Britannia Radio

- A fresh perspective on market cycles and what the bond market is telling investors, What capital controls and the "Buffett Tax" mean for you and your money, Plus, Bill Bonner on why everyone thinks the market is going up and gold's sneaky move to the upside... The Daily Reckoning | Thursday, April 8, 2010 On the Cyclical Nature of Financial Markets Recessions and recoveries in a perpetual state of consumption Eric Fry Reporting from Laguna Beach, California... Most investors believe that markets behave cyclically, like an ocean tide that ebbs and flows. Bull markets give way to bear markets; booms turn into busts; low interest rates yield to high interest rates. And it's true, markets are cyclical...but not like ocean tides.  Financial markets are cyclical...like an Ouroboros - the mythological snake that devours its own tail. Economic trends are forever in the process of devouring parts of the financial markets. Recessions consume stocks; recoveries consume bonds. In the best of circumstances the stock market steers clear of recession for long enough to heal...and to resume growing again. But that's not guaranteed. Often, the stock market drags its mangled body away from the ravages of recession and, eventually, manages to recover its former health...just in time for the next recessionary downturn. Bonds endure a similarly precarious existence. They tend to flourish during recessions and to struggle during recoveries...especially during the kinds of recoveries that also produce inflation. Thus, for long sweeps of time the bond market inflicts more pain than a dungeon master from the Middle Ages.  In other words, as your editors here at The Daily Reckoningnever tire of pointing out, the financial markets are primal...not domesticated. No matter how docile they may appear at times, the financial markets will always be more cheetah than Chihuahua; more Great White than goldfish. We do not present these metaphors to terrify investors, merely to frighten them. A vigilant investor is often a successful one. But what does it mean to be vigilant...especially in today's very baffling macro-economic environment? Should the vigilant investor be buying stocks because the economy seems to be recovering? Or buying bonds because the economy's bounce will quickly fade? As usual, these questions produce no easy answers. The US stock market, in general, seems pricey and dangerous. The US bond market, in general, seems even pricier and even more dangerous.  Therefore, if forced to choose, your editor would be a much more eager seller of bonds than stocks. Although, truth be told, he'd be a seller of both, and a buyer of selective commodities like uranium, gold and natural gas. But you've read all that before. Today our discussion is about the bond market, and the risks that threaten the holders of long- term Treasury securities. The largest single threat to a bondholder is the risk that inflation will re-emerge with surprising strength. So far, inflation remains relatively quiescent, based on the government's suspect data. But even the government's data reveal that signs of inflation are emerging. As we observed inTuesday's edition of The Daily Reckoning, the Consumer Price Index (CPI) calculation that excludes residential rents shows that inflation has been rising at a 3% clip since the end of 2007, despite the fact that the economy has been recessionary throughout most of this period. The residential rent calculation contributes about 30% of the total CPI number...and rents are certainly deflating. On the other hand, the other 70% of the CPI that measures the cost of the goods and service is telling us that inflation is far from dead. A second potential menace that could threaten the Treasury market is declining demand from "Foreign Official Holders." This important source of demand for Treasuries includes foreign central banks, ministries of finance, sovereign wealth funds, etc. Buying by foreign official holders soared from $1.7 trillion worth of Treasuries in mid-2008 to about $2.7 trillion by mid-2009. Foreign official holdings have remained at that lofty level ever since. Unfortunately, the US government's borrowing has not stood still. It has been soaring, which means that foreign official holdings - as a percentage of total Treasury securities outstanding - has been dropping sharply during the last six months. Not surprisingly, 10-year bond yields have jumped during the same time frame. "Bonds have seen their best days," says Bill Gross, manager of the world's biggest bond fund at Pacific Investment Management Co. As the nearby chart illustrates very clearly, an inverse correlation exists between the trend of bond yields and the trend of foreign official holdings of Treasury securities. From the middle of 2006 until the fall of 2008 foreign official holdings increased steadily from about 31% of all of Treasury securities outstanding to more than 40%. Over that timeframe, the 10-year Treasury yield dropped from more than 5% to less than 3%. The inverse correlation between foreign official holdings and long-term treasury bond yields is not precise, but it is evident...and intuitive. Obviously, foreign official holders like central banks are not the only buyers of Treasury securities, but they may be the most important marginal buyers. Therefore, to the extent that their appetite for Treasury securities wanes, bond yields are very likely to rise. Watch this space...very carefully...dear vigilant investor. Lastly, for those readers who were concerned that your California editor might make it through an entire edition ofThe Daily Reckoning without offering a few unkind words about the stock market, fear not... One of our favorite options gurus, Jay