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The Daily Reckoning | Wednesday, July 7, 2010 A look at where sneaky bankers hide all those unrecognized losses, The disappearing distinction between "Emerging" and "Developed" markets, Plus, Bill Bonner wonders what's in store next for the savings suckers of the world... Stocks Are investors losing faith in the so-called "recovery"? Eric Fry Reporting from Laguna Beach, California... For the first time in eight trading days, the Dow Jones Industrial Average produced a plus sign - up 57 points to 9,744. The last time the Dow achieved this increasingly rare feat was on June 23, when it gained five points to end the day at 10,298 - 554 points higher than yesterday's close. The Dow's recent grim performance just goes to show that bad things sometimes happen to good stocks. On the other hand, good things sometimes happen to bad stocks. How else would one explain the stock market's dazzling performance between March of 2009 and April of 2010? During that magical 13-month span, the Dow soared 77% from trough to peak. But bad stocks performed even better. Many homebuilding stocks doubled, while many of the shakiest stocks in the shaky financial sector tripled, quadrupled or quintupled! Perhaps these low-quality high-fliers deserved their mark-ups from the panic lows of early 2009. Or maybe they were just bad stocks that happened to be in the right place at the right time - the right place being the US stock market after a panic washout; the right time being the moment in which most investors believed the Federal Reserve had created an economic recovery out of thin air. But perceptions are changing. Both good stocks and bad stocks are in the wrong place at the wrong time. After the recent spate of disappointing economic news, the Fed's magic touch is attracting suspicion and skepticism. Did the Fed really pull a recovery out of thin air? Or did the Fed merely engage in some sort of monetary sleight-of-hand? Whatever the case, investors are feeling duped...and heading for the exits. The stock market is falling...and economically sensitive stocks are leading the way. With the S&P 500 Index down 15% since late April, the ISE Homebuilders Index is down a hefty 36%. Many financial stocks are also down large double digits from their April highs. Therefore, those readers who are taking notes at home may wish to highlight the following observations: 1) US stocks are down a whole bunch. 2) Economically sensitive stocks are down even more, which is not an encouraging sign. But don't put the notepads away just yet. Please note one additional curiosity: Emerging Market stocks are advancing, even while US stocks are falling. This unusual divergence may not mean anything in particular. But it may not mean nothing. Usually, "risky" stocks track one another, at least during periods of high volatility. Amidst the crisis conditions of late 2008, for example, Emerging Market stocks tumbled tick-for-tick with US financial stocks and other risky sectors of the US stock market. But then a funny thing happened; Emerging Market stocks stopped falling. They reached their crisis lows in December, 2008, even though the S&P 500 did not bottom-out until three months later. Emerging Market stocks have been going their own way - more or less - ever since. The Morgan Stanley Emerging Market Index has soared 66% since December 8, 2008. During the identical timeframe, however, the major indices of US financial stocks and US homebuilding stocks have produced losses...despite their spectacular rally in 2009. This substantial 18- month-long divergence between "risky" foreign stocks and "risky" US stocks makes the recent mini-divergence between these two groups all the more intriguing. Once again, Emerging Market stocks are going their own way and ignoring the disappointing trends in the US economy and stock market. The recent divergence - modest as it has been - may not mean anything at all. But a forward-looking investor may be tempted to wonder if it does mean something. Maybe the distinction between "Emerging" and "Developed" is blurring...or becoming completely irrelevant. In other words, which is the true Emerging Market? The North American superpower with: 1) Annual budget deficits above 10%; 2) Debt-to-GDP above 85% and; 3) Zero employment growth during the last 10 years. Or the South American non-superpower with: 1) Annual budget surpluses (or very slight deficits); 2) Debt-to-GDP below 50% and; 3) Rapid employment growth during the last 10 years. Let the reader decide. But before deciding, let the reader learn Portuguese. In a Remote Part of Chile, One Company's Mines Threaten OPEC's Very Existence There, under a dried up lakebed, lies the future of world fuel demand. And it's not oil. In fact, many companies are all but ignoring OPEC as they scramble to lock up supplies of the "wonder-substance" that could replace up to 148 billion barrels of oil. The riches buried here could generate 6 times the money oil will produce - even if oil reaches $200! And one company owns all of these high quality reserves - making it the world's go-to supplier. Estimates show as much as 2,840% gains for early investors. The Daily Reckoning Presents Avoid Banks Stocks Dan Amoss Credit risk always seems to come out of nowhere. But usually it comes out of somewhere...like the dirty, little recesses of a bank's balance sheet - the places where bankers hide all their unrecognized losses. Ever since the suspension of rigorous mark-to-market accounting rules one year ago, banks have gained the ability to "time" their credit losses. This development does not feel like progress. Banks now possess the ability to defer embedded credit losses for a very long time, in the hopes that a "typical" postwar rebound in house prices and employment comes to fruition. But that's not happening. In fact, housing and employment conditions are worsening. As a result, the US banking sector has been piling up an enormous stash of unrecognized credit losses. Banks may be able to play their games of "make-believe" for a while longer, but they cannot get away with completely ignoring their losses, especially