Friday, October 23, 2009

Gold for the Long Haul; Bill Bonner With a Little Macro for Dummies

Celebrating A Decade of Reckoning
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The Daily Reckoning
Friday, October 23, 2009

Stocks up, financials down; benign divergence or alarm bells? A quick who's who of memorable (and forgettable) economists, Plus, gold for the long haul, the double decade bear cycle and more...

Eric Fry, reporting from Laguna Beach, California...

The S&P 500 Index jumped more than 1% yesterday - lifting the index to within a whisker of a new one-year high. So let's have a moment of silence, please, for the millions of S&P Index put options that have died in vain... Thank you.

As it turns out, not every sort of put option is perishing on the financial battlefield. A handful of very conspicuous stocks and indices are refusing to join the S&P on its march toward new highs. Most financial stocks have slumped about 5% from the highs they hit on October 14. Citigroup and Bank of America are both down more than 10% since then. Likewise, the Dow Jones US REIT Index has been slipping over the last few trading sessions, even though the S&P has been inching higher.

US REIT Index Slump

Is this divergence just a temporary "stock market thing," or does this divergence reflect a very real "Main Street thing." Dan Amoss, editor of the Strategic Short Report, believes it is the latter...and he said as much in yesterday's 5-Minute Forecast...

"The upcoming third-quarter earnings reports from real estate investment trusts will not be pretty," writes Dan Amoss, whose Strategic Short Report readers are currently betting against the REIT rebound. "Second-quarter earnings for the sector were boosted by one- time gains from buying back publicly traded bonds at discounts, and taking advantage of bond investors' newly whimsical attitude toward credit risk by floating new bond issues. Earnings were also boosted as REIT executives slashed property operating and maintenance expenses. But that can only go so far before real estate quality becomes an issue. The competitive environment to fill vacant space will squeeze REIT profits. If you're a high-quality tenant, it will be a 'buyers' market' for years...

"The Dow Jones US Real Estate Index has tacked on a hefty 30% rally since second-quarter earnings season in July. REITs are now priced for perfection, rather than being priced for the obvious multiyear depression staring REIT owners in the face."

--- Dan Amoss' Strategic Short Report ---

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And over to Bill Bonner, with a few thoughts from Waterford, Ireland...

How much juice is left in this bear market rally?

Since it peaked in 2007, the UK stock market lost 60% of its value. As of yesterday, it had recovered half of what it had lost.

All over the world, the story is about the same. Markets have recovered half or more of what they gave up.

The US is a laggard. While the S&P is up 60%, the Dow isn't yet at the halfway point. Some foreign markets, meanwhile, have 100% + gains.

Fund managers who missed the rally are kicking themselves. They've failed to keep up with the benchmarks.

Even before the market headed up in March we echoed Richard Russell's words: "One of the surest phenomena in the financial world is the bear market bounce," he said. We also guessed that the bounce would go to about half the previous losses. We based that on what had happened after the Crash of '29.

Well, we're still not there. But an analyst from Morgan Stanley tells us that markets tend to do better than that. The typical bounce is about 70%, says he.

Whew! That's a pretty serious bounce. If we'd known it was going to be that big we would have encouraged dear readers to bet on it. Instead, we judged it a dangerous a back eddy or rip tide. Yes, it can take you places...but not necessarily where you want to go!

Our outlook here at The Daily Reckoning is very long term. We don't like betting on countercurrents...even important ones. Instead, we like to go with the flow...and keep going with it until it arrives at its end.

That's not as easy as it sounds.

In 1999, it looked like the bull market had come to an end. We thought so. We told readers to get out of stocks...and stay out. Gold was a better place to be.

Investors made nothing in stocks for the next 10 years. In real terms, the stock market decline began in January 2000. Prices went down. They bounced...such a big bounce that it looked like a genuine new bull market. But after inflation, there wasn't much left. Adjust for purchasing power and investors were worse off every year. Even now, after a 7-month bounce and a 45% gain, Dow investors are still down 30% to 40% from the highs set in 1999.

Dave Rosenberg...

"The only thing we really learned in this extremely flashy, seven- month, 60%, nine-point multiple expansion-led rally, is that momentum investing never did become extinguished this cycle. It is really a fascinating commentary on human behavior that so many 'investors' are lamenting about how 'the train has left the station' without them. Please, give us a giant break! The train has left the station countless of times in the last 10 years but obviously none of these trips lasted very long because the reality is that equities have failed to generate any positive return over this time interval.

