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The Daily Reckoning | Thursday, July 1, 2010 Dow plunges 10% in Q2 as double dip recession looms large, World Cup Economics: have the "developed" players missed the goal? Plus, Bill Bonner on the uncertain direction of the markets, the zombies in the Gulf coast...and much, much more... Painful Cure for Debt-Ridden Economies A tough but effective way to fix the economic crisis Eric Fry Reporting from Laguna Beach, California... Another day, another dismal performance on Wall Street. The Dow Jones Industrial Average coughed up another 96 points yesterday - increasing its loss for the year's second quarter to a hefty 1,082 points. In percentage terms, the Dow fell 10.0% during the quarter that just ended, which was only slightly better than the S&P 500's 11.9% shellacking. This is not the script the Wall Street seers had bestowed upon us when the year began. Back in February, Goldman's Abby Joseph Cohen (remember her?) predicted that the S&P 500 Index would reach 1,300 by the end of 2010. Here at the halfway mark, the S&P sits at a 9-month low of 1,030. An optimist might observe that the current S&P 500 level contains one "1", one "3" and two "0's - just like Cohen's S&P 500 target price. Nevertheless, these digits would require a re-alignment - and a 26% rally - if Cohen's prophecy is to come to pass. To be fair to Cohen (or at least, less unfair), lots of Wall Street prognosticators were issuing bullish forecasts at the beginning of the year. Thomas Lee, US equity strategist for JPMorgan Chase agreed with Cohen's 1,300 forecast, while the equity strategists from UBS, Deutsche Bank and several other investment firms pegged their forecasts slightly below 1,300. (Pimco's Mohamed El-Erian was one of the lone dissenting voices with a prediction that the S&P would fall in 2010. So far, so bad.) "Why is the stock market falling?" enquiring minds want to know. The answer, in all likelihood, is that the market should not have been rising in the first place. The "Credit Crisis of 2008" is not an archived historical event. It is an unfolding drama that includes the "Credit Crisis of 2009-2010." Maybe the worst is over, maybe it's not. But whatever the case, crisis conditions persist. In fact, this crisis, like a virulent disease, is continuing to manifest itself in various forms and in varying intensities. Even though the "high fever" that placed the US investment banks in ICU has abated, a sovereign credit "rash" has popped up on the other side of the Atlantic. Secondary symptoms include the incessant nausea of mortgage defaults, the septic shock of contracting consumer credit and the vertigo of soaring T-bond prices. These symptoms tell us that we've still got a very sick patient on our hands...and that the recovery will not be easy. This patient suffers from life-threatening exposure to debt. The cure is known, but it is painful. In fact, in the early days, the cure can feel much worse than the disease. The cure often subjects the patient to sovereign defaults, currency devaluations, deep recessions, high unemployment and sharp reductions in standards of living. Eventually, however, the patient feels better...and goes on to live a healthy and productive life. Consider the bizarre contrast between the successful World Cup teams from Central and South America and the unsuccessful teams from the Developed World. "The 2010 World Cup has started to feel more like a macro-economic metaphor than a sporting event," we observed in Monday's edition of The Daily Reckoning. "Of the six G-7 countries to field teams in this year's World Cup - France, Italy, United Kingdom, Japan, Germany and the United States - only Japan and Germany remain. "Meanwhile, all four nations from the core of South America's Mercosur economic zone - Argentina, Brazil, Uruguay and Paraguay - remain in the competition. Indeed, Uruguay has advanced to the quarterfinals for the first time since 1970." As the World Cup has proceeded, the up-and-comers of South America have continued to dominate the has-beens of the Developed World. So, just for kicks, we prepared the chart below, which places the World Cup's results-to-date in an economic context. For starters, the "Round of 16" teams from Central and South America possess much better national finances than the teams from the Developed World. Uruguay, for example, has a lower debt-to-GDP than the US, England or Japan. This "analysis" means nothing, of course. It is the ultimate faux science. That said, your editors were fascinated to discover that the six Central and South American nations that advanced to the "Round of 16" have an average debt-to-GDP that is only half as large as the average debt-to-GDP of the Developed Nations in the Round of 16. What's more, the four teams with the worst national finances failed to advance to the quarterfinals. These results probably indicate nothing important or relevant about the state of the world's finances. But wouldn't it be funny if these results meant something? Wouldn't it be interesting if the 2010 World Cup foreshadowed unfolding economic trends? Don't rule out the possibility. The 2010 World Cup is all about the failure of established powers and the emergence of new challengers. Global investors, are you listening? The Daily Reckoning Presents The End of the Nominal Recovery Eric Janszen Monetary and fiscal stimulus can halt a deflation spiral, but central banks and governments can't print purchasing power. In other words, one year after the official end of the recession, the economy shows no signs of booming. Emergency Keynesian policy measures taken to keep the debt crisis from devolving into a 1930s deflationary spiral show signs of losing effectiveness, and the self reinforcing economic growth story is giving way to talk of a "double dip" recession, as trouble in Europe is expected to slow the US economy by the end of the year. Confidence in the resilience of the recovery is waning. CEO Confidence Survey noted the bottom of the recession and the beginning of recovery. CEO confidence dipped slightly in Q1 2010 for the first time since Q1 2009, to 62 from 64 