Shartsis, of R.F. Lafferty in New York, points out that bullish investment sentiment has swung to an extremely extreme, extreme...which is a very bearish indicator for the stock market. He observes: "The 10 day CBOE equity put/call ratio is at the lowest level (most call buying) in four years. The 'speculation index' - that is OTC volume compared to NYSE is at the highest (most speculation) in 15 years. The Consensus survey shows 70% bulls. Investors Intelligence shows bears at less than 20%. This is one lopsided bull boat. Something's got to give here." So to recap: Sell bonds, based on a long-term view; sell stocks, based on a short-term view; buy gold, based on a combination of befuddlement and caution. We know it's only April, but maybe it's not too early to "Sell in May and Go Away." The Daily Reckoning Presents Brace for Turbulence, Part II Dan Amoss History shows that when the governments grow desperate to finance deficits, they get creative.  During WWII, the US government needed investors to buy an unprecedented amount of Treasury bonds. Commercial banks loaded up on Treasuries, which limited the amount of credit that could be granted to the private sector. It may have been the patriotic thing to do, but the real returns from war bonds were very poor. Napier said,"That's the type of society [the US and the UK] had to run to sustain our government debt. And I'm suggesting to you that these are exactly the sorts of things we have to look out for in our future."  Napier then summarized one of the conclusions that economists Carmen Reinhart and Ken Rogoff reached in their book This Time is Different. Financial crises morph into fiscal crises. But the thing that has yet to frighten investors is the next stage: financial suppression. This is the process of forcing private sector savings into public sector debt. Most investors will tell you that this is impossible. But Napier ticked off two potential tools the government could use to strong-arm investors into Treasuries:  1. Capital controls: An example of this comes from the UK in the 1970s. For most of this decade, the yield on UK government bonds was below inflation. The government wouldn't let investors take money out of the country.  2. The "Buffett tax": Political leaders would say,"We love capitalism. It is the best thing America has ever had. And we would really, really like to promote it. And the best way we can promote capitalism is to get all you capitalists to invest with a long-term holding period." The idea would involve a 4% "transaction tax." This effectively forces shareholders to engage more deeply with corporate executives, rather than trading shares aggressively. The authorities would say, "This is a wonderful thing because Warren Buffett does it. And if Buffett does it, it has to be good. So as of tomorrow, we'll have a 4% 'Buffett' tax for the trading of all financial instruments except for government debt." Napier says the government can't get away with inflating away its debt in a free market. If it were attempted in an aggressive fashion, yields would soar, making the process self-defeating. So the government will make the Treasury market a "less free" market. In other words, it will stack the deck in favor of Treasuries, to the detriment of all other financial assets.  But the authorities should know that this type of action would have huge consequences for global financial markets. A big driver of the global economic growth over the past three decades has been the liberalization of capital. Capital could easily migrate across borders to seek out the highest risk-adjusted returns. Today, the international flow of capital is just as important as the flow of international trade. Capital controls, if they get too onerous, could wind up leading to a 21st Century version of the Smoot-Hawley tariff.  As distasteful as it is, investors must pay close attention to politics and policy. "We've spent our professional careers analyzing supply and demand," Napier explained. "Now, we must analyze supply, demand, and government. [During the 2008 financial crisis], the government didn't like what supply and demand were doing; supply and demand were inducing deflation and creative destruction, so the government stopped it."  Napier thinks that the catalyst to end the unsustainable status quo of the developing world financing US trade deficits will beinflation in the emerging markets. Emerging economies believe that they can export their way to prosperity, but they cannot. "40% of the world's population has a great plan to get rich by selling stuff to 14% of the world's population," Napier observed. "That can work for several years, and it has - particularly if 14% of the world's population is prepared to gear like crazy to buy all of this stuff."  Now that US consumers are deleveraging, Asia's mercantilist economic and currency policies aren't as effective as they once were. These countries will not be focused on undervaluing their exchange rates forever. If aggressively debasing your currency were a guaranteed road to high growth and low inflation, paper money would have a much better reputation among historians.  The downside of this currency policy is that it can lead to inflation at the local level. Eventually, the supply of existing and new money will overwhelm the growth of productivity in China's industrializing economy. These emerging markets will have to eventually allow currencies to rise to prevent inflation from getting out of control. We're seeing more examples of rising imported commodity prices hurting Chinese industry. The price of iron ore is soaring, thanks to China's aggressive infrastructure investment and its suppressed currency. International iron ore markets are so tight that supply contracts are switching from yearly to quarterly pricing adjustments. The Financial Times this week reported on this evolution in the pricing of iron ore, which will feed through to higher steel prices: "The new price system will lift the cost of iron ore to Asian steelmakers to about $110-$120 a tonne during the April-June period, up between 80 and 100 per cent from the $60 level at which the 2009-10 annual contracts were settled."  