a much larger struggle between China and the U.S. for hegemony in Asia and the Western Pacific.

They are locked in a new cold war being fought on many fronts. These include trade; technology; rights of passage in the Taiwan Strait and the South China Sea; and alliances in South Asia, where China’s Belt and Road Initiative is promising billions of dollars for infrastructure development.

The U.S. is responding with arms deals and bilateral trade deals to counter Chinese influence. Even if a modest trade deal is worked out with China this summer, it will not put an end to the larger struggle now underway.

What are the implications?

If the Chinese view the trade war as just one step in a protracted cold war, which I believe they do, then we’re in for a long period of contracting growth that will not be confined to China but will affect the entire world.

That seems the most likely outcome for now. Get set for slower growth and perhaps stagflation. It could be like the late 1970s all over again.

Slowly, Wall Street is taking the trade wars seriously. But it is still missing its larger implications of a new cold war.

This new cold war could last for decades and it will affect the entire global economy. Let’s just hope it doesn’t turn into a shooting war.

Below, I show you why it could. Read on.

Regards,

Jim Rickards
for The Daily Reckoning

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The Biggest Fraud in History

This post The Biggest Fraud in History appeared first on Daily Reckoning.

My readers know that I’m a longtime critic of bitcoin. Bitcoin rose from about $2,000 in May 2017 to $20,000 by December 2017 in one of the greatest asset price bubbles in history.

I argued repeatedly that it was nothing but a massive bubble and that the bubble would probably burst when it hit $20,000.

In late 2017 it did.

Bitcoin crashed from $20,000 all the way to $3,300 by December 2018 — an 83.5% collapse in one year and the greatest recorded asset price collapse in history.

The crash of bitcoin was even more dramatic than the infamous collapse of tulip prices in the tulipomania in Netherlands in the early 17th century.

But suddenly, bitcoin is back in the news.

You’ve probably seen the headlines about bitcoin’s return. Bitcoin rose from $3,900 on March 26, 2019, to $8,100 on May 15, 2019, a gain of 52% in less than seven weeks.

Happy days are here again! Bitcoin mania is back!

60 Minutes even ran a feature on bitcoin last night.

Is this the start of a new rally back to the heights of $20,000? That seems highly unlikely.

Early Friday bitcoin plunged well over $1,000 in a massive flash crash, about 10% in one day. Easy come, easy go.

What caused the crash?

It seems that a bitcoin “whale” unloaded a massive holding.

A “whale” is a term for a cryptocurrency investor with a large amount of units, or “coins.” That gives them significant influence on the market control.

It’s been estimated that less than 450 people or entities own 20% of the entire bitcoin market.

And when someone buys or sells a massive amount, prices can swing dramatically, as we saw on Friday.

It is still not clear if the large sell order was deliberate or an accidental “fat finger” error.

Prices have recovered to some extent, and bitcoin’s trading around $7,800 today. But either way, Friday’s flash crash highlights a major weakness of bitcoin. It can all come crashing down like a house of cards, as bitcoin’s 2017–18 hair-raising plunge proves.

As an asset, bitcoin has very little to offer outside of speculation.

Bitcoin still has no use case except for gambling by speculators or the conduct of transactions by terrorists, tax evaders, scam artists and other denizens of the dark web. Bitcoin is still unsustainable due to extreme demands for electricity in the computer “mining” process.

It is still nonscalable due to the slow and clunky validation process for new blocks of transactions on the bitcoin blockchain. Bitcoin has no future as “money” because the supply of bitcoin cannot grow beyond a preset amount.

That feature makes bitcoin inherently deflationary and therefore not suitable for credit creation, which is the real source of any system of money. Bitcoin has been subject to continual price manipulation by miners through wash sales, front-running, ramping and other tried-and-true techniques for price manipulation.

The bitcoin infrastructure has been plagued with hacking, fraud, bankruptcy and coin theft measured in the billions of dollars. Bitcoin may go higher from here; it’s entirely possible. But it will then come crashing down again.

