US Solvency Problems Will Bring “Unique Solutions”
...But Point to a lot of Pain Ahead

The Canadian dollar has been on fire recently, rising to almost US$0.91 in trading over the past month. Targets for the C$ have been bandied about in the press, and there has been even one report cited in the Globe and Mail which was done by a technical analyst. (Forget fundamentals: if you don’t know where the C$ is heading, bring on the goat entrails, is what we say.) As it happens, we at SAC think that we know in what direction the C$ is heading. We may not know its precise target value, nor the timing, but we do know what the guiding fundamentals are, as we have been using them for a long time to direct our clients as to the direction which the C$ is most likely to take. Indeed, we refer clients to our market letter of December, 2004 in which we last issued a US dollar forecast, pointing out then that the C$, then at US$0.82 would very likely head much higher.

The central issue that we are and were concerned with is the relative solvency patterns of the US and Canadian governments – and indeed, the overall solvency pattern of the Canadian and US economies. There is one thing that remains clear: the US government and the US economy are getting steadily worse, and the Canadian government balance sheet is getting steadily better, so come what may, we have to conclude that the two currencies are continuing to shear apart. Unless and until the US government and the US Federal Reserve Board do something about the increasingly appalling condition of the US balance sheet writ large, in any longer term sense, the only thing that can happen is for the US$ to depreciate against the C$. While we have been saying this for some years now, nevertheless that trend continues unabated as far as we are able to measure.

The Atrill Solvency Curve

The founder of SAC, Dr. Verne Atrill, did not actually set out to develop a theory that could be applied to the stock market – which is the main application that we currently use Accounting Dynamics, the theoretical construct that he discovered and developed. Dr. Atrill actually began with the development of a theory of solvency (credit strength) and from there, went on to hypothesize that the solvency breakpoints might have application in the world of stocks. The stock market work was left to those who worked with him and followed along behind to develop into the service that we offer today. As an early acolyte of Dr. Atrill, however, the writer quickly discovered that whenever Dr. Atrill said anything about balance sheet changes, things also took place in the stock market, leading to price changes which could actually be considered to be forecastable on a consistent basis.

It transpires that it is not only in the stock market that Atrill’s solvency theories worked very nicely to forecast prices: it also works very well in the currency markets as well. Currency values therefore respond to the changing solvency parameters of their countries, and therefore determining currency trends is somewhat easier than it looks at first blush (using such constructs as “purchasing power parity”).

The Issues of Insolvency

Dr. Verne Atrill’s solvency theory was actually the driving force behind all of the analysis that we do at SAC. It so happens that we use the reciprocals of his solvency breakpoints in our equity work which has achieved a high profile that his credit work, but that does not detract from the fact that over the years we have used his solvency analysis to predict the demise of some pretty interesting and high profile companies such as Dome Petroleum, Canadian Airlines and Repap Enterprises among others. In particular, the identification of the solvency breakpoints at .499… and .289… have been immensely valuable in allowing us to forecast emerging catastrophes well in advance of all other credit analysts.

Essentially, the solvency determination is simple and mechanical. The Atrill Solvency Ratio, R/P, the dynamic receivables divided by dynamic payables, is the ratio of:

R - which is the sum of Total Assets plus accumulated depreciation minus net plant, equipment and inventories, and
P - which is the total debt of the enterprise.

The key feature is the dynamic nature of the analysis rather than the static nature of the debt to equity ratio often employed. What we really are searching for is the ability of an enterprise to meet its ongoing obligations, or total debt without changing the modality of the enterprise (that is, be having to liquidate plant, equipment or inventories to meet ongoing debt payments.

The reason that we are comfortable using these two proxies for the financial condition of the US (or any country for that matter) is that the peak of the Atrill Curve occurs at a ratio of .689, and for most of the entire period from 1920 through to 1980, the US debt/GDP ratio was fairly close to that ratio (+/- .02-3) as reported by economist Kurt Richebächer. As that is Atrill’s ratio of “maximum financial efficiency and least cost of capital”, it stands to reason that any economy left to its own devices should operate in the aggregate very close to that level. Unless an agency of sufficient size and power enters the equation to force that ratio to change, then we suspect that it will naturally go there, in the aggregate again.