"As for the here and now, there is another reality. Price gains in the stock market have generally occurred with low volume. There are limited buyers - hedge funds and flash traders - but no sellers (not yet, anyway). And, we saw in yesterday's decline that volume climbed across the board, and the number of high-volume selloffs is a major red flag that should not be ignored."

The typical major bear market lasts 15-20 years. The last one began in 1966. It wasn't until 1982 - 16 years later - that the next major bull trend began.

This bear market is already 10 years old. Perhaps it will end in 2015. Maybe in 2020. We don't know when. We only know how it will end - in misery.

Now, despite 10 years of stinkin' returns, investors still believe in stocks. They still hope to find the 'next Google.' They still punish fund managers who hold back. They still read the financial press. They still watch CNBC. They still want to know what stock to buy.

Yesterday, they bid up the Dow 131 points. The price of stocks to gold is about 10 to 1. When this trend began ten years ago, we predicted that the Dow and gold would go all the way to 1 for 1. We guessed it would happen at the 3,000 to 5,000 level. We'll stick with that prediction until it proves correct....or it makes us look like a fool.

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And more thoughts...

Government debt? No problem. The net interest paid by the US government is actually about the same - as a percentage of GDP - as it was 40 years ago. It's only 1.3% of output - nothing to worry about.

But wait...what's this? The average maturity of that debt has come down from more than 5 years to only 4. And according to the Office of management and Budget, if the US continues on its present course, net interest will rise to 5% of GDP in 2019 and 10% in 2034.

And that assumes there is no big increase in interest rates...and that the economy recovers as planned. If either of those things fails to happen, the situation will degrade fast.

Imagine if the government were forced to refinance debt at double-digit interest rates - as it was in the late '70s. Net interest could go to 5% of GDP within months.

We're in a depression, not a recession. Depressions take longer to sort out. But they are also far more treacherous. Because there are always periods when things seem to be going "back to normal," only to go back down again as soon as investors turn bullish.

Richard Koo, author of The Balance Sheet Recovery, recalls how it was during Japan's long, dark passage:

"We had these false starts... The economy would begin to improve and then we'd say 'oh my god, the budget deficit is too large.' Then we'd cut fiscal stimulus and collapse again.. We went through this zigzag for 15 years."

Koo understands what is going on, more or less. Companies and households are paying off debt. He and Paul Krugman believe the feds have to continue pumping money into the system or they're going to have a "lost decade," just like the Japanese.

You have to keep the stimulus money flowing "until the private sector de-leveraging is over," he says.

By our calculations, it will take 5-10 years for the private sector to de-leverage. By that time, the feds will have added trillions in debt to public finances. Since they can't finance that much from private domestic savings, and since foreigners will be wary about lending that much even if they had it, the Fed itself will have to pony up the money. This will put the dollar in further danger...along with the entire global financial system.

Koo may be right - as far as his thinking takes him.. He should think a little further. The problem is debt. Too much debt in the private sector caused bear markets and a bank crisis. Too much debt in the public sector will cause big problems too - a default...and hyperinflation. Worse than a depression.

We've got more thoughts on that too, but first, today's essay...


The Daily Reckoning PRESENTS: Have you ever wondered what would have happened if the government didn't step in to bail out every well- connected, "too-big-to-fail" institution on Wall Street?

When the crisis became apparent enough for even politicians to recognize it, those who didn't see it coming in the first place tried to tell us how the future would pan out. Mr. Bernanke told us that if we didn't do something, "we may not have an economy left on Monday." Vice President Joe Biden told us that if the rescue package didn't go through, unemployment would soar to (gulp) 9.6%...

So, what if we had done nothing? No bailouts. No stimulus. No monetary policy. No fiscal policy. What might have happened? As usual, history is ready with the answer, if only we'd care to listen...

Macro for Dummies
By Bill Bonner
Waterford, Ireland

"He who goes a-borrowing, goes a-sorrowing."

The quote comes from Ben Franklin. But it was recalled to us neither by America's president, nor Britain's Prime Minister. Instead, the Telegraph in London reported it from the mouth of Cheng Siwei, a "top member of the Communist hierarchy."

What goes around comes around. The Anglo-Saxons have forgotten what makes a successful economy. The Chinese have remembered.

