But this quintessentially laissez-faire perspective gains very little traction in modern-day America. In fact, it gains no traction whatsoever, except in a few fringey financial publications. Instead, America’s political elite conspires with the Wall Street bourgeoisie to lead the nation from the highest degree of affluence to the lowest barbarism.

The process begins innocently enough in the name of “crisis management,” as the political elite provides multi-trillion-dollar guarantees and bailouts to the Wall Street bourgeoisie. The proletariat embraces these bizarre, counterintuitive remedies because they genuinely believe these “remedies” contain curative powers. In other words, the proletariat believes that bureaucrats and politicians, following the self-serving recommendations of inept finance company executives, can deploy taxpayer dollars to the benefit of the masses.

Include us out.

The bureaucrats and politicians lack the requisite skills; the Wall Street bourgeoisie lack the requisite morality. Like a meeting between coyotes and butchers, nothing good could ever come from close interaction between Washington and Wall Street. If the butchers suggested converting all felines into meal, the coyotes would simply yelp and howl their approval

Your editors here at the Rude Awakening would prefer that the coyotes and butchers not conspire with one another. No one benefits….other than the coyotes and the butchers.

But what’s the use of complaining. We try never to complain, merely to understand. We try to identify and anticipate the key influences that are operating upon the financial markets. Identifying the key influences is usually not that difficult. But determining the effect of these influences is often very difficult.

During the last several months, for example, investors have been greeting the daily barrage of bad economic news as GOOD news for the stock market. We are not exactly certain why this would be so, but we are familiar with the daily banter of various financial news media. Therefore, we have encountered, ad nausea, phrases like, “better than expected,” “green shoots of recovery,” and “credit markets improving.”

We have encountered these phrases, and we have thoroughly and completely rejected them. We do not believe these phrases contain a single atom of validity, nor a single molecule of data that will produce a profitable investment result. That said, we should point out to the newest readers of the Rude Awakening that your editors have been wrong before…and may be again.

But we won’t let that stop us. The stock market’s splendid rally during the last three months was a classic bear market rally. The S&P 500, the Dow Jones Industrials and the NASDAQ Composite all rallied more than 40%. But great big rallies like these are not rare during great big bear markets.

As we pointed out last week, Japan’s Nikkei 225 Index rallied more than 40% on ten different occasions during the last two decades. And yet, the Nikkei remains more than 50% below the all-time high it established in 1989.

Could a version of this sorry scenario unfold here United States? Sure. Why not?

The nearby charts place the recent rally on Wall Street in a “Japanese context.” The chart above compares the first 20 months of our current American bear market to the first 20 months of the Nikkei’s bear market. The chart below places this 20-month period in a 20-year context. If the American stock market were to have the misfortune of mimicking the Nikkei, the road ahead would be long and painful.

Your California editor is not predicting such a scenario. But neither does he believe that “Happy days are here again.” The road ahead – both for the economy and for the stock market – is likely to be long and painful. How long and how painful is anyone’s guess. Our guess would be: Not as bad as Japan’s experience, but much worse than most Americans currently expect.

The chart above may contain a helpful glimpse into the future we fear. Despite the fact that most investors believe the worst of the recession is behind us, the nation’s employment situation is far worse than anything we have endured during the last five recessions.

So you tell me, are things getting worse or are things getting better?

The only thing we know for certain is that government intervention increases by the day, Wall Street’s malevolent influence increases by the day, the pressure to raise taxes increases by the day, the nation’s monstrous indebtedness increases by the day, threats to the dollar’s vulnerabilituy increases by the day, and therefore the long-term viability of America’s legendary capitalistic dynamism DE-creases by the day.

This from Marc Farber:

When I consider that prosperity is created by “peace, easy taxes and a tolerable administration of justice,” I begin to fear that the U.S. and other Western governments are doing their very best to impoverish their countries.

A friend of mine, Michael Berry, whose missives I always read, could not have phrased this idea better than in “Importance of the Individual”, a recent report in which he quotes Milton Friedman in a 1979 interview by Phil Donohue.

Berry writes: “On February 11, 1979, Milton Friedman took two and a half minutes to explain the critical importance of the individual and choice in the free enterprise system to a doubting Phil Donohue…The individual’s freedom and ability to choose and take risks to create value are, of course, all-important life elements and a cornerstone of our country…

And yet, Berry continues, “Under the guise of saving the economy, there is a not so stealthy encroachment on the rights of the individual…This is not, ‘Change We Can Believe In.’ It is ‘change we must be wary of.’ Where is Milton Friedman when we really need him? Think carefully about the following interview which was conducted 30 years ago:

‘Phil Donohue: When you see around the globe the mal distribution of wealth, the desperate plight of millions of people in underdeveloped countries. When you see so few haves and so many have-nots. When you see the greed and the concentration of power. Did you ever have a moment of doubt about capitalism? And whether greed is a good idea to run on?

‘Milton Friedman: Well first of all tell me, is there some society you know that doesn’t run on greed? You think Russia doesn’t run on greed? You think China doesn’t run on greed? What is greed? Of course none of us are greedy. It’s only the other fella that’s greedy. The world runs on individuals pursuing their separate interests. The greatest achievements of civilization have not come from government bureaus. Einstein didn’t construct his theory under order from a bureaucrat. Henry Ford didn’t revolutionize the automobile industry that way. In the only cases in which the masses have escaped from the kind of grinding poverty that you are talking about, the only cases in recorded history are where they have had capitalism and largely free trade. If you want to know where the masses are worst off, it’s exactly in the kind of societies that depart from that.

‘So that the record of history is absolutely crystal clear, there is no alternative way, so far discovered, of improving the lot of the ordinary people that can hold a candle to the productive activities that are unleashed by a free enterprise system.

‘Phil Donohue: Seems to reward not virtue as much as the ability to manipulate the system.