when the evidence is overwhelming that these losses are real and irreversible. Going forward, increased foreclosure activity and mortgage losses will become a growing problem for bank stocks. We could soon see a reacceleration of credit provisioning in the banking sector, which might weigh heavily on bank stocks. Mark Hanson of M. Hanson Advisors does great work on the details behind the headline foreclosure and housing price statistics - the kind of granular research that's scarce on Wall Street. Hanson estimates, using data from the Mortgage Bankers Association, that there are 8 million mortgage loans in the "distressed" category, with and estimated 6.4 million headed for liquidation (foreclosure, short sale, or deed-in- lieu). April saw a record 92,500 foreclosures. At that pace, it would take the market over 8 years to work through the estimated foreclosure backlog. This is much too long if the US housing market is going to return to anything resembling a free market over the next decade. So instead of a continuation of slow foreclosure processing, Hanson believes foreclosure activity will accelerate. In a recent missive, Hanson writes: When factoring in April's 92.5k record Foreclosures (not including short sales), the distressed pool shrank by only 63.1k units... At this pace, it will take 101 months to clear the pool of 6.4 million loans headed for liquidation. At a pace of 180k Foreclosures per month, twice April's record high, it will take 42 months to clear the existing distressed inventory. On the bright side, based upon the default and Foreclosure pipe action, which I track in real-time daily in aggregate and on an originator and servicer-specific basis, it seems that over the past few months the banks have regained a mind of their own. Unlike action I tracked as early as January 10 when all the big servicer's [notice of default] through foreclosure charts looked the same, most have diverged. In fact, two of the nation's top four servicers...have opened the flood gates beginning in March. And the GSEs, who led the Foreclosure charge higher beginning in Feb, are in property liquidation mode, which could force all the big GSE servicers to quickly follow suit on their own portfolios - none expected the GSEs to blink first and do not want to get left in the liquidation dust. Perhaps this is the first sign in almost two years of an efficient default and Foreclosure process poking its head out. Time will tell. I've read Hanson's updates for years. You won't find a more thorough, independent (conflict-free) analysis of the foreclosure statistics. It's fairly obvious that the backlog of foreclosures has built up like water behind a dam. The feds are trying to control the amount of water flowing through the dam. But it remains to be seen if they can keep controlling it to the degree that they have. Once the dam gives way, the market may be shocked at how quickly the headline foreclosure numbers accelerate. A saying you often hear in the banking business is: "the first loss is the best loss." (The same saying will eventually apply when banks as a group rush resolve their zombie commercial real estate mortgages). Hanson highlights that Fannie Mae and Freddie Mac have recently accelerated their foreclosure activity. So the big banks, which service most of the GSE mortgages, can't be far behind. If banks become convinced that housing prices will take another dip, they'll look to liquidate their housing inventory ASAP. The likelihood of this development argues for continuation of the "deflation," or risk-averse, trade - basically, short stocks, long Treasuries. Dan Amoss, for The Daily Reckoning Joel's Note: Followers of Dan's Strategic Short Report portfolio have seen their positions double, triple and even quadruple when periodically markets crack up. When the credit crunch took down Lehman Bros., for example, and everyone else was left scratching their heads, Dan's SSR readers scooped up 400%+ on a put option recommendation he had issued months before. If you want to see what he has his eye on now, before the next leg down in the markets, be sure to take a look at his strategy and portfolio positions here. Wait much longer and your opportunity will already be someone else's profit. US Still Spending Despite Global Shift Toward Austerity Bill Bonner Reckoning from Paris, France... In the sushi again...just like we said! The US stock market managed a weak rally yesterday. The Dow rose 56 points. Gold fell, closing the day below $1,200. This morning, stocks are generally going down again all over the world. Why does everything seem to be going down? Because it's a Great Correction, what else? The correction is doing its work. The feds tried to stop it with trillions in loans, guarantees, and 'stimulus' spending. They failed. Over the last three weeks we have had confirmation after confirmation - the recovery ain't happening. Unemployment is getting worse. Prices are falling - even the price of labor. The banks don't lend and the people don't spend. Cities and states are running out of money. Households are going broke. And the stock market looks like it wants to roll over and die. Is that a great correction, or what? Dear readers who are hoping to get rich on gold are probably going to have to wait. We've entered a period of gentle de-leveraging - at least that's what it looks like today. Until we get some real crises - or better yet, some real inflation - gold will probably drift downwards. Not that we're worried about it. Ben Bernanke has added more to the nation's monetary base than all the Fed chairmen that came before him combined - including Alan Greenspan. But don't have any illusions. It can take a long time for this monetary inflation to turn into the kind of inflation that sends the price of gold soaring. And a lot can happen along the way. But for now, businesses are reducing their debt. Households are reducing their debt. Even government is cutting back. Bloomberg: Rich nations will reduce their primary budget deficits, excluding interest payments, by 1.6 percentage points next year, the most since the Organization for Economic Cooperation and Development began keeping