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The Daily Reckoning | Monday, May 10, 2010 Sovereign debt crises and how the US stacks up  against Europe, Short-term pain for long term gain:  The importance of being prudent, Plus, Bill Bonner on the lowly stamp of a central  banker's origin and plenty more... Make Way for More Debt Why governments are willing to fight the debt fire with more dead wood Eric Fry Eric Fry, reporting from Laguna Beach, California... The leaders of the European Union huddled together over the weekend to devise a dramatic rescue plan for the euro. When they broke from their huddle they announced a $645 billion war chest (of borrowed money) with which to defend their 11-year old currency. The massive rescue plans seems nearly certain to work...for a day or two...and maybe even for an entire week. But trying to combat debt fears with a great big pile of additional debt hardly seems like a winning formula. Rescue plans rarely rescue much of anything. At the heart of the issue lies the simple fact that most European governments are heavily indebted and are increasing their indebtedness at a catastrophic pace. After decades of dispensing services and benefits that tax revenues failed to cover, the moment of truth has finally arrived. And it is too late for austerity measures or tax hikes to restore solvency. Therefore, without some combination of bailouts and money-printing, several governments might default. As this seemingly unthinkable possibility becomes "thinkable," if not likely, every heavily indebted sovereign borrower in the world is starting to wonder if they might be next. This situation is very serious, very pervasive and very unlikely to be cured by any sort of "rescue plan." The panic of early 2009 may be gone and the "crisis mentality" resulting from the Lehman Bros. bankruptcy has vanished. But the seeds of the next crisis are germinating already. Excessive debt remains a very serious problem in almost every corner of the global economy. Here in the US, consumers remain very highly leveraged and US banks continue to hold enterprise-threatening levels of impaired loans. Meanwhile, sovereign borrowers from Greece to Portugal...to America are struggling with unsustainably large liabilities. For the moment, the Greek debt crisis has sparked substantial "flight to quality" buying of US Treasury securities. But panic selling has become the norm in almost every other sovereign debt market. But "quality" may be in need of a re-definition. The Congressional Budget Office's latest numbers reveal that America's national indebtedness will increase by $9.7 trillion over the next 10 years. Further, the CBO projects the national debt will be 90% of GDP by the end of this decade. This projection seems very optimistic, as America's national debt has already reached 86% of GDP. Unfortunately, America's finances are not unique; they are emblematic. Sovereign borrowers throughout Europe are suffering from a toxic combination of sky-high debt and overly generous entitlement programs. The charts above and below place the Greek crisis in a global context. The chart above shows the total "bare bones" funding requirement for various countries during the next three years. Specifically, this chart shows the amount of borrowing that would be required by each country to fund anticipated deficits during the next three years and to re-finance all government debt coming due in the next three years. The resulting sum is expressed as a percentage of annual GDP. As expected, countries like Italy and Greece are high on the list. But surprisingly, the US is on par with Spain and Portugal. The chart below presents the exact same data in absolute terms, rather than as a percentage of GDP. America's three-year funding requirement seems much more ominous when viewed in absolute dollars. These charts clearly show that no indebted country is immune from the kind of investor scrutiny that could produce a debt crisis...or a currency crisis. Most central bankers of the world realize this fact. That's why they all wish to support Greece - not because they care about Greece, but because they care about avoiding close scrutiny of their own finances. Runaway government borrowing creates a frightening context for any would-be buyer of government bonds. That's why long-dated bonds may be some of the riskiest assets on the planet at the moment. (And why rising interest rates may become one of the most important investment influences over the next several years.) Although near-term economic weakness, and/or "flight to quality" buying, may exert some downward pressure on US Treasury yields over the short term, runaway government deficits will exert upward pressure on Treasury yields over the long term. Volatility is the new "black." The Daily Reckoning Presents Prudence in Volatile Times - A Case Study Eric Fry Prudence can seem very imprudent in a runaway bull market. In fact, it can seem downright stupid. Jean-Marie Eveillard's career