‘Milton Friedman: And what does reward virtue? You think the Communist commissar rewards virtue? You think a Hitler rewards virtue? Do you think… American presidents reward virtue? Do they choose their appointees on the basis of the virtue of the people appointed or on the basis of political clout? Is it really true that political self-interest is nobler somehow than economic self-interest? You know, I think you are taking a lot of things for granted. And just tell me where in the world you find these angels that are going to organize society for us? Well, I don’t even trust you to do that.’”

Certainly, you won’t find any angels at central banks around the world or in the Economics faculties of universities. I needed quite a stiff drink after reading a recent Wall Street Journal article by Harvard Professor Gregory Mankiw, who advocates creating negative real interest rates through inflation and seems to have great sympathy for the outright expropriation of savers’ capital.

Professor Mankiw declared his faith in the curative powers of inflation in February 1, 2000 article in the dead Wall Street Journal. “When you look at the mistakes of the 1920s and 1930s,” he said, “they were clearly amateurish. It is hard to imagine that happening again – we understand the business cycle much better.”

The current Federal Reserve Chairman, and of a very large number of US economists, share Mankiw’s perspective – a perspective that he reiterated in a very recent Wall Street Journal piece, entitled, “It May be Time for the Fed to Go Negative” (Wall Street Journal, April 19, 2009).

“With unemployment rising and the financial system in shambles,” Mankiw observes, “it’s hard not to feel negative about the economy right now. The answer to our problems, however, could well be more negativity. [He means negative interest rates]…Lower interest rates encourage households and businesses to borrow and spend. More spending means more demand for goods and services, which leads to greater employment for workers to meet that demand.

Inflation is the answer says Mankiw – a Goldilocks style of inflation that is neither too hot nor too cold.

“Ben S. Bernanke, Fed chairman, is the perfect person to make this commitment to higher inflation,” Mankiw concludes. “Mr. Bernanke has long been an advocate of inflation targeting. In the past, advocates of inflation targeting have stressed the need to keep inflation from getting out of hand. But in the current environment, the goal could be to produce enough inflation to ensure that the real interest rate is sufficiently negative.”

Unfortunately, inflation is a wolf in sheep’s clothing. It seems relatively tame and friendly. But it is quite the opposite. Inflation leads an economy down the path of impoverishment. If a government is determined to create inflation, there is really nothing standing in the way of its doing so.

Nevertheless, an investor can – and should –take precautions. When governments speak openly about creating inflation as a cure for macro-economic ills, the seeds of economic malaise are already germinating.

Gold anyone?

Source:  The Death of American Capitalism

The problem I have with this dogmatic definition of a bear market rally is the following: Assuming (and this isn’t a forecast, since I really haven’t the foggiest idea where stock markets will be in six or 12 months’ time) the S&P 500 moved up to 1350 and then declined to 500, as an investor should you care if the move to 1350 — a 100% gain! — was a bear market rally?

My impression is that investors’ fixation on the recent rally being a bear market rally has actually kept most investors on the sidelines and hoarding cash. Now, put yourself in the shoes of a fund manager who, in the last 18 months, has lost 50% of his clients’ money and missed the recent rally (34% for the S&P 500). What is he likely to do? I would think that he would be inclined to purchase equities as they correct the sharp advance since early March, especially as the economic news in the near term becomes less negative.

Based on our conversations with numerous managers in recent weeks, we believe that most quantitative managers’ portfolios were not positioned in expectation of a rally. Of the nearly 80 managers we have talked to, only one manager said they were up since March 9th and the clear majority admitted to being notably down or stopped out on their positions. These managers were both long-only and long-short quant managers using market neutral and non-market neutral strategies, sector neutral and non-sector neutral strategies, longer term and intermediate-term holding periods. It is fair to say that just about everyone is bewildered and trying to understand when this rally will end.

Another factor to consider is that there has been a significant improvement in the technical position of world stock markets. In the US the largest number of new 12-month lows was reached in October. At the November 21 low at 741 for the S&P 500, the number of new lows had already contracted, and even more so at the index’s March 6 low at 666. Also, market breadth and the number of stocks moving above their 200-day moving averages have taken a decisive turn for the better, indicating that the stock market advance is broadening and that the number of stocks that have bottomed out (at least in the intermediate turn) is expanding.

I have explained repeatedly in the past that if a government is really determined to try and postpone an inevitable collapse by “printing money” in order to lift or support asset prices, it can be done. However, the result of such a monetary policy is to lower the purchasing power of its paper currency, with catastrophic long-term consequences for its economic and financial volatility.

It forces individuals and institutions with cash to buy something…anything. So, this cash is channeled into gold and/or different paper currencies, commodities, equities, bonds, real estate, and consumer goods and services, but obviously with different intensities and at different times. For instance, at some times, such as in 2008, more money will be allocated to gold; while at other times, such as since early March, more money will flow into equities and industrial commodities. It is well understood that these money flows are driven largely by speculative activity (and more than a little dose of manipulation). The result in all asset markets is very high volatility and price fluctuations that don’t appear to make any sense to most market participants and observers who don’t understand the new rules of the investment game that were brought about by “money printing”.

This is where we are today, irrespective of whether or not you and I like policies of “quantitative easing, massive bailouts, and frightening fiscal deficits” and their long-term consequences! Another positive factor for stock markets is that a large number of Asian stock markets and individual stocks in the region had already bottomed out in October and November of 2008 and didn’t confirm the new low in the S&P in early March.

In Asia, the Taiwan and Shanghai indexes, and Korea’s Kospi Index, are all up by more than 50% from their late October 2008 lows. (The Shenzhen Index is up 90%.) But it is not only the Asian equity markets that have outperformed the US and Western European markets over the last few months; since late January 2009, the RTS Russian Index is up 66% and the MSCI Emerging Market ETF is up by 55% from its early November 2008 low.