records in 1970, according to JPMorgan Chase & Co. economists. The budget squeeze will lop 0.9 percentage point off growth in 2011. Greece is on target to cut its deficit in half. Europe, generally, is making a big effort to trim deficits and keep debt from getting out of control. They've all been rapped on the knuckles. They all know what happens when you let debt get away from you. But people come to think what they need to think when they need to think it. And right now, the US government doesn't need to think that debt is such a bad thing. It can borrow at low rates - almost indefinitely. In fact, US treasury yields are falling...it's getting cheaper and cheaper for the US to bankrupt itself. Which is what makes us think we have entered a period of gentle, pernicious de-leveraging. The rest of the world is saving. What happens to the savings? The savers can thank the USA for taking them off their hands. While the rest of the world saves, the US is still borrowing...helping the world get rid of its surplus savings. In effect, the US government is now playing Japan's role in its long, tired saga of de-leveraging. We guessed that the US would follow Japan into a long, slow, soft slump. Okay...we were 10 years too early! But now, it seems to be happening. In Japan, the government helpfully absorbed household savings for 20 years. This allowed the people to de-leverage while the government kept spending. Now, the US is absorbing much of the world's savings...allowing the rest of the world to put its balance sheets in order, while the US government keeps 'stimulating.' In the end, both programs are absurd. The savings disappear in boondoggles and bailouts. And the stimulus doesn't stimulate anything but more government spending. But it suits the egos of the economists who imagine they are saving the world. An economy can go on like this - softly, gently destroying savings...quietly bankrupting the government - for many, many years. That could be what is coming now. But wait. The US Senate refused to extend unemployment benefits. Even in the US, Republicans are talking about 'austerity.' Paul Krugman is hopping mad, referring to a coalition of the "heartless, the clueless and the confused" that is refusing to go along with his 'spend, spend, spend' agenda. All of a sudden, the Americans seem to be catching the 'austerity' bug, too. Uh oh...this could be a disaster for everyone. If everyone saves, who will use their savings? Who will spend? Who will keep the wheels of commerce turning? Who will keep the lights on in the malls and the grills hot in the restaurants? What will happen if all the grasshoppers suddenly become ants...and all of them go on a rampage of financial prudence? Wouldn't it cause a new economic Dark Age for the whole world? Nah, don't worry about it. In the first place, governments are not reducing their debts. They are just moderating the rate at which they add to them. In the second place, there's plenty of demand coming on line from the emerging economies. And in the third place, the world has too much debt; getting rid of it would be no bad thing - even if it occasioned a difficult period of adjustment. More importantly, the feds are zombies. The fewer resources they take the better off we are. And more thoughts... Isn't China going to power the world economy out of its funk? It's still growing at double-digit rates, isn't it? Well...yes...but... Reuters reports: China's property market is beginning a collapse that will hit the banking system, Harvard University economics Kenneth Rogoff told Bloomberg Television. Property transactions have dropped and prices are stagnating in the wake of steps in recent months by the central government to cool the market. XuShaoshi, minister of land and resources, said at the weekend that he expected prices to start falling within a few months. "You're starting to see that collapse in property and it's going to hit the banking system," Rogoff, a former chief economist at the International Monetary Fund, told the agency. Not everyone agrees. Because home owners must make a downpayment of at least 20 percent and many pay entirely in cash, there is relatively little leverage in the Chinese property market. "Despite the importance of the property sector in the economy, we believe that the deflating of this bubble should have only a limited impact on the real economy and the banking system," Nomura's chief China economist, Sun Mingchun, said in a report. The Chinese-language 21st Century Business Herald newspaper on Tuesday quoted a real estate association official as saying government tightening measures were yielding initial results. But prices in Tier-1 cities such as Beijing and Shanghai had not yet declined, he said, so officials needed to step up implementation of the measures, which include higher down payments, the end of mortgage rate discounts, curbs on purchases of multiple homes and restrictions on lending to developers. And this from Bloomberg... China's auto sales grew at a slower pace in June and a services- industry index slid to a 15-month low, adding to signs that the economy leading the world recovery is cooling. Passenger-car purchases rose 10.9 percent from a year earlier, down from May's 25 percent gain, the China Automotive Technology & Research Center said today. The services-industry measure fell to 55.6 from 56.4, HSBC Holdings Plc and Markit Economics said in an e-mailed statement. Today's data adds to weaker numbers in June for manufacturing indexes and a second measure of the services industry after the government cracked down on property speculation and as the effects of stimulus measures fade. A slowing economy could lead officials to delay returning to pre-crisis policies. "It looks like growth will slow to 8 percent in the fourth quarter of this year with risks on the downside," said Paul Cavey, an economist with Macquarie Securities Ltd. in Hong Kong. "The government will be worried" at that point and may loosen policies, he added. China may turn out to be a drag on the world economy, stay tuned. Regards, Bill Bonner, for The Daily Reckoning -------------------------------------------------------