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The Daily Reckoning | Wednesday, May 5, 2010 Down the escalator - cracks appear in the great global recovery Banks make out like bandits...on paper: Dan Amoss on extend and pretend, Plus, Bill Bonner with more on the growth of the police state and the rest of his Vegas speech... ------------------------------------------------------- Gold's "Louisiana Purchase" Not long ago, the world's largest uranium giant practically gave away billions of dollars worth of gold to one small exploration company...for only $250,000! Before their next set of drill results are posted, find out how this rare opportunity could easily triple your money by September! Click Here For Your Free Report Now! World Markets Worried About  Sovereign Debt Crisis Watching people and markets go down the longest escalator in the world Joel Bowman Reporting from a little wine bar on a busy Chinese island... "Voted the best people-watching spot in Hong Kong."  There you have it, emblazoned on the back of the waitresses' dark blue, button down shirts. And who are we to argue? Certainly, from our perch here on the corner of Staunton and Shelley, a few feet away from the world's longest escalator, the view is an interesting one.  We wonder what these passers-by are thinking... A rough looking man, perhaps of Middle-Eastern descent, ambles along the narrow sidewalk. He is unkempt and carries on his shoulders a tattered rucksack full of who-knows-what. A group of Asian schoolgirls, dressed in white blouses and pleated skirts, cross the street when they see him approaching. Hurtling along the winding thoroughfare, a red cab threatens for a moment to swipe the stragglers off their feet. They giggle to each other as they bound up the curb, casting a second glance back at our wanderer. If he has noticed anything at all, his expression doesn't reveal it. He just continues along his way, on and on, up the hill... A trendy young couple takes a seat at the front of the restaurant. He wears his collar turned up and flashes a toothpaste-advertisement grin. His legs are shaved. Maybe he's a cyclist? Or a swimmer? Wait...no...now he's smoking. Well, who knows? She is a petite Asian beauty with slightly darker skin, perhaps from the Philippines or Malaysia. Her body language is confident, but for the briefest moment we catch an almost imperceptible sadness in her eyes. Then, in a flash, it's gone. The waiter arrives with the couple's drinks. They raise their glasses, looking pleased with themselves, more or less... Another rambler, a Sikh wearing a football jersey and a Dastar, passes by the window. And there goes a young woman, a European foreigner, perhaps, walking behind a hundred dogs. Did she come here to walk other people's pets? We can't say for sure. Times are tough. And here, in walks another young lady, this one with her parents in tow. She directs them to a table opposite the counter, throwing a warm, familiar wave to the handsome Nepalese barkeep. She's been here before. Her folks, with shirts tucked into their jeans, are most likely visiting. She looks at dad before ordering a glass of wine. He glances at mom and smiles. They look proud... A kilometer or so down the hill, a few escalator stops away, the financial markets are selling off. The Hang Seng is down almost 2% so far today. Taiwan, South Korea, India, Indonesia are all down heavily, too. Australia's markets, mostly resource driven, were under pressure early, off 1.3% when we checked a few moments ago. Miners there led the move to the downside for a second straight day, with BHP Billiton Ltd. slipping more than 4% in Sydney before we'd even had the chance to order a glass of wine and a few nibbles. The general trend lower across the region echoes similar moves by markets in Europe and the US overnight. The S&P 500 slid 2.3% during yesterday's trading, despite some enthusiastic hollerings out of the manufacturing sector. Major indexes were off for a third consecutive day in Europe. Bourses from the Thames to the Rhine and beyond were last seen languishing near their lows for the session. Investors around the world have suddenly become wary of sovereign debt "contagion" in Europe. They're worried that Greece's financial woes might soon learn to speak Spanish...and Italian...and Portuguese. The problem, folks are coming to realize, is that government balance sheets are riddled with the hot potato debts of other government balance sheets. Dan Denning, filing his reckonings from his DR office in Melbourne, sent us this helpful little graphic, courtesy of The New York Times. As the song goes, "the Greek bone's connected to the...other bones" ..or something like that. And now, with lenders pushing the cost of capital ever higher for the languishing Euro economies, the whole skeletal structure threatens to collapse into a pile of broken bones before too long. It's not a new story, to be sure...just a convenient reason to sell. Sometimes, that's all an overbought market standing atop a phony recovery needs to hit the skids. Unsurprisingly, the euro continued its southbound trajectory today. Some, including Guy Wyser-Pratte, whose investment fund targets undervalued European equities, suggested the beleaguered currency could even hit parity with the greenback, something not seen since 2002. Currently it sits just under $1.30.  