provides a delightful insight into this irony - both the downside of exercising prudence when share prices are soaring; and the satisfaction of exercising prudence long enough to prove its value. Eveillard knows this reality firsthand. "A good value manager accepts that there will be periods of short-term pain," Eveillard once said. "It is one reason that there are so few good value managers. It's not just psychological. You may lose clients, or even your job." During Eveillard's first decade at the helm of the First Eagle Global Fund (originally called the Sogen International Fund), it easily outdistanced every applicable benchmark. From the fund's inception in November 1986 through March 31, 1997, First Eagle Global Fund delivered a total return of 236%, compared to only 133% for the MSCI World Index. This dazzling performance elevated Eveillard to celebrity status - so much so that he became a little nervous about the stock market...and increasingly cautions. He was also concerned that so many flimsy tech stocks were soaring for no good reason, and that compelling values were becoming almost impossible to find. Eveillard responded to these conditions by raising the cash level in his fund and also raising his exposure to gold. As a result of Eveillard's caution, his fund lagged far behind every relevant benchmark during the next three years. Between March of 1997 and March of 2000, First Eagle posted a total return of only 28% - or barely one third the 75% total return of the MSCI World Index. Eveillard's numbers seemed even more pathetic alongside a tripling of the NASDAQ Composite Index during the same timeframe! Eveillard was unflappable. He refused to embrace the tech stock mania that was powering financial markets around the globe to new highs. Instead, he simply maintained the value-based investment process that he had always pursued. In his self-defense, Eveillard simply stated, "I would rather lose half of our shareholders than half of our shareholders' money." And that's exactly what happened. As Eveillard later confirmed, "We did lose half our shareholders; we did not lose half our shareholders' money." For three long years, it looked like Eveillard's illustrious career might end in disgrace. His fund nearly closed down. But as it turned out, Eveillard's prudence was, in fact, prudent. In the ten years from March 31, 2000 to March 31, 2010, the S&P 500 Index and the MSCI EAFE Index both produced a negative total return. Over the identical timeframe, the First Eagle Global Fund more than tripled!  Seth Klarman, another outstanding investor who has been prone to producing mediocre short-term results, shares Eveillard's outlook. In Klarman's 2004 client letter, he wrote: "By holding expensive securities with low prospective returns, people choose to risk actual loss. We prefer the risk of lost opportunity to that of lost capital. With our efforts focused on minimizing permanent impairment of capital, we also do not promise to make you the most amount of money in any short period of time. You have seen that in our results." Klarman expanded upon this theme in his book, "Margin of Safety," when he observed, "Like dogs chasing their own tails, most institutional investors have become locked into a short-term, relative performance derby. Who is to blame for this short-term investment focus? Is it the fault of managers who believe clients want good short-term performance regardless of the level of risk or the impossibility of the task? Or is it the fault of clients who, in fact, do switch money managers with some frequency? There is ample blame for both to share. "There are no winners in the short-term performance derby," Klarman continued. "Attempting to outperform the market in the short-run is futile since near-term stock and bond price fluctuations are random and because an extraordinary amount of energy and talent is already being applied to that objective. The effort only distracts the money manager from finding and acting on sound long-term opportunities. As a result, clients experience mediocre performance. Only brokers benefit from this high level of short-term think." By eschewing the conventional pursuit of superior short-term returns, Klarman has amassed an enviable record of superior long-term returns. From its inception in 1983 through Dec. 31,2009, his Baupost Limited Partnership Class A fund has earned an average annual return of 16.5%, net of fees, compared to 10.1% for the S&P 500. During the "lost decade" of 1998 to 2008, Baupost's fund crushed the S&P, returning 15.9% for the period vs. a loss of 1.4% for the S&P. Prudence sometimes seems imprudent. But it never is. Eric J. Fry, for The Daily Reckoning Joel's Note: We learned recently that Eric will be on hand to emcee this year's Agora Financial Investment Symposium in Vancouver. The event, titled "Assault on Enterprise," will feature 12 guest speakers from as far away as Russia, Brazil and New Zealand, in addition to the editors you read in these pages