Melbourne, Australia

• BRIC nations meet to discuss what to do with their glut of U.S. dollars,
• Obama’s administration meet to discuss how to squander their paucity of U.S. dollars,
• Plus some words of warning from Nouriel Roubini and plenty more…

Eric Fry, reporting from Laguna Beach, California…

Yesterday, the Dow Jones Industrial Average recouped 58 of the 300 points it had lost during the prior week. The bounce did not seem particularly lively or convincing, but it did put 58 points on the board nonetheless.

While the stock market was busy trying to recover from its recent mini selloff, your California editor was busy enjoying one of the proudest moments of his parental experience. He was attending the fifth-grade graduation of his son, Ethan.

This event, in and of itself, did not induce any tears of joy, or inspire any overarching sense of parental pride. After all, Ethan is your California editor’s third and youngest child. So your editor has already attended a very large number of silly school ceremonies and corny events. Therefore, he was not among the crush of video-camera-wielding parents, jostling like paparazzi around the matriculating fifth-graders.

Instead, your editor sat quietly in his chair, tranquilly enjoying the moment.

About halfway through the ceremony, the principal gave a little speech. “Every year,” he began, “I try to think of just one word that describes the graduating class. I try to find just one word that captures the unique personality of that class. This year, I struggled because the class has so many different great qualities. Then one day, I was talking to one of the teachers about this and she said to me, ‘You know, this class is just really nice.’

“And so I thought to myself, yes, that’s it, ‘nice.’ This is just a really nice class. The kids are all extremely nice to one another, they have a great time together, and they include everyone in their activities. Let me give you some examples…”

The principal then proceeded to share a couple of anecdotes that illustrated the collective “niceness” of this particular fifth-grade class. After sharing these anecdotes, he offered a third and final illustration…

“But the one event that best illustrates the spirit of this class occurred just a couple of days ago at the fifth-grade pool party. The kids formed a massive Conga line that snaked all around the pool deck, up and down the slide, into the shallow end of the pool and back up onto the deck. Every single kid in the fifth grade was in that Conga line. And the whole thing was led by Ethan Fry…Ethan, please stand up for a round of applause.”

Ethan stood up, pumped his fists in the air and immodestly accepted the applause. His father was very proud. Ethan is not valedictorian. He is not president of the fifth grade class. He is not captain of the soccer team. But he knows how to lead a Conga line.

Ethan is also a talented and passionate artist. Every year, his elementary school conducts a competition. Any student who wishes to do so submits a drawing. Then all the students in the fifth-grade class vote for their favorite drawing. The school places the winning work of art on T-shirts it distributes to every child in the school. This year, Ethan’s drawing won.

As his father reflected upon these fifth-grade highlights – the Conga line and the work of art – he wondered if Ethan might not be better prepared for the America of the future than some of Ethan’s academically accomplished classmates. If America’s economic standing in the world continues to slide, its manufacturing base continues to disappear, its currency’s value continues to erode – while America’s taxation and regulatory burdens continue to mount – the America of the future might begin to resemble the Paraguay of the recent past.

In other words, America might become a kind of banana republic. In such a place, a talented leader of Conga lines might well enjoy a better livelihood than a Harvard MBA.

Please don’t misunderstand us; earning an MBA from Harvard is a great accomplishment. (Earning an MBA from anywhere is a great accomplishment). But the economic value of this achievement is largely dependent upon the context in which it is achieved. Earning an MBA in a failing capitalistic economy is like inventing an iPod in an Amish village. In the absolute, the achievement is commendable, but in context, the achievement is idiotic.

An economy that squelches entrepreneurial activity and impedes capital formation in innumerable ways is an economy that has little use for an MBA. Such an economy would also have little use for talented artists and Conga line leaders. But even in banana republics, the rich minority provides some small bit of demand for artwork and/or infectiously entertaining Conga lines.

I am proud of Ethan…and worried about the path of the U.S. economy.

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Sell Bonds, Buy Energy
By Dan Denning, editor of the Australian Daily Reckoning

When a large holder of U.S. dollars declares that the dollar is in “great shape,” should we believe him? My answer is, “Probably not.”

Russia’s Finance Minister Alexei Kudrin told journalists this week that the U.S. dollar is in “good shape.” He added that, “It’s too early to speak of an alternative [to the U.S. dollar].” These remarks came after Chinese and Russian officials have quite publicly suggested that the world’s financial system would benefit from using a currency that wasn’t being run by a bunch of inflationistas in America.

But the dilemma for the large dollar-holders of the world – Japan, Russia, and China to name a few – is how candidly they should verbalize in public about what everyone knows in private. By blowing the whistle on the Fed’s inflationary monetary policy, dollar-holders penalize themselves. The lesson? There’s a price to pay for rightly pointing out that a huge supply of Treasury bonds threatens the credit rating of the U.S. That price is paid by owners of dollar-denominated assets.

The dollar-supportive remarks by Kudrin, then, should be seen for what they are: a white lie, designed to halt the dollar’s slide…at least temporarily. In the meantime, however, you can bet that these same dollar-holders are working behind the scenes to find alternatives to the greenback and, of course, to diversify their currency reserves into other currencies or tangible assets. It’s just that you don’t want to precipitate a crisis until you’re good and ready to profit from it with a well-planned trade. Goldman Sachs would never make that kind of mistake!

There may be a few escape avenues from the dollar. It comes down to figuring out what-if anything-will go up when the U.S. dollar resumes going down. In fact, the question on everyone’s minds is what U.S. creditors will do with their money if they aren’t lending it to Barack Obama to spend.

“Over time,” says Nouriel Roubini, professor of economics at the Stern School of Business at NYU, “the willingness of the U.S. creditors to finance U.S. spending and buy dollar reserves is going to be reduced. People are getting nervous rightly about us devaluing or inflating our way out of the debt problem and causing real losses on the holdings of those assets.”

If you’re losing money on an asset, naturally you’re going to either sell of it, or at the very least, accumulate less of it. But then what? Where does your money go after that? We’d suggest the investment needs of the emerging market nations are the natural replacement for throwing away money in the U.S. Treasury market. Granted, there’s risk in emerging markets. But it’s now clear there’s risk in the sovereign bond market too. Take your pick.

Speaking of those emerging markets, four of them spoke with one voice in Russia this week. The leaders of Brazil, Russia, India, and China gathered to figure out how to solve their dollar dilemma. Criticize it too much, you lose value on your current dollar-denominated holdings. Do nothing, you lose value on your dollar-denominated holdings as Obama and his Congress spend America into poverty and servitude…and then inflate like mad men.

“There is a strong need for a stable, predictable and more diversified international monetary system,” the final statement from the BRIC nations read. Russia’s Dmitry Medvedev added his own “two roubles,” saying that existing reserve currencies, “have not managed to perform their functions.”

And what is the function of a reserve currency? Well, it’s probably the same as the tripartite function of any money: as a store of value, a unit of account, and a medium of exchange. Countries hold baskets of currencies (yen, Euros, Swiss Francs, U.S. dollars) in order to conduct international trade and commerce.

Of course all this is relatively new. That is, when money used to be a commodity (gold and/or silver) then a country’s monetary reserves were the same as its precious metal reserves. Debtor nations that consumed more than they produced and borrowed to do so paid the price in a net outflow of commodity money. But things don’t work that way in a world where everyone uses fiat money. So what we’re seeing now is a worldwide monetary system that is, well, systemically flawed.

Make of it what you will. What we make of it is that the very foundation of the world’s commerce and the currency in which it’s conducted is shifting. The stock markets of the world have no idea what to make of all this because it is not clear yet who the winners and losers will be.

All that we know is that paper currencies and government debts are proliferating very rapidly. We also know that natural resources are not. In fact, they are depleting very steadily. So we conclude that the prices of most natural resources will go up…a lot. That’s why lots of bears on the U.S. dollar suggest buying gold. We are sympathetic to this idea, but we’d suggest a slightly different strategy: Sell bonds. Buy energy.