in Q4 2009 (a reading of more than 50 points reflects more positive than negative responses). The Q2 2010 data are due out the week of July 5. A decline in CEO confidence below 50 points will strongly support leading economic indicators that are pointing to a second recession. The last time the economy struggled under the weight of public debt taken on to stimulate demand after a private-sector credit collapse was during the Great Depression. Is the nation's debt-heavy balance sheet able to finance ongoing stimulus spending without triggering a US debt and currency crisis? The question is once again divided along ideological lines. It's 1937 all over again as Democrats and Republicans battled in the Senate last week over how to pay the $141 billion cost of new legislation that extends unemployment benefits to more than two million who remain unemployed a year after the recession ended. What if a second recession arrives while we're still arguing about what to do about the after-effects of the last one? Even if we dodge a double-dip recession, conditions of the economy and debt markets are the opposite today of 1983, the last time new home and car sales were this slow. Without a tail wind of falling interest rates and low debt levels, for the next 20 years inflation and interest rates will rise as policy seeks to deflate debt against wages and the dollar; real housing prices and wages decline. A year after touring the aftermath of the Housing Bust Recession, many retailers remain closed, windows once whitewashed are now broken, boarded up, and festooned with graffiti. The same condition is true for the financial system that got a whitewash but has yet to receive even a partial renovation. An optimist might conclude that home and car sales are thus only as bad as in 1983, except that the economy was only one quarter the size of today's; this post-recession housing market contraction is proportionally four times worse than the housing downturn that occurred at the end of the early 1980s recessions. The May 2010 collapse in new home sales to 1983 levels occurred despite 30-year mortgage rates at levels not seen since 1971. Today's 4.69% rate on a 30-year mortgage is less than half the 13% rate paid by borrowers the last time new home sales were this weak. In 1983, mortgage rates had only one way to go - down - as disinflation proceeded for decades, although they took a detour to 15% in the two years that followed. The ultra low rates result from the Fed's continued purchases of mortgage-backed securities from banks. With $1.1 trillion of MBS on its balance sheet as of early June, starting from zero in January 2009, the Fed can't find private hands to offload the securities onto and instead uses them as collateral at full market value for new loans, despite the fact that the market value is virtually nothing, as evidenced by the unwillingness of private institutions to buy them. Business Week reported recently: Borrowing costs have tumbled in the past two months as concern that a debt crisis in Europe may spread boosted demand for the safety of bonds including mortgage-backed securities. The lower rates have failed to lift housing demand, which has tumbled since a tax credit for first- time and certain other buyers expired at the end of April. The average price of $5.2 trillion of bonds guaranteed by government- supported Fannie Mae and Freddie Mac or federal agency Ginnie Mae climbed to 106.3 cents on the dollar yesterday, according to Bank of America Merrill Lynch's Mortgage Master Index. That's up from 104.2 cents on March 31, when the Federal Reserve ended its program purchasing $1.25 trillion of the debt. But did the Fed really stop buying MBS? The Fed planned to stop buying MBS at the end of this March, yet Fed MBS balances have increased by $45 billion since March 31. What will happen to the housing market when the Fed finally does begin to lower its MBS balances? Regards, Eric Janszen, for The Daily Reckoning Joel's Note: Eric Janszen is Founder & President of iTulip.com, the online economics and financial markets community that CNBC's Bill Griffeth calls "...the place to go for a contrary view of the markets," and The New York Times credits for accurate forecasts of economic developments. He formerly served as managing director of Osborn Capital, CEO of AutoCell and Bluesocket, and entrepreneur in residence for Trident Capital. Recognized by NPR, The Wall Street Journal, Barron's, USA Today, BBC, Reuters, and international media, Eric is author of upcoming Portfolio Hardcover book, The Post-Catastrophe Economy, and co-author of America's Bubble Economy, from John Wiley & Sons. Bill Bonner Gold and Government Debt: The Only Two Things Going Up Bill Bonner Reckoning from London, England... Let's see...what's in the news today? Stocks went down again yesterday. The Dow got trimmed by 96 points. Gold, on the other hand, went up $3 to $1,245. The first half of the year came to a close with the S&P 500 down 6%, global stocks down 10%, oil down 5%, Chinese stocks down 27%, the euro down 14%. What was up? Gold. Plus 13%. There are two major pieces of unfinished business in the markets. Stocks have still not completed their bear market drop. Gold has not fully realized its bull market either. Typically, markets move from excess to excess, passing sensible prices like a cross-town bus crossing main street. Back and forth, from over- valued to undervalued...and then back again. And passengers tend to get off on the wrong end! Gold was very cheap at $260 in 1998. It will be very expensive sometime in the future. Perhaps at $2,600? Stocks were very expensive when the Dow was at 14,000. Where will they be very cheap? At Dow 6,000? Or Dow 3,000? We don't know. We don't even no for sure what direction the markets are heading. All we know is that we're somewhere between the top and the bottom. And gold seems to be heading up while stocks seem to be heading down. Until they've run their course, only a fool would bet against these trends. And here's another trend we wouldn't bet against. Government debt is going up. In the US, the national debt is now officially at its highest