In the short term, of course, anything can happen. If some well known economist wishes to tell us at some point going forward us that oil prices (or whatever) are falling and therefore the C$ will fall as well, and enough traders believe it, then look for setbacks to occur. No trend rises straight upwards unless too many speculators get on the band wagon and cause a short-lived spike. However, SAC’s long-serving director, Tom Hodgson, did his Ph.D. thesis on currency forecasting in which he used relative changes in government solvency to predict future changes in the currencies of the G7 countries. While he was unable to predict very short term swings (which is perfectly understandable as all kinds of ‘noise factors’ come into play in the very short term), the long trends fitted very nicely. And we know something about the long trend in the US and Canadian government balance sheets: Canada’s has been getting steadily stronger and that of the US has been getting steadily weaker. As there is no change in sight, nor does there seem to be any will on the part of the US government to do anything about it, save to jawbone, we can forget about some potential ultimate and near-term peak coming up soon. It just is not “in the cards” (although sooner or later, it will have to be, we firmly suspect).

To provide a little background to today, in 1980, enter Ronald Reagan and the idiotic “Laffer Curve of Taxation”. The GDP/Debt ratio started to change for the worse as tax revenues decline but spending didn’t. Of course, we have the Trudeau Liberals who loved to spend as well so we did not depart from basic US policy ourselves. The Conservative government under Brian Mulroney later swept in with promises to clean up after the Liberals but left ignominiously in 1993, having failed to do anything save make matter worse, and were themselves fittingly swept out down to one last man and women. Canada was then in deep financial difficulties, and the new Liberal government under Jean Chrétien but directed financially by businessman Paul Martin (and David Dodge) began the long process of nursing Canada back to financial health.

In the interim and for a few sensible years, the Clinton government of the US did likewise and both governments were therefore moving in the same direction as well, the US government moving even faster than Canada with the result that the C$ reached a low of US$0.62. By with the election of arguably the stupidest president in all US history, George W. Bush, and supported by our own personal anti-hero, Alan Greenspan, chairman of the US Fed, after the Presidential election in 2000 the US went its own spendthrift course in order to achieve the reelection of Mr. Bush. Canada, however, continued to rebuild it’s financial strength. By 2002, the damage was becoming apparent, and the C$ began an ascent which continues through to this day as the differences between the two countries became worse and worse.

Here is where things get interesting as far as we are concerned. We know, for example, that any company who reaches down towards the .289 Solvency Ratio is not long for this world unless it restructures its balance sheet. Over the past 25 years, SAC has made a regular habit of finding these nasty little ‘gems’ and exposing them to our clients, first so that our clients do not inadvertently own either their shares or their debt, and second so that those who like to do so may sell them short. We have never seen a company reach below a ratio of .289, however, because, as Dr. Atrill liked to say, “at 0.289… they have sold everything on the shelf and now must sell the shelf itself”. In other words, financially, such companies are unable to carry on any longer. Indeed, the principal feature of such companies is that they appear to be in the business of generating additional debt.

Now, presumably, if there is anything to the Theory of Accounting Dynamics (the underlying theory that drives the SAC analytical work), then any entity which reaches .289 must also be a dire straights. We had already observed that the growth rate of US debt greatly exceeded the growth rate of its GDP, and so it was with great interest that this May 8th, Barron’s Weekly had an interesting article on what US cities and states are doing to overcome their “cash-strapped” condition. Essentially, as the US gets deeper and deeper into debt and as the overall solvency of US governments at all levels, both federal, state and local, get worse and worse, they must feel the pressure to do something drastic, and selling assets (“the shelf”) to pay down debt (or merely spend the proceeds) is one good solution.

In the above referenced Barron’s article, the author observed that US states and cities are finding a hot market among major offshore investors for their toll roads. Sale of these roads does two things: it raises a nice chunk of cash and second, it obviates the necessity of performing any repair and maintenance work on those roads, which they can ill afford these days. While the gist of the article was aimed at pointing out the very high prices that these toll roads were fetching in the marketplace these days and the return on equity that was possible, what struck us was that as the US gets itself into deeper and deeper financial hot water, the necessity of selling assets increases by leaps and bounds, as does the pressure to do so.

What we are looking for here, however, is not only the sale of assets to get balance sheets back under control but also the necessity of reigning back on government expenditures in order to achieve balanced, if not surplus budgets. Unfortunately, the US, unlike Canada, has lost the opportunity to do that during a time when the economy was doing relatively well and now may have to do it at a time when budgetary cuts will only add to the weakness which the economy is likely to face.

How Long to Get to .289?

Without wishing to be held tightly to account for a dead precise determination, we have used available information to attempt to extrapolate just how long it will take the US to actually reach UD-Day (uncontrollable deficit day). We have taken the latest approximation for total US debt of all kinds to be just about at the $40 trillion mark, and total US GDP to be $12.8 trillion. Using Kurt Richebächer’s observations, we observe that since the year 2000, total US debt has risen at a rate 6 times faster that US GDP. In other words, the US appears to be in the business of generating debt! Assuming that US GDP continues to rise at a 3.5% rate, then the US will reach our “magic” .289 ratio in roughly 20-22 months. In other words, our target of 0.289 is not some airy-fairy far-off ‘goal’ but should be visited on us all fairly soon. (Change any of the assumptions and the target date will either be close or further, but it is not a difference of, say, 5 years versus 20 months, but perhaps 18-25 months instead. For one thing, we note that recently, US total debt has actually been growing at 7 times the increase in GDP, not surprising as the deeper the insolvency, presumably the faster the debt generation should be.)