This is not to say that the global economy is about to embark on a strong and sustainable growth phase. It also doesn’t mean that a new bull market in global equities à la 1982– 2000 has begun. But I think that, at least in nominal terms (inflation-adjusted), the global printing presses being run by the world’s central banks and fiscal deficits have begun to impact asset prices positively. Therefore, in the case of resource and mining stocks, as well as Asian equities (and, for that matter, most emerging and other stock markets around the globe), the lows thatwere reached between October and March of this year are likely to hold — that is, for now.

The markets that have the highest probability of having made major longer-term lows are resource-related equities, emerging markets, and Japan. Conversely, the asset market that has the highest probability of having made a secular high (such as Japan in 1989, or the Nasdaq in March 2000) is the US long-term government bond market.

Despite a still-weakening economy and massive quantitative easing, long-term bond yields appear to be on the verge of breaking out on the upside. I have listed again below all the equity recommendations I have made since December 2008. Some of these equities have already moved up substantially (resource and mining companies, in particular) and, therefore, I would only buy most of these recommendations on a correction.

In addition, a number of BRIC and other (mostly emerging market) closed-end country funds and ETS were recommended, such as Brazil ETF (EWZ), the Templeton Russia Fund (TRF), the Greater China Fund (GCH), the Asia Pacific Fund (APB), Taiwan iShares (EWT), the Japanese ETF (EWJ), the Japan Smaller Capitalization Fund (JOF), the Morgan Stanley India Fund (IIF), the Turkish Fund (TKF), and the MSCI Emerging Market ETF (EEM).

In the US, late last year we recommended buying the iShares iBox Investment Grade Corporate Bond (LQD) and Nicholas Applegate Convertible & Income Fund (NCV), while earlier this year we recommended the accumulation of stocks of high-tech companies such as Cisco (CSCO), Intel (INTL), Oracle (ORCL), and Yahoo (YHOO). More recently, we recommended beaten-down insurance companies and financials as rebound candidates, including Leucadia National (LUK) and CNA Financial (CNA), Citigroup (C), the BKX, the Financial Bull 3x Shares (FAS), and the Financials Select Sector SPDR.

The market’s advance had been broadening and that more and more groups such as airlines (AMR), homebuilders (TOL, CTX, HOV), and cyclicals such as Dow Chemical (DOW), International Paper (IP), and Alcoa (AA) are showing signs of having bottomed out. Among commodities, I am particularly intrigued by natural gas. There are natural gas ETFs (UNG, GAZ), but costs are high. A better way is probably just to buy future contracts, or Pioneer Natural Resources (PXD) or the First Trust ISE Revere Natural Gas Index Fund (FCG).

Source: What to Buy…or Not Buy

I can see some – albeit very modest – improvement for the US stock market. For one, it appears that the slowdown and problems in other economies, such as the UK (a disaster waiting to happen), Italy, Spain, and Ireland, are even greater than in the US. Also, since numerous emerging stock markets have underperformed the US this year, some money is likely to be repatriated from countries such as India and China, where stock markets are down approximately 40% year-to-date. We should also consider that, as Joachim Fels noted, “Fifty of the 190 or so countries in the world now have inflation running at double-digit rates. Almost all of these are EM economies.” In my opinion, some emerging economies – contrary to expectations – could therefore be hit even harder than the US. So, the good news here is that the “bad news” is even worse in some other countries than in the US (though this may be hard to believe).

The media and some market commentators who were “bullish” until late June have noticed recently that we are in a bear market, because the major indices are down roughly 20% from their peak. This is a remarkable achievement in the annals of forecasting and market timing! How many stocks had to drop by between 50% and 99% before the media and some “bulls” who have continued to talk about another upward wave in stock prices being just around the corner, which would supposedly lift the indices to new highs, finally accepted that we are now in a bear market? Don’t forget that when stock market indices made new highs seven months ago, the media and most advisers were exuberantly optimistic – although most stocks were then already in downtrends. Moreover, sentiment figures (bulls versus bears) among individual investors and investment advisers are now heavily tilted towards the bearish side. Whenever sentiment has been this negative in the past, the odds favoured at least a short term rally. Still, I need to warn our readers that since sentiment remained so extremely optimistic between 2003 and 2007 while the stock market rose, it is possible that sentiment will remain extremely negative for a long time while the market continues to decline.

The third improvement I have noticed is that, from a technical point of view, the market has become “quite” (though not extremely) oversold. But again, I need to warn here that the market would now be oversold in the context of a bull market – not in the context of a bear market, during which the oversold condition could last for a very long time. I suppose that Ambac was already oversold at US$70, and where is the stock now? Moreover, at major turning points, markets can quickly reach oversold or overbought conditions and then work out these conditions without large corrections. Let me explain.

In the summer of 1982, US equities had become extremely depressed; they were no higher than in 1964, and were down in real terms by more than 70% from their 1966 “real” high. The Dow bottomed out at 769 on August 9 and, if I recall correctly, the stock market took off on August 18. By September 22, the Dow had reached 951 (up more than 20% from the August low). The two most overbought conditions I have seen up to that time had occurred at the end of August 1982, and then again on September 22. But, thereafter, the market continued to rise: to 1296 in November 1983, to 2746 at the August 1987 peak, and to the recent high of 14,198 on October 12, 2007.

So, I wish to stress that overbought and oversold conditions must always be put in the context of both the primary trend – up or down – and the phase of the bull or bear market in which they show up. Overbought conditions at the beginning of an uptrend, and oversold conditions at the beginning of a downtrend, are meaningless from a longer-term perspective! If we are indeed in a bear market, which is my view – and has been since the summer of 2007, the current oversold position is relevant only from a very short-term point of view.