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[Rude Endnote: Well, global markets took the ball from Wall Street and ran with it overnight. How far they’ll run before they run out of puff, we can’t be sure, but for now, there seems to be a case of temporary optimism among traders and investors.

Here in Asia, Hong Kong’s Hang Seng and Japan’s Nikkei 225 both added over 0.8% during the week’s final session. The Aussies eeked out a 0.2% gain, but the big story Down Under was the Aussie dollar’s 1.5% rally against the yen. Not-so-curiously, the South African rand also perked up against the wobbly Japanese currency as investors sought higher yields of “commodity backed” currencies.

In Europe, most measures were on the up and up last we checked. London’s FTSE was 1.6% in the green a few minutes ago while Germany’s DAX and France’s CAC were better by 0.2 and 0.9% respectively.

Crude inched over the $72 per barrel mark over in the commodity pits while gold, good ol’ gold, is still hanging in there around $935 an ounce.

That’s it from us for the workaday week. We’ll be back tomorrow with our usual wrap.

Until then…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com

Laguna Beach, California

• Markets soar after banks diagnose themselves financially fit,
• What China is doing with all the dollars U.S. banks don’t have,
• The Dow and gold: where will these two old friends meet again?

Eric Fry, reporting from Laguna Beach, California…

The Dow Jones Industrial Average delivered another spectacular performance yesterday – up 235 points to 8,504. Apparently, the recession is over, and most of the nation’s largest banks are as fit as a fiddle. At least that’s what we’re hearing from the folks who own banks stocks.

So why did we bother with that stupid TARP thing anyway? A lot of the banks now say that didn’t even want TARP funding. The government FORCED them take the money…and then forced the top executives to get by on less than $1 million per year. This whole situation has been so humiliating. Just imagine; being forced to take a $10 billion loan from the government, along with tens of billions of additional low-interest loans and special guarantees. And then imagine the agony of drawing a paltry $1 million paycheck from a company that would have gone bankrupt without the government’s help. It’s been a horrible, horrible experience for all involved.

Therefore, just a few minutes before the close of yesterday’s trading, Goldman Sachs, J.P. Morgan and Morgan Stanley announced that they would apply to re-pay the combined $45 billion of TARP funds that the government forced them to take last October. The incentive to repay this money is no mystery. After returning the TARP funds, these banks may return to their core business of generating plump investment returns for company executives.

“We don’t need this money,” these three large American finance companies insist. And it’s true; they don’t need THIS particular government money, as long as they can continue to receive other sources of subsidy, like the right to issue FDIC-insured debt and the right to borrow directly from the Federal Reserve at rock-bottom rates of interest.

Tell me, which other private enterprises in this vast land of ours enjoy such extraordinary privileges?

If the Goldman Sachses of the world wish to cut their executive-compensation-crimping umbilical to TARP lending, let them also sever every other umbilical to governmental coddling. Let them go it alone…truly alone… just like 99.9% of all other private enterprises in America.

But we’d guess that that’s not going to happen. The big banks will not go it alone. They will continue to nourish themselves at the teat of government-subsidized interest rates and lending programs. To do otherwise, would be to stray from the safety of the litter and to risk dying of exposure.

Out in nature, the infirm perish and the strong survive. But in the U.S. financial system of 2009, the infirm receive preferential treatment. The Government-Mother pushes aside her healthy offspring so that she can try to nourish her financial runts back to health. The annals of biological history do not feature a long list of species that thrived by nurturing their sickest members and abandoning their healthiest…and neither do the annals of capitalism.

Today, Goldman Sachs, J.P. Morgan and Morgan Stanley say they can do without TARP funds. So be it; let them do without TARP funds and without every other form of governmental assistance. And if they should encounter renewed difficulties six or twelve months from now, let them die…please. Spare us taxpayers the misery of rescuing Wall Street’s arrogant, unrepentant elite for a second time.

Our guess here at the Rude Awakening is that the big banks can do without TARP funds like a cistern can do without rain. For awhile, the pre-existing water will suffice. But eventually, this water runs out. If we were to make our metaphor even more accurate, we would note that this particular cistern has lots of holes in it. The balance sheets of the major banks still possess some very leaky assets.

Two weeks ago, at the Value Investing Congress in Pasadena, California, hedge fund manager, Jason Stock, explained why he remains skeptical the U.S. banking sector is on the road to recovery. By way of background, Stock and his partner specialize in BUYING bank stocks. They focus primarily on “small, under-followed bank stocks that the rest of the world just isn’t paying any attention to.” Stock made it very clear that he is much more interested in finding attractive bank stocks to buy than finding flawed bank stocks to sell short.

Stork and his partner are the kinds of guys who travel all over the country meeting with the managers of small banks. They are also the kinds of guy who corroborate the information they receive from the managers of small banks by conducting various boots-on-the-ground analyses. They drive around in the local communities, investigate the condition of the local real estate markets from a variety of angles, and interview real estate agents and trust officers.

“Unfortunately, in our travels,” said Stock, “based on everything we’re seeing, we still have a very bearish outlook. We think the US banking sector is significantly undercapitalized. We think credit quality is deteriorating and it will continue to deteriorate. We think the number of bank failures is still in the early stages and we see a fairly sharp increase [in failures] during 2009 and 2010. We think unemployment will continue to rise. And a big portion of our thesis is commercial real estate. We definitely see a significant amount of losses out on the horizon…”

We’ll be sharing more of Stock’s first-hand observations later this week. For now, sit back and consider what Chris Mayer, a former banker, has to say about the ailing banking sector, and the Chinese response to the deflating value of U.S. dollars…

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What Are the Chinese Buying?
By Chris Mayer

The financial crisis is not over yet. The banks still need capital. And more credit losses are on the way — from commercial real estate to credit cards and everything in between. The Great Deleveraging is still under way, and that’s one reason — among many — that gold should do well.

The ripple effects of the financial crisis have been felt in all sectors, though. In the world of oil and gas, we see lots of production cutbacks and projects shuttered or delayed. Getting financing is tough. About the only people spending money are the Chinese.

One of the interesting bits of news this morning is how Brazil — looking for someone to help finance its massive oil projects — is turning to the China. Today, Brazil’s president, Lula da Silva, will arrive in Beijing to meet with Chinese president Hu Jintao.

The Chinese have lots of money. They sit on mountains of reserves and have been looking for ways to invest that money. So far, they’ve bought gold and put money toward infrastructure projects. They are also buying up natural resources around the globe — everything from rare earths to iron ore.

The Chinese want to seal a deal with Brazil in exchange for guaranteed oil shipments. See, the Chinese are looking out ahead. They know the massive urban migration going on in their borders. They know how much oil they’ll need to fuel their growth.

Brazil’s state-controlled oil company, Petrobras, wants to spend $174 billion over the next five years. That’s one of the largest capital spending plans in the world among the big oil companies. And China is a willing and able source of funds.

China’s government is looking for ways to further its long-term energy security goals. It wants diverse global supplies. It wants its own oil companies to have a foothold and be competitive on oil regions. Already, China has made $45 billion in commitments to Russia, Kazakhstan and several other countries.

By contrast, the U.S. government is too busy trying to figure out ways to hand dying automakers over to the unions. The U.S. government also has two wars to deal with, a massive deficit and a frightening debt load. Furthermore, the biggest states in the Union are in financial crisis. America’s politicians seem to spend most of their time trying to figure out how to fleece citizens and businesses of more cash.

These misguided ambitions and warped priorities are costing the U.S. dearly. “America has a problem,” complains Sergio Gabrielli, CEO of Petrobras, the state-controlled Brazilian oil company. “There isn’t someone in the U.S. government that we can sit down with and have the kinds of discussions we’re having with the Chinese. The U.S. economy cannot easily afford losing access to vast portions of the world’s energy supplies. But that’s a problem for another day.