We do not anticipate that there will be ‘red rockets in air’ to observe the coming of this event, although the colour would be appropriate if that were to occur. However, the intensification of the US solvency problem will continue and we do assume that the US will become increasingly creative in its efforts to get financing for its deficits. And if there is an accompanying recession, everyone globally is likely to feel the strain intensely!

As a final aside here, that figure of 22-24 months (which we should probably widen to 18-25 months to be safe) is interesting all by itself, as that would about carry the US to the next presidential election. Like the almost total demise of the Canadian Conservative Party in 1993, and the ironic rise of the Liberals as the party of fiscal conservativism, it may well fall to the Democrats, the party of big spending, to clean up the fiscal mess left by the current Republicans!

Conclusions

All this is simply to say that the longer term pressures on the US dollar are downwards versus just about everyone (as, be definition, everyone else must necessarily be cast in the role of creditor to the US). The other way of looking at this is that longer term pressures on the Canadian dollar versus the US dollar are upwards. From a non-US perspective, probably not much of a major change should occur except to the extent that offshore jurisdictions and investors assume that Canada is the 51st state of the US and sell our currency regardless simply because of our proximity and our business and trade ties.

Is the Canadian dollar going to US par? It certainly could get there if present trends continue, and for that matter could go even higher if the US does nothing about their current financial situation for the time being (as appears to be the case). And we would not actively bet against it if this were an important consideration for any of our clients. This tide is rising and no King Canute, be it David Dodge of whomever, can stop it by fiat. Nor, we suspect, does Dodge think that he can stop it either, so do not expect him to try to, except perhaps in the sort of desultory way that appears to be cosmetically motivated. We would observe that he appears very much aware of the insanity that has gripped US policy making.

How long will it take the Canadian dollar to get there (i.e. par)? [What? You want direction, magnitude and timing, all in one forecast?] All we can forecast are tendencies based on balance sheet considerations: you will have to ask the market technicians to divine the entrails. However, the higher the C$ goes, presumably the more volatile it will become vis-à-vis the US$ and therefore the best that we can say is that it will not rise in a straight line, but higher it will go. No interest rate adjustments will work long term; no commodity price fluctuations will cause more than a dent in the upwards trend; and finally, since the rest of the world is more or less in the same boat, we don’t expect huge changes in the C$ vis-à-vis other non US-dollar pegged global currencies.

If we look at the Solvency Curve once again, it is obvious why this should be so. If the global economy also seeks the point of least cost of capital, but is being pushed away from there by one massive insolvent, the USA, then it is perfectly clear that everyone cannot operate at the ‘Efficient Mean’ and still accommodate the US. Therefore one of two things has to happen. Either the rest of the world will become more solvent, which is to say will generate excess dynamic receivables which are not used in their domestic economies but are shipped abroad to the US, or like any good banker, they will call their loans to the US and the game will be over (for the US, at any rate). However, the US is also the largest economy in the world, is a bully to boot, and is militarily able to enforce that which it wishes to do. Remember the dumping on that Korea received when one from its central bank suggested that the bank might diversify its foreign currency holdings away from the US. Our guess is that the US will not go quietly into this night but will wreak havoc as it goes.

Should you invest in gold bullion as a hedge? It will probably work out, at least on a speculative basis, but we don’t think that any of the really big numbers are in the cards. Furthermore, if there is a recession and major commodity weakness, we would be very surprised if gold did not follow the general commodity trends. Gold is no magic bullet for the US dollar problems: it is a commodity.

We have used Dr. Atrill’s observation several times in the past (in dealing with corporate balance sheets) to forecast not only liquidations but also the coming collapse of the related stock prices. However, we have never seen, in real time as it were, what would happen to a country as powerful as the US that entered that same condition. As far as we are able to tell, however, we are about to find out. The whole thing conjures up all sorts of images, although reality must intrude as well.

The best scenario (in our imagination) would be a US recession. This would be a bit of a nightmare – for everyone as many, if not most, other countries around the world will be affected. However, a US consumer-led recession which entailed – as we think will occur – balance sheet rebuilding by the over-extended consumer sector could bring about a general understanding in the US (and our Democratic majority thesis) that they themselves will have to do the balance sheet restructuring job. And we do have to ponder the question of relative currency values in a global recessionary environment. For instance, can China, which has bet the farm on exporting, maintain a strong currency if it is hit with a severe recession as a result of a US slowdown? That very much remains to be seen.