The fourth improvement I see is that some previously strong stocks and groups such as US Steel (X), Cleveland-Cliffs (CLF), IBM, and the oil sector, as well as the Nasdaq and some of its leaders such as Research in Motion (RIMM), Apple (AAPL), etc, are beginning to turn down. For the market leaders to collapse is an important precondition for a major low. But again, we need to understand that it will take much longer, and far lower prices, before the very strong stocks and sectors (mostly energy-related and materials) that have so far defied the bear market in financial stocks reach a major low.

Since I fully expect the financial crisis to spread into the real economy, I would sell those sectors and stocks that have so far defied the weakness in financial stocks. Another potentially good piece of news is that the current expansionary monetary policies make the stronger companies in an industry relatively stronger than their weaker competitors, which would then be reflected in strongly diverging stock performances. The weak company stocks could decline so much as to make them, at some point, attractive merger and acquisitions candidates for the financially stronger companies. Industry consolidation would in this scenario accelerate and lead to stronger pricing power (and inflation).

The last potentially good bit of news is that oil and other commodity prices may have reached an intermediate top. Should oil prices decline by, say, 20% to 40%, this fact will certainly be broadcasted by the media – as well as by ignorant cheerleaders and people who still don’t regard commodities as an asset class – as great news for the stock market! A relief rally would likely follow. But wait a minute: why would oil prices and other commodities decline meaningfully? Because of a lack of affordability and a weak economy around the world – not just in the US! This would lead to declining demand for raw materials and likely lower prices. (Supplies are unlikely to increase significantly, but they could be cut as a result of war, civil strife, or concerted action by the producers.) However, a weak economy or economic contraction around the world would be unlikely to be favourable for equities and corporate profits.

I need to make one more comment with respect to oil prices and commodities. It is not a strong US dollar that will lead to declining oil prices, as some commentators argue. What will bring about lower oil prices is a collapse of consumer spending in the US and elsewhere in the world. If US consumption collapses, the US trade and current account deficit will be halved and will lead to a drying up of global liquidity. I have discussed this relationship many times in the past and have clearly shown the relationship between the growth rate in Foreign Official US Dollar Reserves and the US dollar. Declining US consumption will be positive for the US dollar and will certainly bring down commodity prices because of lower demand (at least temporarily). But if you really think that such an outcome will be good for stocks, then dream on!

Finally, since the bull market in commodities began, there has been a body of people who have maintained that commodities are not an asset class. Some have even gone as far as to compare gold to washing machines. But consider the following: my dogs and my books are an asset for me, but maybe not to someone else. My dogs protect my house and my books. My books give me pleasure and – so I hope – some modest knowledge. But my dogs would be a liability to someone else if he lived in a secure condo building. (If there is such a thing as a secure condo building!) Also, my books would be useless to an illiterate person, since he would not be in a position to read them. A high-calibre mathematician is likely to be an asset for James Simons of Renaissance fame, but a huge liability in a rescue mission on Mount Everest. Water may be a huge asset if you are lost in the middle of the desert, but it is not an asset when you are standing in the rain without an umbrella and waiting for a date to arrive. So, the first point to understand is that anything can be an asset for somebody at some time, and not an asset for somebody else at some other time. Normally, cigarettes are not considered to be an asset, but in prisoners’ camps during wars, in wartime in general, and in times of hyperinflation, they are an asset – in fact, they replace cash banknotes.

Now, if someone defines an asset class as something that provides a cash flow, commodities may by this definition not be an asset. However, what if asset markets such as equities, bonds, and cash (T-bills) provide a negative return in real terms (inflation adjusted)? The moment when money loses its purchasing power because real interest rates are negative, and because we need to deal with people like Mr. Bernanke, assets such as raw land, commodities, art and collectibles do become a store of value and, therefore, represent a desirable asset class. All I wish to say is that the term “asset class” is extremely difficult to define, and that at different times and in different situations certain things and certain skills become an asset, whereas on other occasions they are useless. But one thing all my readers should clearly understand: when the last ship leaves the port as the enemy approaches, the captain of that ship will accept one kilogram of gold from you to buy your passage. I doubt that he will accept CDOs, derivative contracts, bonds or, for that matter, stock certificates of Fannie Mae (NYSE:FNM) or Freddie Mac (NYSE:FRE). (Maybe by then the captain won’t even accept US dollars, because their value could decline precipitously during the voyage.) I may add that, in the financial sector, the last ship may be about to leave.

In sum, I believe

As Mark Gongloff noted in a column for the Wall Street Journal, “…what the U.S. really needs, if it seeks a real fix to its energy consumption problem, is less demand, not more. Mr. Market says there’s a simple way to do that. Jack up the gas tax. Don’t lower it. Economists call it a ‘Pigovian Tax’, in honor of the English economist Arthur Pigou, who early in the 20th century examined economic activity that hurts innocent bystanders. To stop behavior that’s not in the public good, you tax it more, not less.

“Of course, a higher tax would hurt working-class Americans who rely on their cars, though other taxes, like the federal payroll taxes or state sales taxes on food, could be lowered to offset it.”

Gongloff then explained that Harvard economist Gregory Mankiw, President Bush’s former chief economic adviser, has proposed increasing the “gas tax” by ten cents a year for ten years in order to give the economy time to adjust. According to Professor Mankiw, who belongs to the Pigou Club, a pro-”gas tax” group, higher gasoline taxes “should lower world oil prices”, as higher prices would curtail demand considerably.

Despite my usual serious reservations about increasing taxes in order to curb demand, I would support higher gasoline taxes in the US (or tax incentives for energysaving engines and heavy penalties for gas-guzzling vehicles) because its implementation would be simple and the revenues obtained from higher gas taxes could be used to improve the entire transportation infrastructure. In particular, a better public transportation system would improve the energy efficiency of the country and lessen its addiction to imported oil. It should also be noted that the US has one of the lowest gasoline taxes in the world

In addition, opinion leaders are increasingly skeptical about the lies dished out by the government. Thomas Friedman opines that Americans “need a president who is tough enough to tell the truth to the American people. Any one of the candidates can answer the Red Phone at 3 a.m. in the White House bedroom. I’m voting for the one who can talk straight to the American people on national TV – at 8 p.m. – from the White House East Room.” And Gongloff concludes that, although higher gas taxes would have all sorts of desirable effects, unfortunately, increasing them “doesn’t win elections. And the only market that matters now is the one for votes.”