Over in the agricultural markets, the financial crisis is also making its presence felt. Farmers have delayed or reduced their buying in fertilizers and equipment. Since we are already in a position where grain inventories are low, this is going to put a strain on the grain markets.

There is also a lot of government intervention here. For one thing, the whole biofuel industry probably would not be anywhere near the size it is today without the government support it receives the world over. This means more acreage devoted to producing alternative fuels, crowding out and raising the prices for food crops like wheat.

In general, I think we are in an age in which political risk is high. Increasingly, we’ll have to take into account what governments are doing. Most of them are broke. Most of them seem intent on bailing out banks and other failing businesses in favored industries. So that would mean the printing presses will run amok. That’s good for gold and commodities generally, which ought to preserve their purchasing power, as paper currencies lose theirs.

Joel’s Note: As longtime Rude readers well know, Chris is one of our stalwart contributors. Put simply, we feature his commentary as often as possible. In deference to his paid readership, we can’t always give you Chris’ most specific investment plays but, today, we’d like to offer you something better…

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Did You Notice…? Stocks Versus Gold
By Dan Denning, the Daily Reckoning Australia

The chart below shows the Dow vs. Gold ratio going all the way back to the 19th century.

What you can see is that large credit expansions lead to a high Dow/Gold ratio. The value of stocks relative to gold soars, as all the funny money in the economy translates into new corporate earnings and inflated expectations of future corporate earnings (i.e., much higher P/E ratios).

The disarming thing about this chart is that that the ratio of nine ounces-to-one and the ratio of one-to-one don’t look that different. Oh, but they are! A one-to-one Dow/Gold ratio means Dow 8,000 and gold $8,000, or Dow 6,000 and gold $6,000. It’s also worth thinking about the extremes. Dow 4,000 and gold $4,000 would be a huge move for gold and a crash in the Dow. You could see this happening with another capital crisis in the financial sector.

But it’s also possible that the Fed and other central banks can pursue unorthodox policy measures like purchasing stocks with freshly printed money. This would support stock markets nominally, although in inflation-adjusted terms it would be a bogus number. But psychologically, gold $9,000 might not be as startling if the Dow were at say, 18,000.

Yes, yes. That sounds absurd. But we live in an absurd world. People trade real goods that have tangible value for perfectly worthless pieces of paper. Anything is possible.

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[Rude Endnote: Hooray! Good times are here again! So say the markets, anyway.

Indexes across Europe and Asia rallied overnight after the broad Wall Street opened the week with a tidy 3% gain on the S&P 500. Hong Kong’s Hang Seng rocketed an equal amount by the close of today’s trading while Japan’s Nikkei 225 and the Aussie All Ordinaries managed gains of 2.8 and 2.2% respectively.

Over in Europe, measures were up from the Thames to the Rhine and beyond last we checked. London’s FTSE and France’s CAC 40 were up almost 1.5% each and Germany’s DAX was above 2.4% for the day.

Crude rallied too, bolstered by belief that the worst is behind us. A barrel of the stuff goes for a touch under $60 as we write. And, as investors crawl out of their financial bomb shelters and begin to thirst again for the sweet, sweet scent of risk in the air, gold dipped 1%. You can now grab an ounce for $921.

We’ll be back with more Rude views tomorrow.

Until then…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com

Melbourne, Australia

• Global markets rally…but is the worst really over?
• The difference between a “tradable” rally and a “sustainable” one,
• Brown and Obama vs. BRIC and plenty more…

Eric Fry, checking in from Laguna Beach, California…

What happens when the money runs out? Nothing good. Dan Denning provides the grisly details in the column below. But this isn’t just doom and gloom, folks; it is a thoughtful analysis of probable economic trends. Please read on…

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What Happens When the Money Runs Out?
By Dan Denning, editor of the Australian Daily Reckoning

In the markets, all the really interesting action is happening behind the scenes. On the surface, things appeared to get better last week. In the U.S., Ford told investors that it lost $1.4 billion in the first quarter. Apparently this was less than analysts expected. The Dow closed up 1.48% and climbed back over 8,000.

The S&P 500 is up 28% in the last thirty-three trading days. It hasn’t done anything like that since the 1930s. The S&P 500 surged 54% in just four weeks by early August of 1932. Over the next four weeks it went up another 30%. Then, in April of 1933, the index provided an encore to one four-week surge of 34% with another surge of 19%.

So there you go. What we do we make of all that? Well, it shows you that even in the middle of the Great Depression, the market was capable of staging mammoth rallies that would tempt investors back in. No doubt those were extremely tradable rallies. But they were followed by lower lows once the forces of economic and earnings reality reasserted themselves on the collective mind of the market.

This time will be different because it’s always different. But if you’re wondering if the stock market is flashing a recovery sign for the economy, you might want to take a look at insider selling. The insiders are selling this rally, according to Data by Maryland-based Washington Service. That outfit says the during the S&P’s 28% climb from twelve-year lows on March 9th, CEOs, directors, and senior officers of U.S. corporations sold 8.3 times more stock than they bought.

Not that there won’t be others. But behind the scenes, other things are happening which are going to drag on stocks.

One of those things is that many of the world’s sovereign governments are in the process of going broke. Spain, Ireland, Greece, and Portugal have all had their sovereign credit ratings downgraded by the ratings agencies. These countries face different challenges like burst property bubbles, declining government tax revenues, and banking sectors hobbled by massive bad loans. But what they have in common is that their respective governments have responded to the crisis by ramping up borrowing to credit-rating ruinous levels.

The scale of global borrowing plans is pretty breathtaking. And what you begin to wonder is a simple question: where is all the money going to come from? Or, to quote David Gray in “Nightblindness”, “What we gonna do when the money runs out?” For example, the UK’s Debt Management office, which issues bonds on behalf of the British government, says that British bond sales between now and 2013 will exceed £696 billion. The Guardian reports that it will be more like £815 billion, according to figures from Deutsche Bank.

Do you think private investors are super excited to loan the British government money when the British economy is expected to contract by 3.5% this year? Under the budget revealed last week by Chancellor of the Exchequer Alistair Darling, the UK will borrow £175 billion this year alone, or about 12.5% of British GDP. Over the next five years, public sector debt would rise to 76% of British GDP from its current level of 46%.

Gee. That is a lot of borrowing. Britain is a country drowning in debt. Adding more millstones around its neck would not seem to improve its chances of paying that debt down. You could pay it down by, say, generating national income from exports.

S&P’s ratings agency keeps track of the sovereign debt to income ratio. If a country exports a lot of finished goods or raw materials, the government benefits from tax and royalty revenues. These monies are used to service the sovereign debt.

But if you’re not generating large export revenues, then you find a big gaping hole in your budget where royalty and tax revenue should be. Maybe that’s one reason Britain’s new budget raises tax rates on high- income earnings from 40% to 50%. What you gonna do when the money runs out?

If Britain’s government thinks it can make up for disastrous public finances by raising taxes, it’s probably making another in a long line of stupid mistakes. The high-income earners who would face the big tax increase are exactly the same people getting fired from their jobs in the City. This shows, once again, that building an entire national economy around high finance puts you in all sorts of trouble.

But wait. Maybe the high-saving nations of the world will bridge the gap between British expectations and financial reality. We wouldn’t count on it though. Remember the big hoopla from the G20 meeting in London when it was announced that the International Monetary Fund’s funding would be tripled to $750 billion?

That funding is desperately needed. The IMF itself reckons it will have to dole out some $187 billion in new loans to national governments just to ride out the current phase of the global financial crisis. But a key piece of information was left missing in London. How would the IMF be funded?