Meanwhile, Down Under, investors were clobbered again today after the government-commissioned Henry Tax Review recommended onerous tax increases on resource companies. More on that kerfuffle later in the week but, suffice to say, the Rudd administration looks bent on slaying the goose that mined Australia's golden egg.  One man for whom the lower drifting indexes will come as no surprise is our resident short seller, Dan Amoss. Dan has been warning his Strategic Short Report readers about the "extend and pretend" fairytale for some time now. Are the cracks Dan foretold in the great global "recovery" beginning to show? It's probably too early to say for sure...but from where we sit, here on the corner of Staunton and Shelley, it doesn't look good. Dan offers his latest thoughts in today's guest column, below... Dan Amoss' Strategic Short Report Reveals... The Fear Factor Strategy: For every $1 these stocks tank, you could pocket at least $3...and as much as $7 While the S&P 500 crashed 43.3%...this strategy has bagged average 102.9% returns Since the start of the financial crisis, the Fear Factor strategy has crushed every asset class - stocks, bonds, gold, you name it It's proven to turn $1,000 into $2,619...$3,383...even $5,718 To get in on the next Fear Factor play, you have to act now. It could come out in as little as 72 hours. The Daily Reckoning Presents Inflation Up; Stocks Down Dan Amoss We've opened earnings season with a market reaction more erratic than usual. Some stocks got pounded after missing earnings estimates by a hair. Other stocks drifted upward, despite nosebleed valuations and unimpressive earnings. Banks are making out like bandits...at least on paper. They simply post whatever earnings they feel like reporting, because loans and securities no longer have to be marked to market. So why not mark down bad loans at a glacial pace? Doesn't matter that they might be in non- performing status and aren't producing cash flow. Some banks have even lowered their credit-loss provisions because they feel they've adequately reserved for what will be the biggest credit loss cycle in history. Such banks may surprise to the downside next quarter if they re-accelerate their provisioning. Outside of the narrow, government-stimulated first-time homebuyers' segment, mortgage and house price fundamentals continue to plague the banks. Since banks are slow to foreclose, many homeowners who bought during the bubble have defaulted and have been living free of rent or mortgage payments. (I've seen credible estimates of a $100-$200 billion annualized bump in US consumer spending from "strategic" mortgage defaulters. This bump is temporary. When folks are finally evicted, they'll have to start paying rent somewhere). Cash flow will eventually fall short of the levels implied by loan marks on bank balance sheets. "No worries," say the bank stock bulls. "Banks can replace the cash flow from defaulted loans with Treasury securities that carry low minimum regulatory capital requirements." In other words, even if a bank is undercapitalized, it can buy Treasury bills and notes to create instant revenue. If it wants to roll the dice on interest rate risk, it can generate a whopping 3.7% yield in interest in 10-year Treasury notes, or 4.5% for 30-year bonds. But this type of activity never ends well. Today's yield curve and lending environment fosters unhealthy carry trades in government and agency securities. If rates rise significantly, those trades will blow up in spectacular fashion. And if yields rise, the Federal Reserve - our giant taxpayer-backed hedge fund - will book huge losses on its bond portfolio. By law, under such a scenario, Congress would have to appropriate money to keep the Fed solvent. Meanwhile, over in the stock market, risks are on the rise. A negative economic surprise in 2010 is likely to originate in Europe, where weak welfare states seek financial support from relatively stronger ones. Just yesterday, global stock markets tanked on fears that rescuing Greece will be easier said than done...coupled with the realization that Spain and Portugal might soon be looking for handouts. This story ain't over yet. Meanwhile, a potent new inflation could inflict a negative surprise for the US economy in 2010. Already we're seeing very high producer prices. The Wall Street Journal described this phenomenon in a recent article entitled "The High Cost of Raw Materials": "Data on producer prices released by