At the same time, investors and strategists are becoming more and more skeptical about the economic statistics published by the various agencies. The employment, inflation, and GDP growth figures are highly suspect. According to Martin Feldstein, a former chief economic adviser to President Reagan and now a Harvard economist, “misleading growth statistics give false comfort” because “monthly data since January indicate that economic activity and GDP have been declining since the start of the year” (Financial Times, May 7, 2008).

Feldstein opines that “…although the tax rebates now underway may provide some temporary help, the combination of falling real incomes, declining household wealth and a dramatic drop in consumer confidence suggests further falls in consumer spending and GDP. But the most serious risk is that the rapid fall in house prices – down 12% in the past year and falling at a 25% rate in the past three months – will raise the number of negative equity mortgages, leading to widespread defaults and foreclosures. Because US mortgages are “no-recourse” loans (lenders have no recourse to the house’s owner beyond the value of the house) individuals with negative equity have an incentive to default. There are now an estimated 8 million negative equity mortgages – more than 15% of all outstanding mortgages. Defaults are rising and foreclosures are now at twice the rate of a year ago. A downward spiral in house prices would cause a fall in household wealth and in the capital of financial institutions, potentially resulting in a deeper and longer recession than any seen in the past several decades.”

According to Feldstein, the government should intervene to “prevent positive-equity mortgages from becoming negative-equity mortgages”. In other words, Feldstein proposes that the government should support the real estate market “by providing low interest loans with full recourse that would allow any homeowner to pay down a significant fraction of his mortgage. Homeowners would be in effect giving up the potential to default on their mortgage loans in exchange for lower interest costs.”

There are, however, some problems with Feldstein’s proposal. For one, it is likely that the majority of homeowners who are burdened with the estimated 8 million negative-equity mortgages (I have seen figures which suggest that there are 15 million negative-equity mortgages outstanding) also have negative-equity car loans and large credit card debts – in short, they have no equity to start with. So, in these cases, “full recourse” loans wouldn’t serve their purpose and would instead amount to a marketdistorting direct government subsidy of imprudent borrowers at the expense of taxpayers. Second, I wonder how Mr. Feldstein would propose supporting the market for unsold condos. In buildings with five to nine units – like a large number of garden apartment buildings – the condominium vacancy rate is at an unprecedented 15.2%. That is up from 12.2% at the end of 2007; whereas prior to 2006, it never exceeded 10%. (For rental units, the vacancy rate is even higher.

According to Floyd Norris, chief financial correspondent with the New York Times, 25.2% – one in four – of the housing units built since 2000 are vacant.) Finally, I very much side with Mrs. Moneypenny who, in a witty Financial Times column dated May 3, 2008, argued that the UK government should not intervene in the housing market, because falling home prices “might be painful for some but what about the benefit for many others? What nurses and teachers and first-time buyers need is for prices to come down.” According to Mrs. Moneypenny, it is not an acceptable excuse from investors that they had not read the disclaimers. “I suspect that borrowers of 110% mortgages are in many cases young and naïve and, in their enthusiasm to buy property, had not read the disclaimers. That’s not an acceptable excuse either. Husbands should carry disclaimers. Your marriage may be at risk if you insist on rationing golf, or some such incomprehensible activity.”

Let us assume that the unthinkable happens: China’s economy slows down sharply, or even contracts – and there are reasons why it could. Commodity prices slump and bring about economic hardship in the resource-producing countries of the world. In turn, these countries’ imports of capital and consumer goods from Europe and Japan decline.

We would then have the perfect setting for a global economic contraction with dire consequences for corporate earnings and asset prices.

Now, I concede that this scenario is not very likely to occur. However, on a recent visit to Dubai, I could see how it might unfold. I have been traveling to the Middle East since 1977, and I experienced first hand the oil boom of the late 1970s and the collapse in equity and real estate prices when oil prices fell in the early 1980s. About three years ago, on a visit to the Middle East, I felt that the gigantic equity boom would come to an end.

In 2006, most of the Middle Eastern stock markets declined by 50% or more, though the economies didn’t suffer. Yet, over the last three years, it has seemed to me that there is something not quite right about the enormous construction and economic boom that Dubai and other Middle Eastern countries are experiencing. (The world’s tallest buildings are going up there….) What if oil prices were to decline? But why would oil prices decline? Obviously, oil prices would decline because of diminished demand for oil from China and other rapidly growing emerging economies.

But why would demand for oil from China slow down or decline? Obviously, because of an economic recession! The assumption that the Chinese and other emerging economies will continue to expand rapidly may prove to be very deceptive. In recent years, the US has experienced a credit boom and China has had a capital spending boom. Both could come to an end at about the same time! I also wish to stress that there is enormous connectivity between all the world’s economies and that it would be wrong to assume that the present financial crisis, whose epicentre is the United States, couldn’t be followed by financial and economic crises elsewhere.

Also, if the Dubai boom was an isolated event, I wouldn’t be particularly concerned. But everywhere I travel I am left with the uncomfortable feeling that the current boom is surreal and unsustainable. The INDABA – the annual conference for natural resources professionals – which I attended earlier this year in Cape Town, has become a huge circus reminiscent of the consumer electronic shows held in Las Vegas in the late 1990s.

And whereas I have a relatively positive view of commodities, I doubt that all these mining executives (predominantly promoters and liars) will make as much money as they hope to, simply because exploration and mining development costs are soaring. Every major city around the world is also experiencing a huge condo and office construction boom, and in resort areas there are enormous developments of secondary homes.