every day. You'll also hear from perennial favorites like Rick Rule, Marc Faber, Doug Casey and, of course, the inimitable Bill Bonner. If you can afford to miss this event, well...good luck to you. If you think these guys might have an insightful nugget or two to help you become a better investor, you'll want to join us. Details are all on the conference webpage, here. Bill Bonner Current Market Valuation: Deciphering the Randomness Bill Bonner And now over to Bill Bonner with the rest of today's reckoning from Paris, France... The Dow lost another 139 points on Friday. Now the stock market is in a downtrend. Is it THE downtrend? Or just another random move, of no particular importance? Hard to say. We began questioning our faith last week. Why do we think there's a bear market in stocks? Why do we think stocks will go below 5,000 on the Dow? For a minute, we couldn't remember. We weren't questioning our reasoning; we were asking much deeper questions. Of course, we don't want to buy stocks - they're expensive. And the economy is worse than people think But what we were wondering about is the idea that stocks move in long trends that take them from epic highs to epic lows. Of course, it is obviously true. Stocks go up and down. They're bound to hit extreme highs and extreme lows from time to time. Then, when you look at the pattern, it's going to look like the stock market knew where it was headed. That is, the motion of the stock market could be purely random, just like the finance professors say. Even so, it would still move from a very high point to a very low point. So what's the difference between random movements and the patterns that the random movements make? To put it another way, what is it about reality that makes it possible for it to appear completely random and completely organized at the same time? Or, what if God made it appear that he didn't exist? What if everything happened in an apparently random way, but according to a plan that was too subtle for us to understand? Whoa...this is, like, getting heavy...and deep. We're already in over our heads. So, let's back up. Let's say you knew that the stock market is theoretically random. But let's say you also knew that this random motion had been headed down for the last 10 years...and that stocks were still not even half as cheap as they were the last two times random motion took it to an epic low? What would you say? Well, "watch out!" That's what we'd say. Our position is that the market is almost random - but not quite. It is so random that almost everything it does can be explained by randomness. It is so random that it is almost impossible to beat with any 'intelligent' system. It is so random that it will drive a thinking man mad if he spends too much time thinking about it. And yet, for all its randomness, it looks to us as though there is a pattern. 29 - 66 - 99 Those numbers were the years in which the Dow hit major highs during the 20th century. Note that they are separated by periods of 33 to 37 years - roughly the period of a human generation. Bonds do more or less the same thing. From a low in '49, bond yields rose until '81 - 32 years. Then, they began an epic decline, which continued until 2008 - 27 years. (This trend may not be over). The big trends tend to last about as long as a generation. Why? Because one generation learns; the next forgets. After the Crash and Great Depression there was no way investors were going to bid up stocks to '29 levels. The old timers had to retire...and a new generation of investors had to take over. Of course, this is just a hypothesis. All we know is that when we look back at the stock and bond markets, we see long trends, punctuated by extreme highs and extreme lows. So, when an extreme high is reached, an investor is well advised to sell. The next extreme will be an extreme low. It can take 10 or 15 years to arrive. But it is a miserable time to be in the stock market. On the other hand, after an extreme low, an investor has little fear and a lot to gain. All he has to do is buy, sit tight...and hope he lives long enough to take advantage of it. Where are we now? It looks to us as though we are 10 years into a bear market. The extreme was reached in '99 - when tech stocks were trading at extraordinary prices. In the years following, the Dow actually went considerably higher. But adjusted for inflation, the Dow never actually set a new record. The period 2000-2007 was a bit like the period following the '66 top. High levels of inflation made it hard to see what was happening. The Dow rose to the '66 level two years later...and never registered deep losses. But year after year, inflation cut the real value of the index...wiping out about 75% of investors' money over the next 15 years. Even before inflation is taken into account, stock market investors made nothing during the last 10 years - not in the US. They ended the decade about where they started it. But this leaves the trend incomplete. Stocks have still not