the Bureau of Labor Statistics on Thursday shows how rapidly the pressure on corporate America is mounting. The producer-price index showed that crude goods such as iron ore, construction sand and pulp shot up 44.5% year-over-year, the fastest rate since 1974. Including energy and food costs, crude goods prices rose 33.4%." The ISM's Prices Paid Index is telling a similar story. On Monday, the ISM announced that its Prices Paid Index registered the largest year- over-year increase since the 1970s. Promoters of the world's crazy, unconventional monetary policies (usually bankers) like to blame rising prices on things like droughts, floods, OPEC, and labor unions. But when they do so, they fail to imagine what might happen to prices if the broad supply of money and credit were relatively fixed. If that were the case, it's likely that rising prices in one sector of the economy would have to be offset by falling prices in another. Demand typically falls in response to rising prices (depending on the "price elasticity" of demand). But when government deficits, easy money, and easy credit (rather than income and savings) drive demand, we could easily see persistently high consumer prices, even in a weak economy. For the past few years, I've written that we would see radical pro- inflation policies from central banks in response to the bursting credit bubble. And I've expected these policies to result in higher commodity and energy prices, rather than another credit boom. We're seeing more evidence that basic materials prices are soaring, which should squeeze margins in many manufacturing businesses.  Even if the strongest-positioned businesses are able to pass through rising raw material costs to customers, the market eventually sniffs out this "inflationary" earnings growth, and lowers P/E ratios. Rising prices creeping into the CPI figures could be one of the many potential catalysts that lower the very high P/E ratios in today's stock market. Dan Amoss,  for The Daily Reckoning Joel's Note: Unsure about the footing of the global economic recovery? We suggest taking Dan's Strategic Short Report service for a spin. Right now we're offering a one-month trial to his premium research for only $1. That way you can try before you buy. Sound fair? Interested parties can check it out here. With over 40,000 copies now in print, read your free online review copy of the brand new breakthrough financial report from Gold, Silver, and Energy expert Byron King... The Curse of the Incas Gold's Untold Story and the Shocking New Role It Could Play in Your Financial Survival A 476-year old mistake could soon cost you your retirement. How so? To understand, you have to let me share a little-told story. It starts like this...(Cont. Here) Bill Bonner An Even Better Trade of the Decade, Part III Bill Bonner Reckoning from Baltimore, Maryland... The present volatility will be resolved by a decisive move to the downside. Yesterday, the Dow moved 225 points into negative territory. Was that decisive? No. Not in itself. But it looks like the top is in. If so, stocks should be going down...down...down... Maybe for a year...maybe for 5 years...maybe for another 10 years... Yes, dear reader...the stock market is now free to complete its rendezvous with destiny. Just where, exactly, will that rendezvous take place? Who knows? About 3,000 on the Dow is our guess. But it's just a guess. Stocks trade around 20 times earnings now...and the Dow is about 10 times the price of gold. Sometime in the future, you'll probably be able to buy Dow stocks at 5 times earnings and maybe only 1 times the price of gold. Three thousand seems like a likely target, because that would move stock prices down into the right range from a P/E standpoint...and we can easily imagine a gold price of $3,000.  Why would stocks move down?  First, because the bear market that began in January 2000 never fully expressed itself. It was distracted, first by the big flood of stimulus during and after the micro-recession of 2001...and then by the huge flood of stimulus following the crisis of '07-'09.  Second, because the economy is in a Great Correction - a difficult time, with lagging earnings, slow growth, and high unemployment.  Paul Volcker is the only financial authority associated with the government who has any credibility left. Here's what he says: "What we need is more saving, more industrial investment, and a stronger trade position. Our expansive and expensive program of entitlements simply must be brought under control. Our mortgage market must be rebuilt from the ground up."  