What is bitcoin’s intrinsic worth?

JPMorgan Chase has tried to break it down. They examined bitcoin as a commodity.

To arrive at its worth, JPMorgan Chase estimated the cost of producing each individual bitcoin by looking at factors such as electrical costs, computational power and energy efficiency. I mentioned these factors above.

When they crunched the numbers, what number did they come up with?

JPMorgan Chase estimated the intrinsic value of bitcoin at around $2,400. Let’s assume for now that’s accurate, or a reasonable approximation. Then even at $8,000, we can conclude that bitcoin is severely overvalued.

JPMorgan Chase compared bitcoin’s recent run-up to the bubble it experienced two years ago. Even though it is still far from $20,000, if we see another speculative frenzy it could undergo a similar run. But it would end the same way.

The bottom line is I would advise you to stay far away from bitcoin. Do not get sucked in by the hype.

Sadly, some people never learn. And my guess is that many will get burned all over again.

Read on for more.

Regards,

Jim Rickards
for The Daily Reckoning

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Trump Attacks!

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The trade war is back on. The trade deadline came and went at midnight last night without a deal. So 25% tariffs on $200 billion worth of Chinese goods took effect at 12:01. The tariffs had previously been set at 10%.

Based on Trump’s comments, 25% tariffs may possibly be applied to an additional $300 billion of Chinese goods.

China said it would respond with unspecified but “necessary countermeasures,” although negotiations continued today in Washington.

Some analysts say China can dump its large holdings of U.S. Treasuries on world markets. That would drive up U.S. interest rates as well as mortgage rates, damaging the U.S. housing market and possibly driving the U.S. economy into a recession. Analysts call this China’s “nuclear option.”

There’s only one problem.

The nuclear option is a dud. If China did sell some of their Treasuries, they would hurt themselves because any increase in interest rates would reduce the market value of what they have left.

Also, there are plenty of buyers around if China became a seller. Those Treasuries would be bought up by U.S. banks or even the Fed itself. If China pursued an extreme version of this Treasury dumping, the U.S. president could stop it with a single phone call to the Treasury.

That’s because the U.S. controls the digital ledger that records ownership of all Treasury securities. We could simply freeze the Chinese bond accounts in place and that would be the end of that.

So don’t worry when you hear about China dumping U.S. Treasuries. China is stuck with them. It has no nuclear option in the Treasury market.

How did we get here?

Trump’s trade representatives have complained that China had backtracked on previous agreements and that China was trying to renegotiate key points at the last minute. The Chinese are not accustomed to such resistance from U.S. officials. But Trump and his team are unlike previous administrations.

China assumed it was “business as usual” as it had been during the Clinton, Bush 43 and Obama administrations. China assumed it could pay lip service to trading relations and continue down its path of unfair trade practices and theft of intellectual property. Trump has proven them wrong.

Trump was never bluffing. He means business, which China is finally learning.

There’s still time to reach a deal, however, before the tariffs actually have any practical impact. The tariffs only apply to Chinese goods that leave port after last night’s deadline. That means goods already en route to the U.S. will not be affected.

So it will be at least two weeks until Chinese goods are actually subject to the extra tariffs. So that leaves the window open for a deal.

Trump announced on Twitter early this morning that “there is absolutely no need to rush” to get a deal done, which removed any urgency from negotiations for the moment. You can expect the cat and mouse to continue for the next couple of weeks, with volatile swings in the stock market depending on the news of the day.

But Trump holds the superior hand as far as trade goes. China exports far more to the U.S. than the U.S. exports to China, so China has far more to lose in the trade war. Since the trade war began, the U.S. has suffered only minor impacts, while the impact on China has been overwhelming. The new tariffs will have even more serious effects on the Chinese economy.

A 25% tariff on $200 billion of goods could take 0.3–0.4% off Chinese growth. And if Trump carries through with 25% tariffs on an additional $300 billion of Chinese goods, it could subtract an additional 0.5% from Chinese growth.