Just look up Warren Harding on Wikipedia. The first entry you will find is not the 29th president of the United States of America, but a rock climber with the same name. But what do you expect? History is nothing but a long list of disasters in chronological order. Historians love calamity. And they reserve their highest accolades for those who cause them. The same is true in financial history. Those who make it big are those who make it worse.

It is safe to assume that no one working at the Federal Reserve or at the White House has a picture of Warren Gamaliel Harding over his desk. Yet, if American presidents were ranked on the basis of how well they faced up to financial disaster, Warren G. Harding might be somebody. His handsome face would be carved on Rushmore. His likeness would grace the $100 bill. Harding was the last American president to deal honestly with a major financial crisis. Every president since has tried to scam his way out of it.

By the time Harding took office in '21 the Panic of 1920 was taking the unemployment rate from 4% to nearly 12%. GDP fell 17%. Then, as now, the president's subordinates urged him to intervene. Secretary of Commerce Herbert Hoover wanted to meddle - as he would 10 years later. But Harding resisted. No bailouts. No stimulus. No monetary policy. No fiscal policy. Harding had a better approach; he cut government spending and went out to play poker:

"We will attempt intelligent and courageous deflation, and strike at government borrowing which enlarges the evil, and we will attack high cost of government with every energy and facility which attend Republican will be an example to stimulate thrift and economy in private life.

"Let us call...for a nationwide drive against extravagance and luxury, to a recommittal to simplicity of living, to that prudent and normal plan of life which is the health of the republic."

Within a decade, Harding's views were collectibles. But in 1921, he still saw the economic world as a moral world ordered not by man, but by God. This was not the result of long study or deep reflection on his part. He was probably the dummy everybody said he was. As Keynes pointed out, politicians are always in thrall of some dead economist. At least Harding was in thrall to the good ones.

"No statute enacted by man can repeal the inexorable laws of nature," he announced. "Our most dangerous tendency is to expect too much of government..."

Harding was not the first to see the economy as a 'natural' that you disturbed at your peril. A Taoist named Zhuangzi, who lived about the same time as Alexander, observed: "Good order results spontaneously when things are let alone."

Later, economists of the Scottish enlightenment, notably Adam Smith and Adam Ferguson elaborated. Smith, like Harding, saw the economy ordered by the invisible hand of God.. Ferguson saw markets as a 'spontaneous order,' which were the "result of human action, but not the execution of any human design".

The same basic insight led Irving Fisher - the greatest economist of the 1920s - to come up with his debt-deflation theory of depressions. After people had borrowed, they needed to pay back. Busts followed booms; there was no getting around it.

Warren Harding may never have been the brightest bulb on the White House porch, but intuitively he understood that proper macro-economic policies were more the product of virtue than of genius. Debt led to trouble; that's all he needed to know.

Keynes came along a few years later. Keynes was a genius; everybody said so. And he had an answer for everything. Nature? Government could do better. Debt? Don't worry about it, he said. Why not just let capitalism sort itself out? Without government intervention, it will only get worse, said Keynes.

But Harding had already proved him wrong. Harding did the very opposite of what Keynes recommended. Instead of increasing government spending, he reduced it. He cut the budget almost in half. He slashed taxes too...and cut the national debt by a third.

Japan at the time struggled with the same downturn. But it had no Harding at the helm. Instead, its masters prefigured Keynes, trying to stay the correction using price controls and other interventions. The result was a long-drawn-out affair that lasted until 1927 and ended in a bank crisis. In America, meanwhile, by 1922 unemployment was back down to 6.7%. By 1923 it was down further - to 2.4%.

This lesson was entirely lost on the world's economists. When the next crisis hit a decade later, they turned to Keynes. Of course, it turned out to be a moral world after all. They got what they deserved.


Bill Bonner,
The Daily Reckoning

--- Major News Outlet Calls This The "Next Crisis"... ---


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And finally, Bill Bonner has today's Daily Endnote...

We sat in a cab yesterday, stuck in traffic in central London. We watched people walk by and wondered. What are they thinking about? What do they want out of life? What do they think of themselves?

There were hundreds of them...different shapes...different sizes. A businessman in a pin-striped suit, briefcase in hand, concentrating on his sales report; he almost stepped in front of a motorcycle. A salesgirl, grotesquely overweight...yellow hair streaked with brown...wishing she hadn't had so much to drink the night before. A lawyer daydreaming about his secretary. A man who would have rather been fishing...still in his waxed coat. A woman annoyed about something. A heavy construction worker, his legs splayed outward as he walked. A tense young woman who dared not look up. A woman worrying about her son. A man thinking about buying a new car. One man trying to remember a line from a song he learned 30 years ago.. Another talking to herself. One looked like a doctor taking an afternoon stroll. Another was stark raving mad.