The G20 finance ministers met in Washington to sort that out. And the early indications are that the IMF will be funded by issuing bonds sold to high-saving nations. If this is true, it’s a victory for the developing world and a defeat for the U.S. and Europe. The U.S. and Europe were both pushing for a direct cash injection funding method. In other words, they wanted China, Russia, Brazil, and India to use their foreign currency reserves to fund the IMF.

But the BRICs batted that proposal away. So now the IMF plans to sell around $500 billion in bonds. They will be denominated in the quasi-currency the fund uses internally (the special drawing rights, or SDR that both Russia and China have floated as a possible new global reserve currency).

How the bonds actually work still has to be sorted out. But the internal logic of the whole arrangement is now clear: creditors hold the whip hand. Debtors are going to get whipped. The balance of power in the global economy is clearly shifting from the borrowers and spenders towards the savers and producers. Advantage BRICs.

Disadvantage Gordon Brown and Barack Obama. With the existing debt-to-GDP ratios in Britain and the U.K., we reckon it is going to be impossible to fund further expansions of financial bailout programs and welfare state programs without much higher interest rates (borrowing costs).

You can avoid the borrowing problem for a while by soaking the rich with higher taxes. You might also use climate change hysteria to tax carbon (really an indirect tax on consumers). If both happen this year, the result will be even more rapid economic contraction. They will be this Depression’s equivalent of Smoot-Hawley: exactly the wrong thing to do, done at the worst possible time.

Of course the easy out, we feel obliged to point out, is not to borrow the money at all or tax it from your citizens. You could just print it instead. But this tends to unleash hyperinflationary pressures which also tend to destabilize civil society. It’s better to avoid this if you can.

Either way, there is no avoiding the reckoning. Right now, you could make a compelling argument that the value of credit-backed assets is falling so fast that government steps to prop them up simply won’t (or can’t) work. Credit deflation rules the day. The West’s unprecedented fiscal and monetary stimulus measures are disappearing in the maw of asset deflation while the world goes broke trying to prevent it.

If this is right, and it’s something investors take the time to notice, stocks are going to make lower lows again…A lot lower.

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[Rude Endnote: European and Asian markets followed in Wall Street’s footsteps today after the Dow stacked on a healthy 160 points in yesterday’s trading.

Japan’s Nikkei 225 was the best of the bunch here in Asia. The island’s main index rallied almost 4% by the close while Hong Kong’s Hang Seng and the Aussie All Ordinaries also ended up, 3.77 and 2.31% respectively.

Over in Europe, London’s FTSE and France’s CAC were inching towards 2% gains last we checked. Germany was the best of the major indexes there, up 2.34% as of this writing.

In the commodity pits, crude rallied again in overnight trading. A barrel now goes for $51.50. Gold, of course, got slapped around as investors poured into equities on renewed confidence that the worst may be over. An ounce of the precious metal fell almost $10 overnight and trades for $891 per ounce this moment.

Your editor is back in Hong Kong for the next few days, renewing his monthly landing visa for Taipei. We’ll have a hunt around the city tomorrow and let you know our how the economy is coping over the next few days.

Stay tuned…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com

Laguna Beach, California

• Markets bounce back, but how long can they last?
• Merrill and B of A’s “non-disclosable” event…disclosed,
• Those first quarter earnings reports, dismantled, and much more…

Joel Bowman, with a few words from Taipei, Taiwan…

Today’s column as quite a bit longer than your regular Rude, but this editor feels it is also quite a bit better. So, in lieu of an unnecessarily lengthy preamble, we’ll dive right in. Please enjoy this “vintage Fry” essay and shoot your thoughts over to us at the address below…

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The Recovery That Isn’t
By Eric J. Fry

“We do not want a disclosable event.”

Thus spoke former Treasury Secretary Hank Paulson to Bank of America CEO, Ken Lewis, last December. Paulson’s remark came in response to Lewis’ request for a letter from Fed Chairman Ben Bernanke, acknowledging the government’s insistence that Bank of America acquire Merrill Lynch, despite the brokerage firm’s mounting mega-billion-dollar losses.

This one little phrase probably tells you everything you need to know about Henry Paulson, the man who put the “secret” in Secretary. And this one little phrase certainly tells you everything you need to know about the structure and actual objectives of the bailout campaigns Paulson orchestrated.

Specifically, the Paulson bailouts sought to divert hundreds of billions of taxpayer dollars toward Wall Street finance companies, and to do so as secretly as possible. In the name of “systemic risk,” the former Treasury Secretary dispensed hundreds of billions of dollars to the likes of AIG, Citigroup, and his former employer, Goldman Sachs, without ever seeking or receiving a single vote from an elected official. Thus, as it turns out, the only system genuinely at risk during Paulson’s tenure was the American system of honest and transparent financial markets.

The initial bailout facilities were created and implemented by Paulson and Bernanke, two unelected officials. And none of the initial bailout schemes ever faced scrutiny from elected officials, much less a formal vote. Even though some of the subsequent bailout programs, like the TARP, did face a vote in Congress, the Treasury Secretary continued to champion numerous ex-legislative activities, like the backdoor bailout of Goldman Sachs through the $170 billion bailout of AIG, and the shotgun takeover of Merrill Lynch by Bank of America.

According to the February 26th testimony of Bank of America CEO, Ken Lewis, before New York State Attorney General, Andrew Cuomo, Paulson strong-armed Lewis into completing the Merrill takeover, without disclosing to B of A shareholders that Merrill’s losses were much larger than publicly disclosed.

“Lewis testified that he asked Federal Reserve Chairman Ben S. Bernanke to ‘put something in writing’ regarding the US government’s plan to support pack of America’s acquisition in view of Merrill’s mounting losses,” Bloomberg news reported yesterday. “After Bernanke said he would consider the idea, Paulson called Lewis and said, according to Lewis, ‘First, it would be so watered down, it wouldn’t be as strong as what we were going to say to you verbally, and secondly, this would be a disclosable event and we do not want a disclosable event.”

Inconveniently, non-disclosable events are also illegal events. “Paulson kept the Securities and Exchange Commission, which is responsible for making sure companies disclose material information to their investors, in the dark, according to Cuomo,” Bloomberg news continued. “The allegations [by Cuomo] suggest Paulson and other policymakers may have resorted to breaking securities laws in order to protect a fragile financial system…”

Do the ends justify the means? Yes, if you’re a muckety-muck at Merrill Lynch or Goldman Sachs. No, if you’re anybody else. Paulson’s groundbreaking lawbreaking facilitated the survival of institutions that deserved death, in the process amassing trillions of dollars of fresh liabilities for American taxpayers who deserved to be left alone.

The adverse effects of these criminal acts extend far beyond annoying your California editor. For one thing, bailing out incompetent executives enables the incompetent executives to continue their incompetent behavior. For another thing, lavishing hundreds of billions of dollars upon ailing, functionally bankrupt companies, promotes a web of deception and illusion that impedes the healing process that would lead to a bona fide recovery.

If you hand $10 billion to any bankrupt company in America, that company will seem healthy for a while. The truth of the matter is that the Paulson bailouts, along with subsequent multi-trillion initiatives, have injected various finance companies with short-term stimulants that produce an image of health, while leaving the underlying disease untreated.

The resulting fraud is that diseased corporate entities appear to be recovering. They can pretend they are A-OK once again, while the top brass at these companies can pretend they no longer require government assistance – certainly not any of that dreaded TARP money that imposes limits on obscene executive compensation.

Eventually, as a result of all these falsehoods, investors begin to imagine that they actually see what the finance companies’ CEOs pretend to see. And before you know it, you’ve got a great big rally in bank stocks, fueled by nothing more than deception, hype and hope.

Is your California editor being too hard on the Wall Street boys and girls? He thinks not…and neither does his colleague at the Australia Daily Reckoning, Dan Denning:

“So the banks have returned to profitability have they? If that were true, bank balance sheets would also be recovering. But that’s not true.