Should the financial sector contract, as I believe will occur for several years, will all these new offices find tenants? I also wonder if all the condo and second home buyers are aware of the maintenance costs of their units and that in over-supplied markets prices can decline sharply.

Lastly, I think that investors fail to appreciate fully the process of deleveraging after a period of accelerating credit growth. In a credit-driven economy, a deceleration of credit growth will depress all asset prices and tip the economy into recession. In this respect, I am particularly surprised that analysts still expect S&P 500 earnings per share to increase to above US$110 in 2009.

Over the past few months, I have discussed corporate profits a number of times and shared with my readers my concern that we are in the midst of an earnings bubble, which has been driven largely by an explosion of financial sector earnings.

Richard Berner, chief economist at Morgan Stanley, recently published an excellent study entitled “Downside Risk for Corporate Profits”, in which he opines: “I think the earnings outlook will disappoint.

“The US economic outlook has darkened and fading operating leverage, dwindling pricing power, and deteriorating credit quality will squeeze margins. Despite the benefit of a weaker dollar, slower growth abroad seems likely to tame the overseas earnings boom” (Morgan Stanley Research North America, US Economics, March 17, 2008). In

Berner’s view, “the combination of slower growth and high operating and financial leverage in Corporate America made a contraction in earnings unavoidable even if the economy skirts recession”. (He is referring here to the corporate earnings decline in the fourth quarter of 2007.) “Lower marginal but higher fixed costs have increased operating leverage. Corporate America’s ability to exploit that leverage propelled earnings to record levels when growth was healthy. Strong increments to revenue went straight to the bottom line…. But leverage – both operating and financial – works both ways. Slower growth means that operating leverage is working in reverse, with decreases in revenues going right to the bottom line.”

Berner’s two principal concerns about US corporate profits relate to “operating leverage” and the fact that the “strength of overseas earnings” is about to be “challenged”. Operating leverage is at present far higher than in the 1990s, which, according to Berner, could mean that “a deeper recession, especially one that spreads abroad, would promote a much more serious profit squeeze.”

Berner shows that overseas earnings have increased from 15% of overall earnings 20 years ago to 31.5% at present, as “growth abroad – and the higher oil price that comes with it – are powerful engines for US earnings”. I may add that a weak dollar is another extremely powerful driver of overseas earnings as a percentage of total earnings. Also, that “growth abroad – and the higher oil price that comes with it – are powerful engines for US earnings” supports my view about the extreme connectivity we now have between economies in the global economy.

At the same time, the sharp decline in the yield of ten- and 30-year Treasury bonds and the collapse of lower-quality bond prices seem to indicate that a bad deterioration in US and world economic conditions is about to occur. Since, according to Philip Isherwood, equities tend to perform poorly when volatility is high, cash and bonds would seem to be a good alternative. But, stating his case in favour of US equities on CNBC, a US money manager made the comment that “money in cash is also at risk”. This is certainly true for bank deposits, CDs all structured products, and even money market funds, because the return of capital is uncertain. In the case of Treasury securities, “money is also at risk” but for different reasons.

In the case of Treasuries, the return of capital won’t be a problem for now, but I suppose that with a yield of less than 2% on two-year, 3.7% on ten year, and 4.5% on 30-year Treasury securities, the risk is that inflation (not that published by the government, but the cost of living increase for the median household), which is already higher than these yields, will over time completely eat away the purchasing power of the principal, including the interest.

I hope my readers understand the problem of interest rates, which are artificially low and below the rate of inflation. This forces investors, including individuals, institutional investors, and state and private pension funds, into risky investments, which as we have now seen can also lead to widespread losses. In fact, the losses are now so large that they threaten the entire financial system. I estimate that, when all is said and done, the losses experienced by the financial sector and investors brought about by Mr. Greenspan’s and Mr. Bernanke’s irresponsible monetary policies will exceed several trillion US dollars if we add up the combined capital losses on homes, nongovernment bonds, and equities.

Expressed in Euros or gold, the total wealth of the US has already shrunk by at least 40–50% since 2000. I don’t have a high regard for any government (except, possibly, that of Singapore), but the most destructive course a society can embark upon is to appoint academics to positions of responsibility. A problem of artificially low interest rates that is seldom discussed is that many individuals depend on interest income in order to meet their living expenses. Equally, pension funds depend on a certain annual income to meet their present and future liabilities. Moreover, high interest rates provide investors with a cash flow, which can cushion downturns in asset values. Say, an individual or a pension fund owns a balanced portfolio: 50% in equities and 50% in fixed income securities of various maturities. Let’s assume that, in a given year, the stock portfolio declines by 20%. If interest rates average 10% on the fixed income portfolio, the total loss on the portfolio will “only” be around 10%.

Moreover, the cash flow from the fixed income portfolio can be reinvested in equities. But what if the yield on the fixed income portfolio averages only 3%? Obviously, the opportunity to make up for the losses on the stock portfolio by investing the cash flow and averaging down diminishes. And what if the annual cost-of-living increases average 5% or more? In this case, the purchasing power of money will rapidly vanish. Moreover, because of negative real interest rates, consumer price inflation will accelerate, as was the case in the 1970s. At the same time, the “real” spending power of households whose income depends on fixed interest securities will be cut and their standards of living will decline.

My friend David R. Kotok, chairman and chief investment officer of Cumberland Advisors, writes regular insightful comments on the US financial market. Recently he stated: “We still have to deal with dysfunctional credit markets. The Fed must persist in their work of creating liquidity. Only time and transparency will relieve the problem of insolvency. That process is working, too. It takes time and it does and will succeed. Remember, there are no examples of Depression in economic history where stimulus was applied and where the inflation-adjusted interest rate was brought to zero by the central bank. That is the condition in the US today. In sum, stimulus works.”