Volcker is talking about a Great Correction, which he describes in the same way we do: "a long period of economic adjustment:" "Not much of that can be done this year, or even next," Volcker said. "It is a challenge not just for this Congress and this administration, but for years ahead." Neither Tim Geithner nor Ben Bernanke seem to understand this. But the man on the street feels it. This from Charles Delvalle, who runs the research team for our family office: Floyd Norris points out that the Conference Board's economic survey, which dates back 4 decades, shows a curious change in future expectations. Since 1967, Americans have for the most part, remained more optimistic than pessimistic about their own futures. This was true even when their expectations for the overall economy were negative. But that optimism disappeared during the 2007-9 downturn. A majority of folks began to expect their own financial situation would get worse - versus those expecting better personal times ahead: "In April, the Conference Board reported this week, about one person in 10 expected his or her family's income to improve, while about one in six expected family income to go down. "...good times in recent years have produced less net optimism than in previous cycles, while bad times have brought more pessimism. "On its face, such a result would seem to indicate Americans are losing their optimism, but it may not be as simple as that. In this cycle, unlike earlier ones, many workers were forced to take pay cuts, at least on a temporary basis. So it became reasonable to expect lower income, even for some who did not expect to lose their jobs. "Still, the decline in expectations regarding their own incomes is another indication of how much this recession scared people - and that some of the fright remains." As we keep saying, this is not a typical post-war recession. So, it is no surprise that consumers and investors aren't acting like they usually do. This time it's different - really. This time people are beginning to doubt that old formula works. They know they can't continue to run up debt in their own accounts. And they doubt that the government can do it either. That's why gold is moving the way it is. Only a few months ago gold and the dollar were headed in opposite directions. Now they're moving together. When investors get worried, they move into gold AND the dollar.  The next trend will be to move into gold and reject the dollar. But that trend may be far in the future. See the rest of our Las Vegas speech, below: And now, more thoughts...and the conclusion of our speech...in which we explain why GDP is a lie.... On the police state of things... On Saturday, we heard a speech by Judge Andrew Napolitano, no relation to the Attorney General.  "The Patriot Act, pushed through Congress and signed into law by George W. Bush, probably did more damage to the US Constitution than any other legislation in modern times. It empowers the FBI to write its own warrants - something that has always been prohibited by the Constitution. "As a result of this law, two very diligent FBI agents went into a public library in New Jersey. They handed a warrant to the 86-year-old woman behind the desk. They wanted to know who was checking out what books. Of course, remember, this is a government-owned building, with books purchased by the government, sitting on government shelves. So, how bad could these books in a New Jersey public library be? "And I should tell you too that the law makes it a crime to tell anyone when you've gotten one of these warrants. You're not allowed to tell the person the warrant concerns. You're not allowed to tell your spouse. You can't even say anything when you're asked the question under oath, in court. "Well, these two agents go to the library and hand their warrant to the librarian, an 86-year-old woman. She looks at the warrant. She looks at the agents. And she says: 'Who the hell are you?' "Don't worry about it, lady,' says one of the agents. 'Just read the warrant.'" "I can't read it," says the lady, and she hands it over to her 78-year- old assistant. Another nice old lady.  "Well, the agents decide to take these two women to court for a criminal violation of the Patriot Act. You may wonder how these two librarians posed a threat to the republic, but that's what the FBI did. And so these two ladies were in front of the court in New Jersey when the judge turned to the FBI and said: "If you pursue this case I will have to find your law unconstitutional." "So, the FBI wisely withdrew their case." And the final installment of our speech in Las Vegas...on why you can't engineer a genuine recovery...and why GDP is just a number...and why China will blow up... The problem with trying to engineer a 'recovery' is the same problem with all central planning - it substitutes the honest signals from the marketplace with imposters. For example, instead of getting the message that they need to conduct their business in a different way, the banks get the idea that the feds will always bail them out...and automakers - thanks to the Cash for Clunkers program - may get the idea that there is more demand than there really is...and everyone could get the idea that the economy is healthier than it