From the desk of Will Bonner:

Still no word from dad…

As I reported yesterday, he’s up on the family ranch in northwestern Argentina. And he’s lost his satellite Internet connection.

So, we have another classic Diary issue for you today instead – a warning about what happens when the world places its faith in “elastic” money.

Why Our “Elastic” Money System Is Doomed to Fail

This financial world we live in is completely new. There are few historical data points that help us understand it. And those that do exist tend to be incomplete and inconclusive.

President Nixon changed the money system on August 15, 1971. Since then, we’ve been in a brave new financial world. From a gold-backed monetary system, we switched to a system based on paper money, managed by people with PhDs.

The idea was that, rather than be stuck with a fixed quantity of money, academics could instead figure out how much money and credit was needed and provide them as necessary.

This was not the first time governments have tried to put in place an elastic monetary system. Several times in history nations found paper money a convenient way to pay their bills – typically when they were at war and had run out of real money.

But this was the first major episode during peacetime in which the world’s financial systems had come to depend on a paper money controlled by a single nation: the United States of America.

Gresham’s Law

Gresham’s Law tells us that “bad money drives out good.” If people have a choice between holding a debased or deteriorating money (paper) or holding real money that is not losing value (gold), they will choose to hoard the good money and pass along the bad stuff.

In effect, that’s what happened. The good money (gold) disappeared from circulation. The bad currency (dollars) became what everyone recognized as “money.” Central banks in the developed world generally decided that the prudent thing to do was to hold some gold… as well as US dollars.

And now that the developing countries are becoming more prosperous, unsurprisingly, their central banks are also accumulating gold.

Dollars are not the same as real money. They are liabilities of the US federal government – Federal Reserve Notes – much the same as Treasury bills, notes and bonds. In this way, dollars are the opposite of money. Instead, they are debt instruments of immediate maturity.

Washington tells us to use them as “legal tender for all debts, public and private.” But it provides no guarantee of their value.

Real money has intrinsic value. Once a debt is paid in real money, the transaction is finished. Over. Complete.

Not so with US dollars. They are debt instruments, just like all government-issued paper. And debt depends on the debtor. If he defaults, his paper promises can become worthless – including his dollar bills.

Drenched in Debt

As dollars replaced gold, the capitalist system became a strange and grotesque amalgamation of market-based transactions, but with less and less real capital involved.

Debt replaced real money. Gradually, debt spilled over and saturated all sectors. Households, businesses – everyone became drenched in debt… from the recent college graduate with his student loans… to the young family with its mortgage and credit-card debt… to the retirees, depending on the unfunded liabilities of the Social Security and Medicare systems.

And when this tsunami of debt threatened to drown millions in the deleveraging crisis of 2008-2009, the powers that be rushed to the scene with aid. But what help could they give? More debt!

There was no way they could afford to let so many debt-soaked institutions sink. They made it clear they would give the economy as much new liquidity as it needed.

And now, even the faint suggestion that they might be getting tired of pumping so vigorously staggers the market for stocks.

But where does all this new liquidity go? We now know it goes into buying more financial assets. This pushes up their prices. And makes the rich even richer.

Take it away, and it may be that Mr. Market is preparing some real excitement.

It will be fun to watch… from a distance.



Market Insight:

Will the S&P 500 Take Out Its March Low?
From the desk of Chris Hunter, Editor-in-Chief, Bonner & Partners

Take a look at this chart…


As you can see, the S&P 500 is dangerously close to taking out its March lows (highlighted by the horizontal blue line).

If it does, you can expect more bears to come out of hibernation, as it will mean a monthly reversal for the S&P 500. In other words, the index will have set a new high and a new low in the same month – a bearish signal.

Regular readers know we believe the US stock market is dangerously overvalued… and that the primary driver of higher stock prices are QE and share buybacks (funded, to a large extent, with ultra-cheap corporate debt).

Now, all eyes will be on earnings season. It kicked off in the US this week with bellwether aluminum producer Alcoa, Inc. (NYSE:AA) reporting a 6% drop in year-over-year revenues – which is hardly encouraging.

And of the 4% of S&P 500 companies that have so far reported Q1 earnings, one-third have missed their earnings-per-share estimates – again, not a good sign.

We continue to recommend limiting your exposure to US equities… and looking instead at beaten-down emerging markets. The MSCI Emerging Market Index is trading on 10 times expected earnings, versus 15 times for the MSCI Developed World Index.

Editor’s Note: We also recommend you check out the new piece of research from Bonner & Partners senior analyst Braden Copeland. Braden has identified six specific stocks to buy in the next panic – what he calls his “Open in Case of Emergency List.” Each one has a crisis-proof balance sheet, has a business that’s easy to understand (no banks) and a proven track record of generating high income for shareholders. Go here to learn more.