“The big three banks reporting recently – Citibank, Goldman Sachs, and JP Morgan – all reported huge revenues from their trading desks. As we reported last week, Goldman’s $6.6 billion in trading revenues was not only 70% of total revenues, but it was also a ten billion dollar improvement on a $4 billion loss in the fourth quarter.

“JP Morgan reported nearly $5 billion in revenues from trading fixed-income securities. And Citigroup reported $4.69 billion in fixed-income trading. In fact, all of Citigroup’s other major operating segments reported declining revenues for the quarter. Its global credit card revenues fell by 10%. Consumer banking revenues were down 18%. And Citi’s Global Wealth Management revenues were down 20%.

“But something magical happened in the fixed-income trading group for Citi. If you dig into the quarterly report, you’ll learn that fixed-income trading revenues were boosted by a net $2.5 billion positive CVA on derivative positions, excluding monoclines, mainly due to the widening of Citi’s CDS spread.

“That takes some sorting out. A CVA is a ‘credit value adjustment.’ As you can learn here, it’s the credit risk premium of a derivative contract. Once you sort it out, you learn that Citi ‘made’ $2.5 billion on a derivatives position designed to profit when the companies own credit default swaps spreads widen.

“Or, in plain English, Citi profited because it made a bet that the cost of insuring itself against a default would go up. The credit default swap market is the place where you can bet on the credit worthiness of a firm, or, essentially, the chance that a firm might default on its bonds. Citi appears to have reported a $2.5 billion trading gain in the fourth quarter precisely because the market thought the company stood a good chance of failing (hence the widening CDS spread).

“As far as we can tell, if you use this kind of perverted logic, the closer Citi gets to bankruptcy, the more money it would ‘make’ on its derivatives. That shows you how bogus the quarterly number was. The company reported declining revenues in its core banking and lending activities. But thanks to fixed income and this handy $2.5 billion CVA, the company was able to report $1.5 billion in net income.

“Also, don’t forget that all of the banks benefitted from what financial sector analyst Meredith Whitney called back door financing.” Whitney described what amounts to Fed-sanctioned front-running of the fixed income market by the banks. The Fed publicly telegraphed its intention to buy $750 billion mortgage-backed securities from Fannie Mae and Freddie Mac and $300 billion in U.S. Treasury bonds. And that was AFTER it announced in late November of last year it would be wading in as a buyer for all agency bonds to support the U.S. mortgage market. In other words, the big banks were able to take positions in the exact securities that they knew the Fed would be buying. Huge profits were not guaranteed, just highly likely.

“Since the financial statements of the banks don’t break trading revenues out a line item basis, it’s hard to say how much money each bank may have made by frontrunning the Fed’s actions in the bond market.

“But from the looks of it, what we have here is a kind of back door subsidy to bank profitability provided by the Fed. First quarter earnings were strongly boosted by an increase in the valuations of mortgage-backed securities that went up with Fed buying. Before you get all excited about the recovery in financial stocks, you may want to keep that in mind.”

And let’s also bear in mind, dear investor, that the AIG bailout may have contributed mightily to Wall Street’s enormous trading profits in the first quarter. According to a widely circulated theory to which we alluded in the March 19, 2009 edition of the Rude Awakening, Paulson bailed out AIG so that AIG could bail out Goldman Sachs and other ailing Wall Street firms.

Whether directly or indirectly, intentionally or unintentionally, the federal government enabled the big Wall Street banks to produce billion-dollar profits in the first quarter. Certainly, the federal government will attempt to repeat the performance in the second quarter. But we suspect the jig is up. We suspect the trading profits of the first quarter were one-off events that will not become two-off events.

As a result, we suspect that finance company earnings will resume their downward trajectory throughout the rest of the year, as adverse real-world trends swamp government-subsidized trading profits.

The truth is that banking profitability is not actually recovering, and neither is the economy. And that means that every stock market rally rests on shaky ground. The nearby chart tells the tale…or at least most of the tale.

Foreclosures have become nearly as numerous as home sales. Unless and until the two lines on the chart above begin to diverge, rather than converge, a recovery in the finance sector will remain a deception, a recovery in the economy will remain a false hope and a recovery in the stock market will remain a dangerous illusion.

And one final thought: Would America be any worse off if Paulson had simply told the truth?

- Agora Financial’s Master FX Options Trader -

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—————————————–

[Rude Endnote: European markets are following Wall Street’s lead thus far today after the major indexes in the U.S. posted modest gains yesterday. The Dow and S&P 500 both rose almost one per cent while the Nasdaq managed a 0.37% gain.

Last we checked, London’s FTSE was higher by 2.1% while measures in France and Germany had gained 1.99% and 1.89% respectively. Asian markets had a tougher time today. Japan’s Nikkei 225 and the Aussie All Ordinaries both ended lower and Hong Kong’s Hang Seng managed a mild, 0.27% gain.

Over in commodities, a barrel of the world’s goo is back up over $50. Our favorite yellow metal is on the move too and fast closing in on $910 per ounce.

We’ll be back with the usual weekend wrap tomorrow.

Until then…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com

Laguna Beach, California

• Dow dips again – where to from here?
• China dumps Treasuries, snaps up commodities,
• On the road to a $10 TRILION deficit and more…

Eric Fry, reporting from Laguna Beach, California…

We are fast approaching the “What now?” phase of the bear market rally that began on March 9th. On the plus side, the Dow Jones Industrial Average has soared 1,400 points from its low on March 6th. On the minus side, the Dow has slipped more than 300 points since last Friday.

So the acrophobic investor has every reason to wonder if the stock market is advancing on the granite steps of legitimate fundamental underpinnings, or if it is “pulling a Wile E. Coyote” – standing on nothing but air, moments before becoming small plume of dust on the canyon floor below.

Regular readers of this column will not be surprised to learn that your editors’ grant higher odds to the “Wile E. Coyote scenario” than to the “fundamental underpinnings scenario”…and our reasoning is simple: there are no fundamental underpinnings.

The economy continues to contract at a rapid pace, while signs of credit distress continue to accelerate in every visible corner of the credit markets. These virulent trends act like the two sides of a vice – squeezing the life out of investment capital and discretionary spending alike. Thus, the sustainable corporate profits that would justify rising share prices simply do not exist.

Lack of fundamental justification is not automatically a death sentence for a stock market rally. The stock market often relies upon the triumph of hope over substance. Furthermore, the Fed is furiously pumping liquidity into the economy through various finance-sector intermediaries. This liquidity is finding its way into the stock market. So even though this contrived liquidity is not a “fundamental underpinning” in the same way that rising corporate earnings would be, it is nevertheless a potent real-world influence that can overwhelm negative fundamental trends for some period of time.

But after the stimulative effects of Fed policy wear off, and the delusional effects of hope dissipate, investors will find themselves shackled to fundamental underpinnings, for better or worse. And at the moment, those underpinnings are decidedly worse… and getting worser.

Yesterday, a Bloomberg News headline proclaimed, “U.S. Home Prices Unexpectedly Gain for Second Straight Month.” Shortly thereafter, an offsetting headline appeared, “California Home Mortgage Defaults Climb 19% to Record.”

Which headline should we trust? The one that offers hope of recovery or the one that delivers proof of disaster? We are inclined to trust proof over hope – not just because proof is proof and hope is hope, but because the proof is overwhelming.

Consider this fact: 1.18 million existing homes changed hands during the first three months of this year. 803,000 homes received a foreclosure notice during the same time frame. In other words two thirds as many homes went into foreclosure as went into escrow. If you add in the households that were more than 60 days delinquent, you wind up with about 2 million delinquent or foreclosed households. These numbers do not add up to a recovering housing market, no matter how you do the math.

The Fed sees the same numbers that we see. It sees the same crisis that we see. Which is why the Fed is pumping liquidity into the economy in every imaginable – and unimaginable – way. The hope is that this effort will stave off a more severe crisis than that which already exists. But the likelihood is that the Fed will ignite the greatest inflationary trend since the 1970s.