If China allowed its currency to appreciate, it would pay less to import iron ore and other crucial imports like oil. A strengthening Renminbi would increase demand for imported oil, which translates into more expensive oil for US consumers. A few years from now, Washington, DC may come to regret its push for China to appreciate its currency. Napier also addressed the subject of Europe, Greece, and the Euro. He said, "The creation of a single currency is not an economic event, it's a political event. Unfortunately, the ten guys in Europe who run this currency have all got Ph.D.s in economics."  Napier then told us about his experience working in Hong Kong in 1998. That year, the French senate sent a delegation to Honk Kong to investigate the Asian financial crisis, and consult Napier about the evolving project that was the Euro.  The French delegation was convinced of the merits of establishing the Euro, because it would supposedly bring lasting peace along with economic integration. WWII was still a searing memory. The delegation asked whether the Euro would help "iron out the inefficiencies" across Europe. Napier replied, "The things you call 'inefficiencies' here in Hong Kong are the things in France you call 'culture.'" He knew that currency integration without political integration wouldn't work. Napier fears that the political will to save the Euro is forcing "economic deflation" in Greece and the other spendthrift countries within the Eurozone. Those running the ECB may rightly note that wages in Greece might decline to achieve a healthier Eurozone equilibrium. But Napier believes that if too much harsh austerity is imposed on the Greek economy, the democracy in Greece might be destroyed in the process. Napier points out that democracies very rarely deflate. They instead devalue their currencies and push new money supply through the channels of commerce.  Napier is concerned that "the ECB will not change its mind on hard money until it destroys one of the democracies in Europe." Then came the most shocking thing Napier said in his hour-long speech: a prominent Greek businessman confidently assured him that the United Nations will be running Greece by September. If so, this should keep fear in financial markets at healthy levels through this spring and summer. Greece is not resolved, yet the markets appear to believe so. When asked for a forecast of the best potential asset class over the next decade, Napier's replied: "A basket of Asian currencies."  Dan Amoss for The Daily Reckoning Joel's Note: The last time we opened up a $1 offer for Dan'sStrategic Short Report, Dan had just recommended his readers buy put options on Old Dominion. The trucking company had, by Dan's reckoning, expanded too aggressively during the boom years. It was due for a correction. Having traded around $34 at the end of December '09, the price of Old Dominion quickly fell to a fraction above $26 by late January. Dan sent a note to SSR members days after that bottom, advising them to "Sell ODFL puts for 85% or better gain." As part of our Financial Darwin Awards, we urged readers to take advantage of the $1, one-month trial to Dan's service, a service that actually profits when stocks decline. A few readers got on board early...and grabbed the gains. Others, having missed their window, wrote to us afterwards wondering when we'd again open up the special trial offer.  So now, as your editors become increasingly convinced a stock market correction is coming due, we're giving you another crack at trying Dan's Strategic Short Report for just $1. For obvious reasons, we can't keep special offers like these open indefinitely, which is why we're urging you again to grab hold of this opportunity while you can.  Serious investors who see a market correction looming will find all the info on how to play it in Dan's brief Strategic Short Report invitation letter. We hope you can take advantage of this limited time offer. Bill Bonner Goldman-style Capitalism: Separating Fools from Their Money Bill Bonner And now the rest of today's reckoning from Baltimore, Maryland... Cut expenses. Go broke. Be happy. Everybody is convinced the market is going up. So what does the market do? It goes down - 72 points yesterday. What do you call it when the market goes down 72 points? A beginning! Well, we don't know if it's really the beginning of the end or not. We've seen more beginnings than we can count. Still, no sign of the end. But there must be an end out there somewhere. Always is. And look at what is happening in the gold market. While everyone has been watching health care...and stocks...and bonds, gold has been moving up. It rose another $17 yesterday to bring the price up to $1,151.  Why is gold moving up? Because it anticipates higher inflation? Because it is afraid of government defaults?  