That would cost China 0.8–1% of lost GDP at a time when the Chinese economy is struggling and can least afford it.

To go along with slowing growth, the Chinese financial sector is totally insolvent. Consumers’ savings have been used to finance ghost cities, white elephants, capital flight, Ponzi schemes, bribes and kickbacks.

There are some real assets to show (their trains are the best in the world) and some growth, but not nearly enough to cover liabilities.

With a debt-to-GDP ratio of about 250%, China is already well into the danger zone. How much more debt-financed stimulus can it take?

Research by economists Kenneth Rogoff and Carmen Reinhart indicates that debt-to-GDP becomes a drag on the economy at 90%.

China’s leadership can only hope the damage can be limited before the people begin to question its legitimacy.

Could China’s leadership lose “The Mandate of Heaven?”

Regards,

Jim Rickards
for The Daily Reckoning

The post Trump Attacks! appeared first on Daily Reckoning.

The Trade War Is Back

This post The Trade War Is Back appeared first on Daily Reckoning.

President Trump shocked markets yesterday when he announced that a new, heavy round of tariffs on Chinese goods will take effect this Friday. Complacent markets had assumed that a trade deal would get done, that it was just a matter of sorting out the details. Now that is far from certain. Failing a last minute deal, which is certainly possible, the trade war is back. And it could get worse.

What most surprised me about the new trade war was not that it started, but that the mainstream financial media denied it was happening for so long. The media have consistently denied the impact of this trade war. Early headlines said that Trump was bluffing and would not follow through on the tariffs. He did. Later headlines said that China was just trying to save face and would not retaliate. They did.

Today the story line has been that the trade war will not have a large impact on macroeconomic growth. It will. The mainstream media have been wrong in their analysis at every stage of this trade war. And it did not see this latest salvo coming.

The bottom line is that the trade war is here, it’s highly impactful and it could get worse. The sooner investors and policymakers internalize that reality, the better off they’ll be.

For years I’ve been warning my readers that a global trade war was likely in the wake of the currency wars. This forecast seemed like a stretch to many. But it wasn’t.

I said it would simply be a replay of the sequence that prevailed from 1921–39 as the original currency war started by Weimar Germany morphed into trade wars started by the United States and finally shooting wars started by Japan in Asia and Germany in Europe.

The existing currency war started in 2010 with Obama’s National Export Initiative, which led directly to the cheapest dollar in history by August 2011. The currency war evolved into a trade war by January 2018, when Trump announced tariffs on solar panels and appliances mostly from China. Unfortunately, a shooting war cannot be ruled out given rising geopolitical tensions.

The reasons the currency war and trade war today are repeating the 1921–39 sequence are not hard to discern. Countries resort to currency wars when they face a global situation of too much debt and not enough growth.

Currency wars are a way to steal growth from trading partners by reducing the cost of exports. The problem is that this tactic does not work because trade partners retaliate by reducing the value of their own currencies. This competitive devaluation goes back and forth for years.

Everyone is worse off and no one wins.

Once leaders realize the currency wars are not working, they pivot to trade wars. The dynamic is the same. One country imposes tariffs on imports from another country. The idea is to reduce imports and the trade deficit, which improves growth. But the end result is the same as a currency war. Trade partners retaliate and everyone is worse off as global trade shrinks.

The currency wars and trade wars can exist side by side as they do today. Eventually, both financial tactics fail and the original problem of debt and growth persists. At that point, shooting wars emerge. Shooting wars do solve the problem because the winning side increases production and the losing side has infrastructure destroyed that needs to be rebuilt after the war.

Yet the human cost is high. The potential for shooting wars exists in North Korea, the South China Sea, Taiwan, Israel, Iran, Venezuela and elsewhere. Let’s hope things don’t get that far this time.