really is, thanks to the feds $1.5 trillion deficits. The authorities are trying to force the economy back into the shape it was in before the crash. They're preventing it from taking a new, better shape....and preventing the correction from doing its work. A correction is supposed to cleanse out the mistakes from the 50-year credit expansion. But it's hard to do so when you don't know what is really going on. Markets - when they are allowed to do their work - are always in the process of discovering what assets are worth. They were doing a good job of it in the fall of 2008. They were discovering that the US had too many houses, and too many shopping malls, (the US has 10 times as much retail space per person as France...) We also had too many derivatives backed by real estate, and too many private equity deals based on too many optimistic assumptions about the future. [Anyway you look at it, we have, as Paul Volcker puts it, a "long period of economic adjustment" ahead of us. The feds are just getting in the way...and making it even longer.] The market was in the process of discovering what assets were worth when the feds stepped in. They stopped the process of discovery. Instead, they forced the market into a process of Price Hiding. Probably the most dramatic example of price hiding has been in the financial sector itself. There, the feds took away the risks of bad debt from the bankers and put it on the general public. The Fed bought the toxic loans, transferring hundreds of billions of losses from the banks' balance sheets onto the balance sheet of the Fed.  The Fed also lent the banks money at near zero percent...and then the federal government borrowed it back. The banks were able to make profits without doing any work or taking any risks. No wonder they didn't lend money to private businesses or consumers. It was too much trouble. And they didn't have to.  If you look at the latest figures from the Fed you will see that private credit is still falling. Commercial and industrial loans in March fell 16%. Asset backed commercial paper fell 20%. This correction, by the way, marks the first major reversal of commercial and consumer credit since WWII.  And now the Treasury has the gall to tell the public that it made money from its 'investments' in the banking sector. If so, those were the most expensive profits in the history of finance. They cost the nation about $4 trillion in fiscal stimulus deficits - added to the national debt. And another $1.8 trillion worth of dodgy debt on the FED balance sheet. And about $6 trillion more worth of financial guarantees of various sorts. If the SEC wants to redeem itself, it should forget about the small fry. It should get off Fabulous Fab's case and go after the real frauds in this case...Ben Bernanke and Tim Geithner.  That won't happen. But everything regresses to the mean. That's the work of a correction - to bring things back to normal, back in balance. First, the private sector is corrected. And then, the public sector.  When something is out of balance on one end, you can be sure it's out of balance on the other side too. Americans consumed too much during the Bubble Epoch. Now, they need to save and produce more. But who was on the other side of this trade...? Let's begin by going back to the 1920s. Back then, the USA was the industrial powerhouse of the world and its number one exporter. In those boom years, America had the largest trade SURPLUS on the planet. At the time, trade balances were settled in gold. So, the US built up the world's largest reserves - in gold. It still has them. But that pile of gold didn't keep the US from financial trouble. The stock market crashed in '29 and the following two years cut the US GDP in half. It took the stock market 27 years to recover. In the 1980s, Japan had the biggest trade surplus in the world. You remember Japan, Inc? It was such an export success story that people worried that the Japanese would take over the world. But in 1989, Japan, Inc. peaked out. Its stocks have been going down ever since - 20 years already. Now, it's China's turn. China has the world's largest trade surplus and its largest pile of reserves. (Unfortunately for China, after 1971, treasuries switched to using paper dollars for reserves. So China has one enormous pile of paper...not gold.) Thomas Friedman wrote that he wouldn't bet against a country with more than $2 trillion in reserves. But does this pile of paper money guarantee that China cannot fail? To the contrary, history tells us that China is most likely to fail - spectacularly - even though, over the longer run, like the US after the '30s, China may turn out to be a great success story.  Everything regresses to the mean. Everything tends to go back to normal. Corrections are normal. They help things get back in balance.  