Most likely, it has no more idea than we do. It doesn't know what's going to happen...but with the feds borrowing more than 10% of GDP each year, it ain't going to be pretty. The S&P is now trading at a P/E over 23, according to the most recent Barron's report. Dave Rosenberg: "No matter how we slice it, whether on a Shiller P/E, Tobin Q or historical profit basis, the US market is anywhere between 20% and 30% overvalued." Emerging markets are soaring. Oil is over $85. And the temperature here in Baltimore is 83 degrees. The heat is on. Something's gonna blow. But Goldman Sachs is as cool as a cucumber. Goldman released its annual report earlier this week. The firm said it hadn't done anything wrong. It hadn't bet against its own clients. Nor had it expected any help from the government. Here at The Daily Reckoning, we've always taken Goldman's side. We've always had a weak spot for cripples, lamebrains and predatory lenders. Besides, Goldman stole the money fair and square.  Critics charge that Goldman 'perverted' capitalism. But they just don't understand how kinky capitalism can be on its own. You see, dear reader, when it comes to putting meat on the table, nothing beats capitalism. But it only succeeds so well because it is allows foolish hunters to blow their own heads off. In his book FIASCO, Frank Partnoy recalled his days on Wall Street: "The way you made money from derivatives was by trying to blow up your clients," he writes. He described how Wall Street regularly sold extravagantly complicated derivative instruments to institutional buyers who were either too dim or too lazy to figure out what they were buying. If they had known what was in them, they wouldn't have bought them.  Then, of course, the instruments blew up...along with the pension funds, endowments and insurers who bought them.  But that's just the way it should work. Capitalism doesn't like it when idiots have too much money. So it uses people like Goldman to help take it away from them. That's what Lloyd Blankfein meant when he said Goldman was doing "God's work." We don't know if God wanted Goldman to blow up the world economy...but capitalism seemed to be calling for it. And it looked like capitalism was going to blow up the bomb tosser, too. Unfortunately, the feds stepped in. They bailed out AIG...and the whole financial industry - including Goldman. Now, they lend the big banks money for practically nothing...which the banks lend back to the feds at 4%. The banks make money. They restock their reserves with US Treasury debt. And the feds get to finance their gigantic deficits. It's great for everyone - until it blows up too. It's true, of course, that capitalism had already been twisted long before the feds bailed out the banks. Individual investors believed they could make money just by buying mutual funds or a house. Institutional buyers thought they could make money by buying collections of mortgages, any one of which they knew was likely to be garbage. But these crackpot ideas are just part of what makes capitalism so much fun to watch. And don't worry, just leave it alone...it will correct those mistakes in a jiffy. Here we are barely 24 months after the correction began. Who thinks he can make money by buying a house now? Only people standing on the courthouse steps and hoping for an extreme bargain. Who thinks he can finance his retirement by buying stocks? Only the young and the dreamers. And who thinks you can make an economy richer by consuming more? Or cure a problem of too much private sector debt by adding more debt in the public sector? Only economists! And that's a whole 'nuther subject. And more thoughts... While the markets are hot, the economy is cool.  Nearly 7,000 people go bankrupt every day - a record number. And in March, M3, the broadest measure of the money supply, recorded its biggest drop ever. And get this. Peak to trough, December '07 to February '10, 8.3 million jobs were lost. As we reported yesterday, take away the statistical tricks and the number of people with real jobs actually fell last month - despite reports of an additional 163,000 new jobs in March. Consumer credit fell again in February - down $11 billion. To put this number in perspective, the US government has run about $2.5 trillion in deficits since the correction began. So, in spite of pumping monthly deficits on the order of $120 billion...consumer credit still sank by $11 billion. What can we say? It's a Great Correction, after all. Greece is going broke after all. Yields on Greek debt rose over 7% yesterday. So let's look at how this works. Investors worry about a default. They push up yields (they need higher interest payments to justify the risk). This causes Greece to go further into debt (the cost of paying the extra interest), which causes even more worry among lenders. Why doesn't Greece just cut expenses? Ah...glad you asked. This just goes to show what a dead-end debt can be. The government has already proposed substantial cuts. But it has to answer to the voters - who are on the verge of rioting in the street. And its own cabinet ministers are calling the Germans 'racist' because they refuse to give the Greeks money. It's hard for a popular democracy to cut spending. And then when it does, it discovers that it is in another trap. So much of the private sector depends on government spending that, take it away, and the whole economy shrinks. This causes tax revenues to fall by more than the budget cuts. In other words, a multiplier works in the other direction - causing the budget deficit to widen when cuts are made! And guess what? Greece is not the only government that is falling into this hole. Latvia. Iceland. Maybe Ireland, England, California...and even the US... Where, exactly, the point of no return lies, we don't know. But it's out there somewhere... What's the solution? Well, just to bite the bullet. Make the cuts. Default. Be happy.  Regards, Bill Bonner,  for The Daily Reckoning ----------------------------------------------------------- Here at The Daily Reckoning, we value your questions and comments. If you would like to send us a few thoughts of your own, please address them to your managing editor atjoel@dailyreckoning.com