But the easiest way to understand the trade war dynamics is to take Trump at his word. Trump was not posturing or bluffing. He will agree to trade deals, but only on terms that improve the outlook for jobs and growth in the U.S. Trump is not a globalist; he’s a nationalist. That may not be popular among the elites, but that’s how he sets policy. Keeping that in mind will help with trade war analysis and predictions.

Trump is entirely focused on the U.S. trade deficit. He does not care about global supply chains or least-cost production. He cares about U.S. growth, and one way to increase growth is to reduce the trade deficit. That makes Trump’s trade policy a simple numbers game rather than a complicated multilateral puzzle palace.

If the U.S. can gain jobs at the expense of Korea or Vietnam, then Trump will do it; too bad for Korea and Vietnam. From there, the next step is to consider what’s causing the U.S. trade deficit. This chart tells the story. It shows the composite U.S. trade deficit broken down by specific trading partners:

The Gap https://s3.amazonaws.com/paradigmpress-uploads/wp-content/uploads/2019/05/chart_the-gap-in-trade.pnin Trade - Chart

The problem quickly becomes obvious. The U.S. trade deficit is due almost entirely to four trading partners: China, Mexico, Japan and Germany. Of those, China is 64% of the total.

President Trump has concluded a trade deal with Mexico that benefits both countries and will lead to a reduced trade deficit as Mexico buys more U.S. soybeans.

The U.S. has good relations with Japan and much U.S.-Japanese trade is already governed by agreements acceptable to both sides. This means the U.S. trade deficit problem is confined to China and Germany (often referred to euphemistically as “Europe” or the “EU”).  The atmosphere between the U.S. and the EU when it comes to trade is still uneasy, but not critical.

But the global trade war is not global at all but really a slugfest between the U.S. and China, the world’s two largest economies. In the realm of global trade, the United States is an extremely desirable customer. In fact, for most, we are their best customer.

Think the still export-based Chinese economy can afford to sell significantly less manufactured goods across borders? Think that same Chinese economy can allow for a significant devaluation of U.S. sovereign debt? That’s their book, gang.

But China has finally come to the realization that the trade war is real and here to stay. Senior Chinese policymakers have referred to the trade war as part of a larger strategy of containment of Chinese ambitions that may lead to a new Cold War. They’re right.

Trump seems to relish the idea of bullying the Chinese in public. That’s certainly his style, but it’s also a risky strategy. To quote Sun Tzu: “Do not press a desperate foe too hard.”

China doesn’t like to be chastised publicly any more than anyone else, but culturally, saving-face may be more important to the Chinese. The Chinese are all about saving face and gaining face. That means they can walk away from a trade deal even if it damages them economically. Saving face is too important. But Trump is playing for keeps and will not back down either.

Unlike in other policy arenas, Trump has enjoyed bipartisan support in Congress. The Republicans have backed Trump from a national security perspective and the Democrats have backed him from a pro-labor perspective. China sees the handwriting on the wall.

This trade war will not end soon, because it’s part of something bigger and much more difficult to resolve. This is a struggle for hegemony in the 21st century. The trade war will be good for U.S. jobs but bad for global output. The stock market is going to wake up to this reality. The currency wars and trade wars are set to get worse.

Investors should prepare.

Regards,

Jim Rickards
for The Daily Reckoning

The post The Trade War Is Back appeared first on Daily Reckoning.

The Fed’s Dangerous Inflation Game

This post The Fed’s Dangerous Inflation Game appeared first on Daily Reckoning.

By now you’ve heard that the U.S. economy expanded at an annualized rate of 3.2% in the first quarter of 2019. That was reported by the Commerce Department last Friday morning.

That strong growth coming on top of 4.2% in Q2 2018 and 3.4% in Q3 2018 means that in the past twelve months, the U.S. economy has expanded at about a 3.25% annualized rate. That’s a full point higher than the average growth rate since June 2009 when the expansion began and it’s in line with the 3.22% growth rate of the average expansion since 1980.