Well, David, on this one I must disagree with you. I know many economies where monetary and fiscal stimulus was applied and yet they still went into depression. In all these economies, the inflation-adjusted interest rates were not only brought down to zero but, in fact, significantly below zero. The failed experiment by John Law with paper money in France at the beginning of the 18th century ended with a depression, and money printing in Germany between 1918 and 1923 brought about total impoverishment of the German working and middle class. Latin America went through extremely poor economic conditions in the 1980s. (In Argentina, car sales declined by more than 50% between 1980 and 1988.)

However, in all these instances, the depression wasn’t accompanied by nominal price declines but by hyperinflation and collapsing asset prices, GDP, and standards of living in real terms. In fact, I know of two little empires that, as a result of excessive monetary and fiscal stimulus, went bankrupt and ceased to exist: the Roman and Spanish empires.

Admittedly, these empires’ rulers weren’t as smart as our present-day leaders of Western democracies….

Also, I was pleased to hear that Robert Mugabe (another academic with several degrees from Oxford and an honorary degree bestowed on him by China’s Hu Jintao “for his brilliant contribution to international diplomacy and peace”) has offered Mr. Bernanke a teaching job at the University of Harare. This will provide him with a first-hand opportunity to study the devastating impact of excessive monetary and fiscal stimulus on a society.

So, to a large extent, I agree that “money in cash is also at risk”, because there is the risk either of default or that money’s purchasing power will decline. Also, I am beginning to wonder for how much longer buyers of ten- and 20-year Treasury bonds will accept their low yields, which are now below the cost-of-living increases and below nominal GDP. The poorly delivered, contradictory, and incoherent statements made by Mr. Paulson and Mr. Bernanke at a recent Senate hearing didn’t provide much comfort to holders of US fixed interest securities. Not surprisingly, gold has more than doubled since Bernanke was appointed Fed chairman, while the yield on 30-year US government bonds is higher now than before the January 125 basis points Fed fund rate cuts.

Surely, the Fed can cut the Fed fund rate to zero. But this doesn’t mean that longer-dated bonds will rally. If inflation were to accelerate further, rate cuts would inevitably lead to higher long-term rates and capital losses on long-term bonds — particularly if the dollar weakens further! In other words, the Fed can bring down short-term interest rates, but it has little power over the longterm bond market. I may add that one of the problems of hyperinflating economies is that the long-term fixed rate bond market ceases to exist.

I should like to introduce one more thought. Throughout most of the 1970s interest rates were below the rate of nominal GDP growth and negative in real terms. So, what happened? Inflation accelerated, bond yields soared from 6% in 1970 to above 15% in 1981, and the US dollar tanked. After 1981, we had for most of the following 20 years bond yields that were above both nominal GDP growth and the rate of inflation (positive real interest rates).

What happened? We had a lengthy period of disinflation. Also, because real interest rates were particularly high in the early 1980s, we had a huge US dollar rally between 1980 and 1985. After 2001, we again had interest rates that were below both nominal GDP growth and cost-of-living increases, which led to the unprecedented credit inflation we experienced between 2001 and 2007 and the subsequent historic bust.

Now, let us assume that market participants begin to believe in the nonsense Mr. Bernanke has been coming out with concerning “money printing” and “dropping dollar bills from helicopters” in order to stabilize asset markets and avoid economic downturns. They will begin to realize that he is the messiah of the gold bulls and the arch-enemy of sound money.

What will investors do? They will dump bonds and the US dollar en masse. In this context, it is interesting to note that recently, on very poor economic statistics, bonds didn’t rally but sold off. The Institute for Supply Management’s non-manufacturing index, which is representative of almost 90% of the US economy, fell in January from 54.4% to 41.9%. (A reading of 50 is the dividing line between growth and contraction, and the index has averaged 57.6% since its inception in 1997.) January retail sales — closely scrutinised — were a disaster and confirmed my view that US economic statistics published by the government misinform the public about the true state of the economy.

How can January auto retail sales increase by 0.6% when volume sales were down 6% month-on-month? According to David Rosenberg, in addition to declining sales at department stores (down in three of the last four months), sporting goods and book stores, furniture and building materials stores, sales at electronic stores were down 1% in January on top of a 2.5% slide in December, which represents the worst back-to-back performance since the 1990 recession. According to Rosenberg, the “bottom line is that the cyclical components of retail sales — autos + clothing + furniture + electronics + sporting goods + building materials + department stores — were down 0.1% in January.

By way of comparison, spending on gasoline, food and health care rose 1.1% collectively for the month.”

The poor state of the economy is reflected by the collapse of the ABC News/ Washington Post Consumer Comfort Index and its various components. The personal finance component is now lower than it was in 2002. Also, the University of Michigan index of consumer sentiment collapsed in January to its lowest level since 1992. According to Rosenberg, “consumer sentiment is now at a level that is telling us that we are not on the eve of a recession but are rather already several months into the downturn”.

As I have noted in earlier reports, the US economy is already in recession in real terms, but this fact is obscured by the government’s grossly understating price increases throughout the economy. Despite, in my opinion, horrible economic statistics (in real terms), the Fed needs to be very careful not to disturb bond holders by “printing too much money” (electronically), which — aside from the collapse in lowerquality bonds that had already occurred — would also lead to a rout in long-term government bond prices. At the same time, the US must be increasingly careful about its budget deficits and about bailing out the entire financial sector, which is loaded with crappy paper.

Otherwise, Treasury securities will reach “junk status” sooner than I had expected. But I can very confidently predict that, in the long term, US debt will become “junk”!

So, whereas under a sound monetary regime high-quality bonds would be — like utilities — a candidate to outperform, under a central bank that lacks any monetary discipline they are a rather dangerous investment. But this isn’t to say that, at some point in the current downturn, distressed lower-quality bonds won’t provide a great buying opportunity.