gotten down to super-cheap levels. Look back. The last extreme was on the upside. That means the next one should be on the downside. And it must be extreme - say, Dow below 5,000. Otherwise, the long-cycle prophecy won't be realized. For every extreme high there is an extreme low. Otherwise, nature would be out of balance and Heaven would be unfulfilled. So, until we finally reach an epic low...an epic low still lies ahead. And until that time, the souls of dead value investors and grumpy perma-bears are doomed to walk the earth... They can never relax. They can never sit down and have a beer. They will never be satisfied. Only when the Dow finally sells for 5-8 times earnings will they get to say 'I told you so.' Then, they can take up their eternal rest. It is coming, dear reader; it is coming... And more thoughts... We knew it! Yes, we could tell by the cut of the chin...and by the eyes. You know, that dim look of someone who thinks he knows what he is talking about but who really has no idea. We've been saying for a long time that Ben Bernanke is a Neanderthal. Now, at last, we have proof. Is this not the ancestor of Ben Bernanke? (Below...) And now that we know more about Ben Bernanke's lineage, it is tempting to draw other conclusions as well. Yes, dear reader, why did Neanderthals go extinct? Was it because of climate changes? Competition from other humans? Or, did one of Ben Bernanke's ancestors doom the whole race with his inept Neanderthal central banking? Yes, we now have the genome deciphered. Now we're ready for the rest of the story! Wired Magazine: After years of anticipation, the Neanderthal genome has been sequenced. It's not quite complete, but there's enough for scientists to start comparing it with our own. According to these first comparisons, humans and Neanderthals are practically identical at the protein level. Whatever our differences, they're not in the composition of our building blocks. However, even if the Neanderthal genome won't show scientists what makes humans so special, there's a consolation prize for the rest of us. Most people can likely trace some of their DNA to Neanderthals. "The Neanderthals are not totally extinct. In some of us they live on a little bit," said Max Planck Institute evolutionary geneticist Svante Pääbo. It took four years for Pääbo's team to assemble a working sequence from DNA in the bones of three 38,000-year-old Neanderthal women, found in Croatia's Vindija Cave. The sequence, published May 6 in Science, covers about 60 percent of the entire genome. Though much remains unfinished, researchers were able to compare the Neanderthal genome to the human at 14,000 protein-coding gene segments that differ between humans and chimpanzees. Researchers link these proteins to changes in humans' cognitive development, physiology and metabolism. At all but 88 of those hot spots, Neanderthals were no different than us. The differences are so slight that the researchers suspect them to be functionally irrelevant. If more genomes could be compared, there might be no differences at all. Changes in the biology of humans and our close caveman ancestors may be a result not of simple genetic changes, but of evolution in how humans use our genes, turning them on and off at different times and places. That type of evolution won't be easy to study by looking at a few ancient fossils. "There are a lot of aspects of differences between species that can't be solely obtained from DNA sequence," said University of Michigan genetic anthropologist Noah Rosenberg, who wasn't involved in the study. "But at the same time, the DNA sequence is a good place to start." Such studies will occupy scientists for years to come. In the meantime, the researchers produced a more immediately stirring result. They compared the Neanderthal genome to genomes of five people from China, France, Papua New Guinea, southern Africa and western Africa. Among non-Africans, between one and four percent of all DNA came from Neanderthals. On a functional level, the DNA was no different from our own, but bore telltale molecular marks of Neanderthal heritage. Many studies have posited a Neanderthal-human inbreeding. In 1999, researchers discovered a 25,000-year-old girl with mixed features. Population geneticists have found historical patterns of genetic influx so sudden that breeding with Neanderthals seems the most plausible explanation. But studies like those have not proved conclusive. For people of African descent disappointed that they lack Neanderthal ancestry, Pääbo gave solace. "It's totally possible that inside Africa, there was a contribution from other archaic humans that we don't know about," he said. "We shouldn't take these results as saying that only people outside Africa have caveman biology." [Images: 1. Neanderthal sculpture by John Gurche./ Photographed by Chip Clark, Smithsonian. 2) Neanderthal bone fragments./Max Planck Institute.] 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 at joel@dailyreckoning.com