It looks as if the “new normal” is back to the old normal of 3% or higher trend growth. Or is it?

The headline growth rate of 3.2% was certainly good news. But, the underlying data was much less encouraging. Most of the growth came from inventory accumulation and government spending (mostly on highway projects). But, business won’t keep building inventories if final demand isn’t there. That’s where the 0.8% growth in personal consumption is troubling.

The consumer didn’t show up for the party in the first quarter.

If they don’t show up soon, that inventory number will fall off a cliff. Likewise, the government spending number looks like a one-time boost; you can’t build the same highway twice. Early signs are that the second quarter is off to a weak start.

Dig deeper and you can see that core PCE (the Fed’s preferred inflation metric) cratered from 1.8% to 1.3%. That’s strong disinflation and dangerously close to outright deflation, which is the Fed’s worst nightmare.

The data just show that the Fed is as far away as ever from its 2% target. But why should it even have 2% as its target?

Common sense says price stability should be zero inflation and zero deflation. A dollar five years from now should have the same purchasing power as a dollar today. Of course, this purchasing power would be “on average,” since some items are always going up or down in price for reasons that have nothing to do with the Fed.

And how you construct the price index matters also. It’s an inexact science, but zero inflation seems like the right target. But the Fed target is 2%, not zero. If that sounds low, it’s not.

Inflation of 2% cuts the purchasing power of a dollar in half in 35 years and in half again in another 35 years. That means in an average lifetime of 70 years, 2% will cause the dollar to 75% of its purchasing power! Just 3% inflation will cut the purchasing power of a dollar by almost 90% in the same average lifetime.

So again, why does the Fed target 2% inflation instead of zero?

The reason is that if a recession hits, the Fed needs to cut interest rates to get the economy out of the recession. If rates and inflation are already zero, there’s nothing to cut and we could be stuck in recession indefinitely.

That was the situation from 2008–2015. The Fed has gradually been raising rates since then so they can cut them in the next recession.

But there’s a problem. The Fed can raise rates all they want, but they can’t produce inflation. Inflation depends on consumer psychology. We have not had much consumer price inflation, but we have had huge asset price inflation. The “inflation” is not in consumer prices; it’s in asset prices. The printed money has to go somewhere. Instead of chasing goods, investors have been chasing yield.

Yale scholar Stephen Roach has pointed out that between 2008 and 2017 the combined balance sheets of the central banks of the U.S., Japan and the eurozone expanded by over $8 trillion, while nominal GDP in those same economies expanded just over $2 trillion.

What happens when you print over $8 trillion in money and only get $2 trillion of growth? What happened to the extra $6 trillion of printed money?

The answer is that it went into assets. Stocks, bonds and real estate have all been pumped up by central bank money printing. The Fed, first under Ben Bernanke and later under Janet Yellen — repeated Alan Greenspan’s blunder from 2005–06.

Greenspan left rates too low for too long and got a monstrous bubble in residential real estate that led the financial world to the brink of total collapse in 2008.

Bernanke and Yellen also left rates too low for too long. They should have started rate and balance sheet normalization in 2010 at the early stages of the current expansion when the economy could have borne it. They didn’t.

Bernanke and Yellen did not get a residential real estate bubble. Instead, they got an “everything bubble.” In the fullness of time, this will be viewed as the greatest blunder in the history of central banking.

The problem with asset prices is that they do not move in a smooth, linear way. Asset prices are prone to bubbles on the upside and panics on the downside. Small moves can cascade out of control (the technical name for this is “hypersynchronous”) and lead to a global liquidity crisis worse than 2008.

If the Fed raises rates without inflation, higher real rates can actually cause the recession and/or market crash the Fed has been preparing to cure. The systemic dangers are clear. The world is moving toward a sovereign debt crisis because of too much debt and not enough growth.

Inflation would help diminish the real value of the debt, but central banks have obviously proved impotent at generating inflation. Now central banks face the prospect of recession and more deflation with few policy options to fight it.