I BELIEVE WE ARE IN A WAR BETWEEN TWO MAJOR ADVERSARIES. On the one side, we have the Fed (and other central banks) pumping liquidity into the system in a desperate attempt to support the asset markets and the economy. On the other side, we have the private sector, which is being forced to curtail lending due to heavy losses in the credit market and to fight the Fed’s reflation efforts by widening credit spreads.

Complicating matters is the fact that both adversaries have powerful allies. The Fed has the Treasury and the government, as well as the Wall Street elite, as allies. The government could implement massive tax cuts in order to stimulate economic activity; the Treasury could bail out financial institutions, which in reality should be punished by bankruptcy; and the moneyed Wall Street elite will ensure that politicians and the Fed make it possible for them to continue their con game.

The private sector has allies in the form of inflation, a weak dollar, and a dissatisfied public (declining consumer confidence and lack of trust in government, which is reflected in the strong showing of Ron Paul), all of which form a powerful phalanx when battling the Fed’s reflation attacks. Inflation is a powerful ally for the private sector, because it squeezes corporate profits and curbs personal consumption.

The war between the Fed and the private sector will, in my opinion, be very protracted. The Fed will win some battles, which — along with much brouhaha in the media — will see Pyrrhic victories such as the stock market rally of August-early October, which led in dollar terms to new highs, but failed to do so in euro and gold terms, and was followed in euro terms by renewed severe weakness.

Other battles will be won by the private sector, which through its contraction (recession) amid inflation will lead to sharp downward movements in equity prices. I am well aware that the Bureau of Labor Statistics and the Bureau of Economic Analysis will continue to use bogus figures when reporting inflation, and hence real GDP growth, but they won’t be able to hide the squeeze on corporate profits and the consumer from rising prices.

Cost of living increases vastly exceed the reported inflation figures and are squeezing the consumer, which leads to revenue pressure for the corporate sector. According to the Kaiser Family Foundation, health insurance premiums have risen 78% since 2001, while wages have gained only 19%. At the same time, corporations are faced with a squeeze on margins due to rising costs. Cost pressures contributed to the dismal performance of earnings in the third quarter of 2007.

For example, Starbucks increased coffee prices by an average of nine cents per cup in July. However, customer visits to U.S. stores fell 1% for the quarter ended Sept. 30. According to the CFO, “Unbeknownst to us, we saw economic head winds that, quite frankly, came up probably stronger than I thought.” Earlier, Starbucks’ CEO had remarked: “The consumer is being faced with rising costs in every sector of their lives, and so part of that is reflecting on us.” An informed friend of ours suggested that declining traffic at Starbucks stores in the U.S. is of particular concern, since Starbucks serves all income levels. Therefore, declining traffic is not just a “subprime problem”!

This rate of economic contraction would seem to be consistent with the impending slump in corporate profits, and with the observation that the U.S. economy is already in recession.

Investment Observations

On one side of the new inflation war, the Fed is pumping liquidity into the system via rate cuts and repurchase agreements. On the other, the financial sector is withdrawing liquidity from the system via huge write-offs and newly timid lending policies. This war should lead to increased volatility. Ten percent market moves will be the order of the day.

As was the case in the 1970s, we can expect the stock market to sell off by more than 20%. At the time, the two adversaries facing each other were “easy monetary policies by the Fed” and “consumer price inflation.”

Nobody won that war decisively, since stocks in 1982 were at about the same level they had been in 1964. However, since U.S. equities had declined in real terms by 70% from their real 1966 peak to their real August low, one can now assume that the Fed lost that war. Today, the adversaries are the private sector, which with its inflated asset values now wants to deflate, and the Fed, which under Bernanke and Greenspan, never quite understood that larger and larger injections of liquidity into the system, leading to excessive debt growth, brings about a gross misallocation of capital.

I have no doubt that the Fed will lose this war as well — if not in nominal terms, then in real terms, or adjusted for the sinking value of the U.S. dollar. More to the point, the Fed has already lost this war: U.S. equities fully recovered after October 2002 and made an all-time high in October 2007 in dollar terms, but even at their recent highs they were down by 37% in Euro terms (measured by the S&P 500) and by 60% in gold terms.

Still, we have to be mindful that even if the present economic and financial environment doesn’t look particularly enticing, as was the case between 1964 and 1982 when the market didn’t make any headway, plenty of investment opportunities will present themselves from time to time for the nimble trader and for the long-term investor who will be positioned in the few asset classes that will perform well.

Moreover, it would be wrong to simply assume that recession and slumping corporate profits will inevitably knock down equity prices. Other factors such as negative real deposit rates and negative real yields on Treasury bonds because of the Fed driving down the Fed Funds rate, a weak dollar, and “bubbly” emerging markets could make U.S. equities a relatively attractive proposition compared to other financial assets.

With Bernanke at the Fed and Paulson at the Treasury, and a Euro that could face some problems (a breakup, some believe) because of badly deteriorating economic conditions in Italy, Spain, Portugal, and Greece — precious metals are likely to outperform financial assets for some years to come, resulting in the persistent decline of the Dow/gold ratio.

As Michael Berry remarked, “Gold is no friend to the world’s central bankers. The printing press is their friend.” In fact, I would be very surprised if the Dow Jones Industrials/Gold Ratio didn’t decline to between 5 and 10 within the next three years. Therefore, I should like to reiterate my recommendation to accumulate gold.

Other commodities that could come to life this year are sugar, cotton, natural gas, and palladium. Moreover, uranium is unlikely to disappoint the longs. In general, some special situations aside, I am not positive on industrial commodities in a slow growth or recession type of environment.

Among commodities and currencies, my preferred asset remains physical gold held outside the U.S., for the simple reason that — depression or inflation — it is very likely to outperform financial assets. For gold, I believe the best is yet to come!

Best regards,
Marc Faber

Greg’s Endnote: How does 201% upside and zero downside sound? Too good to be true? Well there is a safe and easy way to invest, even in this market, that leaves you almost completely free from risk. Don’t believe me? Just read this free report to find out how…