Now, here's the interesting thing. While Japan's government tried to prevent it, the Japanese private sector de-leveraged. Over a long period of adjustment - 20 years - the household, business and financial debt went down by about 40%, in GDP terms.  And now, in the US, even though the government tries to hide prices and delay the correction, the private economy is still de-leveraging. The latest figures suggest that households took a little pause in the first quarter of this year. Savings actually went down as consumption went up. But if we continue to follow the Japanese example the de-leveraging should resume soon.  We know from the Japanese history too - if we had any doubt about it - that price hiding doesn't work. First, they tried fiscal stimulus. That didn't do anything. The banks took the monetary stimulus and held onto it, just as US banks are doing now. Then, they tried fiscal stimulus. Now, this deserves a little discussion. Because Richard Koo among others argues that the fiscal stimulus did work in Japan. He points out that Japanese GDP did not drop significantly - thanks to massive doses of fiscal stimulus. And now, Paul Krugman and others are saying that fiscal stimulus has worked in the US too...because our GDP only went down less than 3% in what they call the Great Recession.  Here is where we see the claptrap theories at work. Fab Finance turned the economic profession from historians and philosophers into mathematicians and engineers. Dozens of these fellows won Nobel Prizes for elaborate mathematical proof of what were essentially bogus or inconsequential ideas. And now they turn to GDP as proof that fiscal stimulus works, without bothering to think about what is really going on. GDP measures economic activity. Like everything else in modern finance, it is sensitive to quantity and completely ignorant about quality. To borrow from Oscar Wilde, it knows the price of everything but the value of nothing. Yet, here again, as the Soviet Union showed us, you can summon up all the GDP you want. Just divide the country at the Mississippi. Get half the population to dig a big hole in Tennessee...and get the other half of the population to fill it up. Imagine the trucks...the fuel...the machinery...the labor...the housing you'd need... GDP would go up. You'd have full employment. Modern economists would be content with themselves. They'd sit by the phone, waiting for the Nobel committee to call.  But what would you really have? You'd have Japan! That's what the Japanese did. Well, not quite like that... They put people to work building roads and bridges...pouring concrete on a massive scale. Until then, Japan had the healthiest government finances in the world. Now, it has more government debt/GDP than any other nation - approaching 200%.. And think about what really happened. Japan's population is getting older. These are people who lent the government money so that it would be safe. They wanted to be sure they'd have the money they needed when they retired.  But where is that money? It has literally been poured into a hole in the ground. The savings of an entire generation have been turned into bridge abutments and canals - most of them unnecessary and many of them unwanted.  That is what is happening in the US too. Except we don't have enough savings to finance our own holes in the ground. We're more like Greece.  And like Greece, we will pay a high price when the final correction comes.  Regards, Bill Bonner,  for The Daily Reckoning ------------------------------------------------------- And a final note from Joel, last seen somewhere around Staunton Street, Hong Kong... If you've been following the trends we outline here in these pages, you'll be interested to know that our executive publisher, Addison Wiggin, recently released his "rubber meets the road" research service, tentatively titled Addison Wiggin's Apogee Advisory.  The project, in the chief's own words, is aimed at "providing investment research for individual investors that will not only cover the nexus between money and politics, between Wall Street and Washington, but would crush even the finest research published by the Wall Street houses, such as they are." In his latest issue, Addison covers, among other things, the best actionable angles of the Trade of the Decade you've been reading about here in The Daily Reckoning. That's the "short US Treasurys, long Japanese equities" trade Bill's been talking about. And, best of all, there's still time to get in on the free "beta-test" deal.  In short, Addison's offering his best research, gratis, during his first three "test" issues. So, if you wanna grab a boatload of Mr. Wiggin's latest investment insights, we urge you to get yourself on the list now while it's still complimentary. Here's a quick info page if you're interested. The regular retail price will kick in here soon, so you'll want to be nimble.  Cheers, Joel Bowman Managing Editor 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 at joel@dailyreckoning.com