According to Dan Denning, our colleague down in Australia, the Chinese are already preparing for the likelihood that inflation will erode the dollar’s value. Maybe we should be doing likewise…

- Agora Financial’s Master FX Options Trader -

Currency Trading Breakthrough: At Last, the World’s Most Liquid, Recession-Proof Market is Open To You…

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23.4% in 48 hours
33.24% in 7 days

_________________________________

Average = 52%
Average holding time = just 3 days

If you want fast, recession-proof gains like these, I must hear from you today.

———————————–

Sell Bonds, Buy Copper
By Dan Denning, editor of the Australian Daily Reckoning

Why are the Chinese selling Treasury bonds and buying commodities? Is it because they are afraid to increase their holdings of U.S. dollars? Let’s examine the evidence…

A smattering of articles in recent weeks has highlighted the stockpiling of metals by the China State Reserves Bureau. The Bureau scarfed up 329,000 tonnes of copper in February and 375,000 tonnes in March. This buying has partly fuelled copper’s 47% rise year-to-date and its 70% rise since December of 2008.

Couple this with additional stockpiling of metals like aluminium, nickel, zinc, and tin, and you could make a case that China is trying to back its currency with metal. After all, that would be consistent with the call in March by People’s Bank of China Governor Zhou Xiaochuan for a global reserve currency that was not the U.S. dollar. Also, a currency backed by a basket of commodities would certainly have more tangible value than a currency backed by a basket case of basket case currencies (yen, dollar, euro, Yuan).

But the story is probably simpler that a great global currency end game. Copper prices fell by 70% from their July 2008 high to their December lows. So trading depreciating U.S. dollars for copper at rock-bottom prices is probably a great trade. It’s especially great for a nation that plans to ramp up its electricity generation. (See the April 16, 2009 edition of the Rude Awakening, “An Electrifying Investment”)

So is China laying the foundation for a commodity currency backed by stockpiled metals and minerals? Probably not. It’s just stockpiling minerals and metals while prices are low. And to the extent that the move has anything to do with a currency, it’s not China’s currency. It’s the U.S. dollar.

The Chinese economic planners realize they have made themselves strategically vulnerable to dollar devaluation by owning so much long-term U.S. Treasury debt. The U.S. government is loading up on debt. It intends to pay it back with printed money. This classic devaluation punishes long-term bond holders whose principal is thrashed by inflation.

Besides, since Chinese companies (State-owned and otherwise) keep getting rebuffed trying to take equity stakes in foreign resource producers, it’s better to take the Jim Rogers approach and just by the stuff directly and not bother with Wayne Swan and FIRB.

Chinese stockpiling of metals has lead to a seven percent rise in aluminum prices in the last month and a nearly twenty percent gain in much maligned zinc prices.

This situation isn’t exactly the same as the across-the-board rally in all asset classes that began in 2003 after Alan Greenspan cut U.S. short-term rates to 1% and left them there for awhile. But it is absolutely the same in one particular aspect: U.S. monetary and fiscal policy is fuelling inflation in certain asset classes, and probably not the asset classed policy makers intended.

In this case, the Fed’s quantitative easing policy is designed to drive-down borrowing costs and free up credit. What’s happening, though, is that U.S. creditors are abandoning the long-end of the yield curve of the bond market and flooding the short-end. Fewer creditors want to lend the U.S. government money for 30-years. More are willing to do it for 90 days, even if yields are low, just for the sake of having a liquid, near-cash investment in a still dodgy financial landscape.

You can see this vividly by looking at yields on 90-day T-Bills and 30-year Treasury bonds. They are heading in opposite directions. Bloomberg reports that China bought $5.6 billion in bills in February and sold $964 million in longer-term notes. Its preferences are clearly changing. You’d expect the 90-day T-bill to again approach zero, and 30-year yields to rise. And in fact, that’s exactly what’s happening.

This chart is bad news for Uncle Sam. For the U.S., the shift in borrowing to shorter-term notes and bills makes future borrowing needs extremely interest-rate sensitive. Ever try rolling over a $1 trillion in debt when interest rates have doubled? And remember, future borrowing needs are massive, with the Congressional Budget Office predicting a deficit of $1.4 trillion next year and nearly $10 trillion by 2019.

If creditors aren’t willing to fund U.S. deficits, then the Fed will. And that means printing money. This has two effects. One, it drives up interest rates on longer-term bonds even more (making long-term financing expensive) and it accelerates the flight out of U.S. debt into tangible assets.

Either way, funding U.S. deficits with borrowing – whether its long- or short-term – is the prelude to dollar devaluation. The only way that money gets paid back is through money printing. There is a remote possibility that new taxes could cover the interest expense on U.S. debt.

The Congressional Budget Office projects the 2009 Obama budget will produce a deficit 13.1% of U.S. GDP. Even under an optimistic scenario, the ratio only declines to 9.6% by 2010. The trouble with deficits is that they become part of the public debt. And the public debt as a percentage of GDP is already at 74% in the U.S. and climbing.

Granted, it’s been much higher in other countries (like Japan) and not led to a collapse deficit financing. But each country’s case is particular. And what we’d say here is that the long road to national debtor status begins with running annual deficits out of “necessity.” The real trouble with short-term deficits is that they add up, year after year, into long term debts.

Americans keep getting told that government stimulus is the way to soften the effects of recession until the recovery takes hold (an event which keeps getting further and further away on the horizon). But this is a lie. The stimulus doesn’t solve any of the problems that face the economy. It just keeps people busy and distracted for awhile, while annual deficits and a rising debt (which must be financed by foreigners) become a fact of life.

The only upside to continued world-wide government ham-fistedness is that the monetary and fiscal insanity heightens the appeal of real assets. That’s why we resume our search for smashed-down base metals stocks that have exposure to commodity price gains by way of proven reserves of various base and precious metals. It’s the best trade of the year so far…and might be the best trade of the decade. Just ask the Chinese.

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[Rude Endnote: Europe mostly followed the U.S. markets into the red overnight while Asian indexes made slight gains.

Hong Kong’s measure, the Hang Seng, had advanced 2.08% about an hour before the close here while Japan’s Nikkei 225 was up 1.37%. Even the Aussie All Ordinaries managed a 2.04% gain at their close.

Over in Europe, however, trader’s screens were awash in red. London’s FTSE was down 0.44% while measures in Germany and France were off almost one percent each.

Nothing much going on in the oil patch. A barrel of crude hovers around the $48 mark. Gold, meanwhile, inched it’s way closer to $900. Each ounce under your mattress will fetch you around $894 as of this writing.

We’ll return tomorrow morning with more thoughtful scribbles.

Until then…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com

· Why oil at $40 just won’t (and can’t) last,
· Commodities gear up for Bull Market, Version 2.0,
· Merrill’s dishonorable mention and plenty more…

Eric Fry, lobbing hand grenades from Laguna Beach, California…

It’s companies like Merrill Lynch that make companies like Merrill Lynch look bad. The “Thundering Herd” may have established a new high-water mark for Wall Street chutzpah and greed.

Wall Street’s extreme greed and perverse sense of entitlement are nothing new, of course. But even so, Merrill’s recent behavior merits a dishonorable mention. In early December, Merrill’s Compensation Committee, at the behest of then-CEO John Thain, dispensed about $4 billion in bonuses to top management. Did these bonuses represent a just and reasonable reward for a job well done? Or gang rape?

Let the reader decide. But before deciding, let the reader ask himself, “If no rape occurred, why do Merrill shareholders and U.S. taxpayers feel so violated?”

Here are a few of the pertinent details, courtesy of the Financial Times:

“Merrill and BofA shareholders…voted on December 5 [to approve BofA's takeover of Merrill]. Three days later, Merrill’s compensation committee approved the bonuses, which were paid on December 29. In past years, Merrill had paid bonuses later – usually late January or early February, according to company officials.