So the Fed has been considering some radical ideas to get the inflation they desperately need.

One idea is to abandon the 2% inflation target and just let inflation go as high as necessary to change expectations and give the Fed some dry powder for the next recession. There are other, more drastic solutions as well.

I’ve discussed how Modern Monetary Theory (MMT) is becoming increasingly popular in Democratic circles, even though the Fed has disavowed it. But it can’t be ruled out if Democrats win the 2020 election.

That means 3% or even 4% inflation could be coming sooner than the markets expect if they’re pursued.

But those who want higher inflation should be careful what they ask for. Once inflation expectations develop, they can take on lives of their own. Once they take root, inflation will likely strike with a vengeance. Double-digit inflation could quickly follow.

Double-digit inflation is a non-linear development. What I mean by that is, inflation doesn’t go simply from two percent, three percent, four, five, six. What happens is it’s really hard to get it from two to three, which is ultimately what the Fed wants. But it can jump rapidly from there.

We could see a struggle to get from two to three percent, but then a quick bounce to six, and then a jump to nine or ten percent. The bottom line is, inflation can spin out of control very quickly.

If people believe inflation is coming, they will act accordingly en masse, the velocity of money will increase and soon enough the inflation will arrive unless money supply has been severely constricted. That’s how you get the rapid inflation increases I described above.

So is double-digit inflation rate within the next five years in the future? It’s possible. Just to be clear, I am not making a specific forecast here. But if it happens, it could happen very quickly. So the Fed is playing with fire if it thinks it can overshoot its inflation targets without consequences.

It doesn’t seem like a problem now. But one day it might.

Regards,

Jim Rickards
for The Daily Reckoning

The post The Fed’s Dangerous Inflation Game appeared first on Daily Reckoning.

Investors Are Falling Into a False Sense of Security Again

This post Investors Are Falling Into a False Sense of Security Again appeared first on Daily Reckoning.

In January 2018, two significant market events occurred nearly simultaneously. Major U.S. stock market indexes peaked and volatility indexes extended one of their longest streaks of low volatility in history. Investors were happy, complacency ruled the day and all was right with the world.

Then markets were turned upside down in a matter of days. Major stock market indexes fell over 11%, a technical correction, from Feb. 2–8, 2018, just five trading days. The CBOE Volatility Index, commonly known as the “VIX,” surged from 14.51 to 49.21 in an even shorter period from Feb. 2–6.

The last time the VIX has been at those levels was late August 2015 in the aftermath of the Chinese shock devaluation of the yuan when U.S. stocks also fell 11% in two weeks.

Investors were suddenly frightened and there was nowhere to hide from the storm.

Analysts blamed a monthly employment report released by the Labor Department on Feb. 2 for the debacle. The report showed that wage gains were accelerating. This led investors to increase the odds that the Federal Reserve would raise rates in March, June and September (they did) to fend off inflation that might arise from the wage gains.

The rising interest rates were said to be bad for stocks because of rising corporate interest expense and because fixed-income instruments compete with stocks for investor dollars.

Wall Street loves a good story, and the “rising wages” story seemed to fit the facts and explain that downturn. Yet the story was mostly nonsense.

The fact is that stocks and volatility had both reached extreme levels and were already primed for sudden reversals. The specific catalyst almost doesn’t matter. What matters is the array of traders, all leaning over one side of the boat, suddenly running to the other side of the boat before the vessel capsizes.

The technical name for this kind of spontaneous crowd behavior is hypersynchronicity, but it’s just as helpful to think of it as a herd of wildebeest that suddenly stampede as one at the first scent of an approaching lion. The last one to run is mostly likely to be eaten alive.

Markets are once again primed for this kind of spontaneous crowd reaction. After coming to within a fraction of an official bear market in December, the Fed capitulated to markets by pausing on rate hikes and ending QT far ahead of schedule.