level since WWII. Yesterday, a film crew caught up with us on the banks of the Thames and posed the question: "What's the big deal about debt? The US had as much debt after WWII. The next years were among the best the country ever had..." We sat at a sidewalk eatery near the river, with a camera focused on us. People walked by and stared. They figured we must be somebody. They looked disappointed when they couldn't place us. "The big deal is that we're going broke," we explained. "Until very recently debts of this magnitude were always associated with war. From time to time countries went broke. But they almost always did so because of emergency expenses driven by war. In other words, they were spending money for what looked like a very good reason - self preservation. "For the first time in history, almost all the developed nations of the world are running regular, structural deficits. They're going deeper and deeper into debt, as though there were a war...but there is no war. "We have emergency budgets, but no emergency. You may think that they are fighting the emergency of a recession or the threat of a depression, but you would be wrong. Most of the deficits have little to do with stimulus or bailout efforts. They are just the ordinary results of social welfare programs that have gotten out of control. "For the first time ever, countries are going broke just in the normal course of business. Without an emergency. "The nice thing about WWII is that it came to an end. But there is no victory in the fight against old age. The pension burden won't go down. It will go up. There is no VE day for national health programs. There are no tickertape parades...the troops are never de-mobilized and sent home...and the spending never goes down. "We can never pay off the debt, in other words, because the debt never stops growing. "National leaders at the G-20 conference over the weekend pledged to bring their deficits under control. Some governments are taking this seriously. The government of Britain, under David Cameron, seems to have the right idea. But we are still waiting to see what happens next. "The modern welfare state was only invented about 150 years ago. The Romans tried it and it didn't work out very well. The modern version is still an experiment. "And currently, in America, there are more people getting money from the government than there are people paying taxes. Forty million people get food stamps. Millions more depend on federal tax credits and so forth. Still others have jobs that are either paid directly by the government or by a contractor for the government. "All these people have the right to vote. Which is a shame. Because they are likely to vote for more social welfare spending. Then, governments will go broke. " Yes, dear reader, the welfare state is another piece of unfinished business. So is the dollar-based monetary system. Both of them are approaching the end of the road. And more thoughts... A letter from a dear reader, about a letter to the editor: Last week Bill Bonner wrote, in The Daily Reckoning, a piece about UK pensioners and BP (the oil company whose oil is spilling into the Gulf of Mexico and whose share price in consequence has been shredded.) Bill Bonner based his piece on a letter that he had seen in the British newspaper, The Financial Times. That letter was written by me, Angus Palmer. My point in writing the letter to The Financial Times was to say that pensioners who are shareholders in BP are losing out. I pointed out that the directors of BP had agreed to give Barack Obama a sum of $20 billion to spread amongst the folk in the South of the United States, although there is no legal obligation for BP to do this. I pointed out that this largesse is at my and other pensioner shareholders expense. However I have not been a BP shareholder very long. Another correspondent to The Daily Reckoning [UK edition] is Theo Casey. Theo Casey believes that BP is a good investment and I bought shares in BP only four or five weeks ago partly at the instigation of Theo Casey. I thought Mr. Bonner might appreciate the irony that he took up the cudgels in his column to defend a poor British pensioner stiffed by what he calls "the zombies" when in fact the pensioner in question was partly led astray by The Daily Reckoning, of which I am a keen reader. Bill Bonner reply: Well, BP must have seemed like a good buy at the time...that is, before the rig blew up in the Gulf. BP had its disaster in the worst possible place. The Gulf coast is practically the home of America's tort law zombies - the fastest-moving of the species. Down there, suing big business is not just a profession; it's a lifestyle and a culture. Tort lawyers compete for bragging rights as well as money. They get together in country clubs and tell each other how much money they made. Zombieism is a matter of pride as well as money. Even the worst of them deserve Oscars for their courtroom histrionics. The best go on to buy sports teams. Right now, every one of them within a hundred miles of the coast must be designing a new beach house. *** Last night, we had dinner at our favorite club, with our old friend Lord Rees Mogg and a new member of parliament, his son Jacob. Jacob: "The developed economies are in very deep trouble. In Britain, the new government seems to be doing the right things. But it will be very hard. They're planning to cut an amount equal to about 1.5% of GDP each year for the next 5 years. This has never been done before. These cuts are much greater than those made by Maggie Thatcher. "On the other hand, the emerging economies seem to be very well positioned. They can turn their production towards meeting domestic demand and grow at high rates for decades. The next few years may be difficult. But the long run looks very good for them." *** It may be worth having a look yourself, dear reader. Our old friends Barb Perriello and Karim Rahemtulla are leading a tour to India, which Karim considers "the world's best emerging market." Details available here: E-mail: barb@opptravel.com Web site: http://www.opportunity-travel.com Regards, Bill Bonner, for The Daily Reckoning