“Within days of the compensation committee meeting, BofA officials said they became aware that Merrill’s fourth-quarter losses would be greater than expected and began talks with the US Treasury on securing additional Tarp money.

“Last week, BofA said it would be receiving $20bn in Tarp money, in addition to the $25bn that had been earmarked for it and Merrill last year. It was then revealed that Merrill had suffered a $21.5bn operating loss in the fourth quarter.”

Did you follow all that? Merrill’s compensation committee doled out $4 billion in bonuses just days before Merrill’s management went hat-in-hand to Washington to beg for $20 billion. And why did they go begging for more taxpayer dollars? Because about the time the Merrill execs were cashing their bonus checks, they “discovered” that the firm’s fourth quarter would produce an “unexpected” loss of $21 billion.

Here’s my question: If the $21 billion loss was such a shock to the top executives at Merrill Lynch, why did these folks receive any bonuses at all. Any finance company executive who could have been shocked by a large loss in the fourth quarter should be tending sheep for a living, or issuing driver’s licenses, because that executive knows absolutely nothing about the financial markets here on planet earth.

So who ordered these large, premature bonuses at Merrill, you may be asking? The man himself, John Thain. Remember, this is the guy who cashed a $15 million check one year ago, just for agreeing to come over and redecorate the corner office while Merrill completed its death spiral.

Thain spent about $1.2 million to adorn his office with ostentatious baubles of one sort or another. His preposterous purchases included an $87,000 area rug, a $68,000 “19th century credenza” and a $35,000 “commode on legs.” $35,000 seems like a lot of money for a “commode on legs”…until you consider that Merrill paid $15 million for Thain.

Fortunately, Thain’s abuse of power ended abruptly yesterday, as BofA CEO, Ken Lewis pushed him out the door. But let’s weep not for Thain. He rides off into the sunset on a pony we taxpayers purchased for him, and carries saddlebags brimming with our gold.

Unfortunately, there is no posse in pursuit! Where are the white hats when we need ‘em? Where are the hangin’ judges? Is Thain’s behavior so different from Bernie Madoff’s, the man who orchestrated a massive hedge fund fraud?

Madoff tried to dispense $300 million to friends, immediately before his arrest. Thain successfully dispensed more than $3 billion dollars to friends, immediately before asking the government for $20 billion more. Which one of these frauds is more criminal?

For as long as America’s hanging judges let the horse thieves to ride out of town, the American financial markets will remain a perilous destination for investment capital. Without true law and order, the financial markets will merely consume capital, not multiply it.

As long as CEOs may engage in legal acts of corruption and fraud, a mattress will provide better returns than the stock market. Therefore, the cautious investor will want to invest even more cautiously than usual…And he will want to be as certain as possible that he is investing alongside an honorable management team.

Of course, the cautious investor might also consider the sorts of investments that CEOs cannot destroy. Commodities come to mind.

Crude oil, wheat and gold do not care how many commodes John Thain buys with taxpayer money, or how many billions of dollars worth of unwarranted bonuses he doles out to fellow insiders. The commodity markets only care about supply and demand…and that’s about all.

For the moment, commodity demand is slowing and commodity prices are plummeting. But past performance is not necessarily indicative of future returns. On a 3- to 5-year view, commodities seem severely undervalued.

Consider the following data point: During the last six months the BKX Index of Bank Stocks has fallen 41%. Hardly a surprise. But over the same time frame, the CRB Index of commodity prices had dropped more than 50% and the Goldman Sachs Commodity Index has plummeted 65%.

Maybe commodities deserve a second look. Dan Denning offers a specific suggestion below…

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Oil is Too Darn Cheap
By Dan Denning, Editor of the Australian Daily Reckoning

Prices communicate information…unless they’re communicating disinformation. Crude oil has plummeted more than $100 a barrel since the middle of last year, and now costs about what it did five years ago.

This price trend certainly contains some information – like the fact that demand for crude oil has been falling. But this price trend might also contain some disinformation – like the notion that the falling oil price is destined to continue falling.

Crude oil may not yet have found the bottom of its bear market, but we suspect the bottom is very near.

After all, the current depressed oil price results from two factors. First, the ongoing de-leveraging by speculative participants in the oil market has removed billions of dollars of “buying power” from the marketplace. As these participants have de-levered, they have sold oil into a marketplace that is fairly well supplied at the moment (so much so that OPEC is cutting production). Second, oil demand will be flat or slightly fall this year because of the worldwide financial slowdown.

Adequate supply plus stagnant demand plus speculative de-leveraging equals $42 oil. So why is the December 2010 oil contract trading nearly 40% higher at $59.57? What could possibly happen between now and December 2010 that would cause oil to go up 40%?

Well, for one thing you might be in the early stages of an economic recovery by then. Demand would have recovered. Shares could be higher. Everything could be fine.

But we can think of at least three reasons why the current oil price is headed much higher this year (not in 2010). First, the lower oil price is actually going to lead to lower oil production later this year and next. Oil production is declining to begin with. But the crash in prices has put the kibosh on exploration and production.

Second, as my colleague, Dan Amoss, noted one year ago in this column (A Sexy Import), the clear trend within the oil market is that traditional oil exporters are exporting less oil. There are several reasons for this.

One is that oil exporters are hoarding it now and waiting for higher prices later. Another is that oil exporters are consuming more of their own production, leaving less for export. And still a third reason is that the world’s largest oil exporters face declining production trends thanks to…you guessed it…Peak Oil.

Yes. Peak Oil has not gone away. It’s been sent to the corner while the Credit Depression hogs the stage. But Goldman Sachs oil analyst Jeffrey Currie issued a report yesterday predicting a, “swift and violent rise” in oil prices in the second half of 2009.

Currie told a conference in London that, “”Thirty dollar oil reflects the same imbalances that got us to $147 oil. The problems haven’t gone away. We still believe the day of reckoning is to come.” What problems?

There are still major infrastructure bottlenecks in the global oil supply chain. Currie says that despite the big fall off in demand, “This is not 1982-1983 all over again. The supply picture is radically different…the demand picture is radically different. The key difference is that today there are no large-scale next-generation projects that are going to save the world. Commodity demand is exponentially higher than it was.”

This brings us to the third reason oil prices should rise later this year: a new kind of speculator is entering the oil market. Bloomberg reports that, “Morgan Stanley hired a super tanker to store crude oil in the Gulf of Mexico, joining Citigroup Inc. and Royal Dutch Shell Plc in trying to profit from higher prices later in the year, two shipbrokers said.”

Dan Amoss calls this the oil-arbitrage trade, where supply is stockpiled offshore, and thus withheld from refiners, allowing existing gasoline inventories to be worked down. Then in six to twelve months time, when crude prices have moved higher, you simply park your ship at the terminal and cash in on the difference between what you paid six months ago (today) and the new market price.

It is normal for the oil futures to be in contango, where spot prices are lower than futures prices. What’s less normal is the amount of oil being stockpiled offshore.

“Frontline Ltd., the world’s biggest owner of supertankers, said Jan. 14 about 80 million barrels of crude oil are being stored in tankers, the most in 20 years,” Bloomberg adds.

We also suspect that oil as an inflation hedge will come back into vogue later this year, which might be adding to the appeal of buying today at bargain basement prices. What’s more, you can never discount (although you can never fully quantify) the geopolitical aspect of oil prices. A good general rule of thumb is the more war there is in the Middle East, the more likely oil is to go higher.

So what should you do? Resume investing in oil and oil stocks. Crude oil is simply too cheap…and that’s no lie.

— Bulletin Board Elite – Positions Now Open —

The first time, I called it beginner’s luck…

When it happened again, I called it a coincidence…

But after 9 stocks in a “secret” market one ace analyst was screening JUMPED to major exchanges – and major profits – in just a 12-month span, I knew he was hunting in the right place for huge gains.