All of them walking along...from one place to another...shuffling along...the living towards the dead.

We were thinking of our children. What a different world they grow up in. And yet, it is still the same too. A man might have been stuck on a London street 50 years ago...and hundreds of years ago he might have watched the same shopkeepers and carpenters walk by, each caught in his own thoughts like a fly in a spider's web.

Our old friend John Mauldin wrote to say that his mother's experience was not much different than ours. She joined the WACs during the war....met John's father...and then nature took her course.

But both John and your editor had a big advantage in life. We both caught the upswing.

Not so with our children. They inherit a different world. America was the world's leading nation in the '50s and '60s. And it was growing in power and wealth - rapidly. We grew up with it. Things were getting better and better...we were sure we'd live much grander, richer, and more exciting lives than our parents. The sky was always the limit!

Now, America is in decline. China's economy grows while hers declines. The Far East has savings, while she has none. The Asia nations are net exporters, making huge profits...while American industries are judged too old, too expensive, and too highly regulated to compete. Americans have debt up the kazoo, while their competitors have little. A young person in America has to look forward to supporting 70 million retired baby boomers...and paying for their drugs, their food, their wars, and their bailouts.

For our children - ours and John's - the situation on a personal level is different too. Coming from poor families, we could look forward to much more wealth and material success than our parents ever knew.

We came back to Ireland this week for a reason that our parents would never have dreamed of. Your editor has set up a family office. It is a very modest affair by family office standards. The typical family office manages a fortune of $100 million, according to The New York Times. We may not even be on the same planet with these rich families; but we are in the same universe. That is, we try to think about...and manage...our wealth as rich people a family legacy or an endowment, not as a retirement fund.

What wealth we have accumulated - even if it is paltry - will be held by a family-owned corporation. Then, the corporation, run largely by the adult children, manages the assets - from our base in Ireland.

Your editor, freed from the responsibility of managing his own money will be free to wander and a vagabond, a gypsy, a refugee, an itinerant mendicant...forced to sup on whatever is at hand and take lodging wherever he can find it - but favoring the Four Seasons and Chateau Margot when they are available.

Whatever else this does, it puts the children in a very different situation from their parents. Instead of starting out with nothing, they're starting out with something. While this would seem to be a big advantage to them, it has huge hidden disadvantages. Like America itself, they are in danger of finding themselves slipping downhill. Instead of expecting things to get better, they may find it hard even to hold onto what they've got. Instead of the "Morning in America" that Ronald Reagan promised, they may find that it seems more like evening, both in their personal as well as their national lives.

"From shirtsleeves to shirtsleeves in three generations," say the French. The grandfather begins without a coat. His grandson ends that way.

But what to do? Spend it all the children begin with the same clean slate we had? Move to Brazil or India - countries with more obvious upside?

In the deep, cosmic end, it probably doesn't matter. The advantage to starting out on an upper rung of the ladder may be about equal to the disadvantage of having to worry about falling off. Who can know?

Every man has to play the cards he's been dealt. What else can he do? He may have a humpback or a beautiful voice. He may have had a hard upbringing or a soft head. He may have a fortune worth of poetry in his soul but not dime in his pocket. As far as we can tell, every young man starts out even. Each one begins life in the same place - where he is. And every generation takes what it is given, and makes the best of it.

The real advantage in life is having the gumption to get on with it; no one knows where that comes from.

Enjoy your weekend,

Bill Bonner
The Daily Reckoning

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The Daily Reckoning - Special Reports:

Gold: The Truth About Gold

Fiat Currency: Using the Past to See into the Future

"THE GREAT AMERICAN RECOVERY RP-OFF" Brace yourself for what's about to go down as the BIGGEST FINANCIAL SWINDLE in world history.

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About The Daily Reckoning: Now in its 10th anniversary year, The Daily Reckoning is the flagship e-letter of Baltimore-based financial research firm and publishing group Agora Financial, a subsidiary of Agora Inc. The Daily Reckoning provides over half a million subscribers with literary economic perspective, global market analysis, and contrarian investment ideas. Published daily in six countries and three languages, each issue delivers a feature-length article by a senior member of our team and a guest essay from one of many leading thinkers and nationally acclaimed columnists.

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