The Price of Gold: No Solution

Let us suppose for a moment what if the price of gold bullion were to be increased to the level at which the amount of gold held in the vaults at US Fort Knox would be enough to totally back the outstanding issuance of US money, or even total US debt. Those Gold Bugs who calculate such esoterica tell us that the price of bullion would have to rise to $2500 (or whatever) in order to do this. So let us say that this occurs and the US then takes its gold bullion hoard and presumably pays down a great slug of its debt, thus rendering the US government solvent once again. Let us ask the question, what would happen on the day afterwards?

The first thing that would happen is that a number of the holders of that bullion would presumably attempt to cash it in because bullion itself is entirely sterile save for its jewelry and industrial value. Central banks and other former debt holders would clearly prefer to hold currencies of some kind because they can be invested for the prevailing interest rate return. In any case, the speculative reason for owning bullion would be over. We would postulate that the price of bullion would then collapse to the clearing price for industrial usage. Indeed, we could easily postulate that the bullion would enter a downwards spiral that would approximate the collapse of the high tech stocks following the peak in 2000 because industrial usage demand would, in all probability, collapse at those exotic levels. In other words, the former holders of US debt would, in all probability, lose horrifically on their new bullion holdings and therefore would probably not wish to enter into such a transaction with the US in the first place.

Now, of course the “fatal flaw” in our argument is that this would not happen if someone guaranteed the subsequent price of bullion. It would have to be set and pegged there so that such a collapse could not occur. Therefore the revaluation is still possible. But hold up there, didn’t the US already do something like that back in the Dirty 30’s? And what happened then? Well, the answer is even more unpalatable to those who think that this is a viable solution. The US did raise the price of bullion and then pegged it in 1937. In the ensuing haste of holders of bullion to unload their holdings at this enticing price, the US was forced to use up its banking reserves to purchase the bullion and triggered the liquidity crisis of 1937, a sharp recession and market collapse. And that was only due to a modest increase in the price of bullion. Fancy gold bullion rising from today’s $700 (+/-) level to $2500 and picture the kind of liquidity carnage that would ensue for whomever was the guarantor of the new price of bullion. And if that guarantor was the US, would it not force the US to issue more obligations (which it had just dumped) to do so?

Logically, we would argue that the Gold Bugs are sort of sweet in their naïveté but probably impractical, as history has already demonstrated. We are of the opinion that modern central banks would not likely countenance such a move nor be a party to such a major revaluation. And, of course, who knows what would happen to those industries that rely on the usage of gold for whatever their output. The wild swings that would result would create carnage everywhere. Overall, we come back to the fact that this is a solvency problem, not a reserves (and hence gold bullion) problem. There is not nearly enough gold on the face of the globe to take care of the problem even if central banks would like to do so, and silly prices for what is essentially an industrial commodity are no solution either.

In the end, we conclude that when the US adjusts its overall balance sheet, the process will be long and slow, not to mention painful, and that there are no magic bullets out there – the revaluation of gold bullion being the primary hoped-for solution by the gold bugs in particular – which will help the US to quickly and easily overcome its solvency problem. This is not to say that if the US$ falls even further that gold bullion will not rise even further than it has already. The ‘Gold Bugs” will undoubtedly see to that. But the move will be more speculative and will, in the end, prove to be sterile in our opinion.

As a final piece of [useless] trivia, the price of gold bullion now (around $675 an ounce) is about where it was in the 1930s after its revaluation, adjusted for inflation.

Collateral Damage

As almost all commodities are priced in US dollars, if there is significant weakness in the US dollar, then we would have to wonder what would happen to the earnings of many of the Canadian commodity stocks, and hence the stock prices. Not that we have any “fix” on the overall issue, but it does strike us that if the US dollar is really weak and the US economy is weak as well, causing the global recession that the Bank of Canada appears to expect, then commodity prices are likely to weaken in any case, and US pricing will not help the stocks, if nothing else from a psychological point of view.

We do not think that we are at that point as of yet, so we are not throwing this into the hopper as a reason to sell commodity stocks right now, but if, as, and when the US does weaken as expected, then we could look for a bit of a double whammy to take place.

The Outlook For Interest Rates

Finally, we suspect that the vast majority of market participants think that [long term] interest rates are close to being about as high as they are likely to get and that the Fed has one last magic bullet to fire and save us all. Unfortunately, we also think that the risks in the global economy today, or more aptly, the risks in the US economy today are larger than most believe and therefore if the US does enter into recession, those risks will erupt full blown and are far more likely to push rates higher than permit the Fed to push them down. In sum, if solvency problems strike, the Fed will be toothless