Financial conditions eased dramatically. The markets rallied hard, and the stock market turned in its best first quarter in 20 years. The S&P and Nasdaq stormed back to record highs this week, while the Dow is only about 1% away from its own previous record.

Meanwhile, CNNMoney’s Fear and Greed Index has gone from “greed” to “extreme greed” within the span of a week. Good times are here again and investors are getting complacent again, just like last year.

But there are just as many if not more catalysts for a sharp market selloff.

Despite today’s surprising GDP report, which is likely an outlier that doesn’t mean much, there are signs the economy is slowing down.

In March, for example, the yield curve inverted. The yield on the 10-year Treasury note fell below the rate on the three-month note. Thats happened prior to each of the past seven recessions.

That doesn’t mean a recession is imminent; it could still be another year or more away. But it is an ominous sign.

Meanwhile, a recent report revealed a record seven million Americans are now at least 90 days behind in their car loan payments. There is also a student loan crisis unfolding.

Total student loans today at $1.6 trillion are larger than the amount of junk mortgages in late 2007 of about $1.0 trillion. Default rates on student loans are already higher than mortgage default rates in 2007. This time the loan losses are falling not on the banks and hedge funds but on the Treasury itself because of government guarantees.

Not only are student loan defaults soaring, but household debt has hit another all-time high. Student loans and household debt are just the tip of the debt iceberg that also includes junk bonds corporate debt and even sovereign debt, all at or near record highs around the world.

But it’s not just the U.S.

Other signs are appearing on the horizon also as the global economy is slowing down. Europe and Asia are showing marked declines.

China’s problems are well-known. And while the causes may vary, growth in all of the major economies in the EU and the U.K. is either slowing or has already turned negative. The world is discovering the limits of debt-fueled growth.

According to the Institute of International Finance (IIF), it required a record $8 trillion of freshly created debt to create just $1.3 trillion of global GDP. The trend is clear. The massive debts intended to achieve growth are piling on every day. Meanwhile, many of the debts taken on since 2009 are still on the books.

The U.S. debt-to-GDP ratio is now 106%, the highest since the end of the Second World War. The Chinese debt-to-GDP ratio is a more reasonable 48%, but that figure is misleading because it does not include the debts and guarantees of provinces, state-owned enterprises, banks, wealth management products and numerous other entities that the government in Beijing is directly or indirectly obligated to support.

When that additional debt is taken into account, the real debt-to-GDP ratio is over 250%, about the same as Japan’s.

Debt-to-GDP ratios below 60% are considered sustainable; ratios between 60% and 90% are considered unsustainable and need to be reversed; and ratios in excess of 90% are in the red zone and will produce negative growth along with default through nonpayment, inflation or other forms of debt repudiation.

The fact is, the world’s three largest economies — the U.S., China and Japan — are all now deep in the red zone.

What is striking is the speed with which synchronized global growth has turned to synchronized slowing. Indications are that this slowing is far from over. While growth can create a positive feedback loop, slowing can do the same.

Warnings of economic collapse are no longer confined to the fringes of economic analysis but are now coming from major financial institutions and prominent economists, academics and wealth managers. Leading financial elites have been warning of coming collapses and dangers.

These warnings range from the IMF’s Christine Lagarde, Bridgewater’s Ray Dalio, the Bank for International Settlements (known as the “central banker’s central bank”), Paul Tudor Jones and many other highly regarded sources.

We have had major stock market crashes or global liquidity crises in 1987, 1994, 1998, 2000 and 2008.

That’s five major drawdowns in 31 years, or an average of about once every six years. The last such event was 10 years ago. So the world is overdue for another crisis based on market history.

The trouble is, most investors will never see it coming.

Smart investors can profit from this with a combination of long-volatility strategies, safe-haven assets, gold and cash.

Regards,

Jim Rickards
for The Daily Reckoning

The post Investors Are Falling Into a False Sense of Security Again appeared first on Daily Reckoning.