In just the first six months of 2007, the AVERAGE top-tier stock in this all-but-unknown universe of securities gained 25,498%! Just $100 invested in the best of these on New Year’s Day would’ve handed lucky shareholders gains of $409,900 before the Fourth of July…

Starting RIGHT NOW, I’m offering those who respond to this dispatch a chance to turn even a small investment into a small fortune on this ace analyst’s best picks in this overlooked market

But you must act quickly: Only a few spots remain in this revolutionary services ranks. Full Details Here

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[Rude Endnote: Taking their cue from the imploding U.K. markets and the continued selloff in the U.S. markets across Asia and Europe splashed red across investors screens today.

The Aussies were the worst hit in this neck of the woods with the All Ordinaries Index slumping a massive 3.83% to close at just over 3,300 points. Japan’s Nikkei 225 came in a close second, falling 3.81%, while the Hang Seng dipped a relatively mild 0.63%.

Over in Europe, London’s FTSE had slipped another 1.38% while France’s CAC and Germany’s DAX were down 2.02% and 2.34% respectively as we write to you this morning.

For it’s part, oil maintains it’s price around $42 while an ounce of that gold you’ve got under your mattress just gained $13 overnight and now goes for $869.

That’s all for the Rude work week. Please join us again tomorrow for your weekly wrap-up.
Until then…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com

· When inducing losses leads to massive bonuses,
· The $32 trillion year of losses and what it means going forward,
· A look back at when the credit crisis might have seemed over and more…

Eric Fry, trying to find out who’s naughty or nice, reports…

A lot has changed since the column below first appeared in the Rude Awakening nearly one year ago. For one thing, investors around the globe have lost about $32 trillion of stock market wealth…And $32 trillion doesn’t disappear without a few tears along the way.

As this staggering sum of paper wealth vanished, so did the optimism, bravado, lunacy and leverage that powered the “Bubble Years.” Remorse is the emotion that now resonates with most investors. Risk-aversion is the impulse that guides them.

Investors have become so terrified of losing money, that they couldn’t care less about making it. Which brings us to another of the things that has changed since last year: Treasury bond yields have plummeted to multi-decade lows.

As investor-refugees flee from the bombed-out myth of “buy and hold,” they seek the sanctuary of Government-guaranteed securities like T-bonds. During the last couple of months, a crush of safety-obsessed investors has stampeded into the market for Treasury bonds. Thus, for the first time in many decades, Treasury bonds yield less than stocks. The 10-year Treasury yields a near-invisible 2.17%, compared to a 3.63% dividend yield on the Dow Jones Industrial Average.

One year ago, the numbers were almost exactly opposite; the Dow yielded 2.26% and the 10-year Treasury yielded 4.02%.

So what else has happened since the column below first appeared?

You name it!

The Federal Reserve and Treasury Department tossed out their “rule books” in order to implement a variety of improvisational, ad hoc, policy responses to whatever crisis attracted the nation’s attention on any given day. Without so much as a polite nod toward fiscal responsibility, the stewards of America’s national treasury have directed trillions of tax-payer dollars toward of ill-defined bailout schemes and guarantees.

In other words, nothing is as it was one year ago…Well, almost nothing.

One thing hasn’t changed much at all: Wall Street’s perverse sense of entitlement. The architects of the greatest financial crisis since the Great Depression continue to receive multi-million-dollar paychecks and bonuses, even after their companies borrowed billions of dollars from the U.S. Treasury.

That’s right, the same folks who produced hundreds of billions of dollars of losses for their shareholders, and who then borrowed hundreds of billions of dollars from taxpayers to offset those losses, are still receiving great, big boom-era paychecks. And some finance company CEOs are still flying private jets, as if they deserved it.

A nifty new study by the Associated Press points out, “The 116 banks that so far have received taxpayer dollars to boost them through the economic crisis gave their top tier of executives nearly $1.6 billion in salaries, bonuses and other benefits in 2007.”

For example, the AP notes, “Lloyd Blankfein, president and chief executive of Goldman Sachs, took home nearly $54 million in compensation last year. The company’s top five executives received a total of $242 million.”

We ordinary folks would not begrudge the rich their riches, were it not for the fact that the rich borrowed their riches from us. Goldman received $10 billion of taxpayer money on October 28.

But so it goes…just like it went one year ago, when our colleague at the Australian Daily Reckoning, Dan Denning, noted, “Let’s not blame the rogue traders or the hedge funds for the mess we’re in, dear investor. Let’s blame the rogue capitalists – the people who’ve turned financial companies into vehicles for funneling shareholder capital directly into their own pockets.”

Dan’s column appeared on January 29, 2008, back when the Dow was trading around 12,500 and almost everyone wondered when it would make new all-time highs. To continue this stroll down memory lane, read on…

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Dan Denning, spiritual leader of the Rude Awakening brain trust, reports from Melbourne, Australia…

Hey, did you see that 31-year old Societe General trader Jerome Kerviel lost his French bank $8 billion on stock futures trades gone wrong? Wall Street likes to call these incidents “rogue trading,” as if it perpetrated by renegade madmen, pursing their own nefarious agendas.

Please…The real rogues are in the corner offices.

What about rogue CEO Stan O’Neal who made a market call on subprime mortgages and cost his shareholders billions of dollars in equity and losses? Kerviel didn’t even personally profit from his trades, according to wire service reports. He was either a bad trader, or one who thought he knew how to make the bank some extra money. “Better to ask forgiveness than permission,” goes the old saying. If he had been right, he would probably have been given a raise and several billion euros of the bank’s money to play with.

By contrast, guys like Stan O’Neal and Chuck Prince at Citigroup made strategic decisions to immerse their company’s balance sheets in risky financial products at the height of a credit bubble. They shifted operational focus, dedicated company resources, and committed their companies’ non-risk capital to extreme risk. Oops! O’Neal and Prince lost their big bets. But they hardly walked away as losers. O’Neal cashed about US$161 million worth of severance checks after leading Merrill Lynch to its largest loss in the firm’s 93-year history. Prince received a $40 million farewell package from Citigroup. Kerviel will likely receive a jail sentence. Something is very wrong here.

Let’s not blame the rogue traders or the hedge funds for the mess we’re in, dear investor. Let’s blame the rogue capitalists – the people who’ve turned financial companies into vehicles for funneling shareholder capital directly into their own pockets. These titans of the banking world were supposed to be the men and women that made Britain and America the best “allocators of capital” in the world.

Little did we know that these folks would excel at allocating your capital into their pockets…and would put the entire Western financial system at risk in the process.

— When Fear = Profit: A Special Volatility Report —

Bailouts…Deleverging…Government Shenanigans…Unprecedented Volatility…

Put simply, the markets are bucking and kicking like we’ve never seen before .

With such unpredictability, it is difficult to know where to invest, if at all.

There is, however, one man who has been relishing the recent whipsawing market conditions. Steve Sarnoff has been on an absolute tear lately. His last five picks have all more than doubled… and are sitting at cumulative highs of 1,222%.

Take a different approach and learn how to make fear in the markets work FOR you with Steve’s Options Hotline Service Right Here

—————————————–

The Credit Crisis Lives
By Dan Denning

Is the credit crisis over?

Our colleague, Steve Sjuggerud, says part of the crisis is over, at least. What makes him so sure? He points out that the interest rate banks charge each other for overnight loans has gone down, and even briefly dipped under the Fed funds target rate. (This overnight rate is called the LIBOR rate). In other words, the Western world’s major banks are not scrambling for cash as desperately as they were a few weeks ago.

Banks in Europe and America have taken substantial losses both in their proprietary trading departments and in their loan portfolios. They’ve had to go hat-in-hand to creditors (mostly Sovereign Wealth Funds) in the Middle East and Far East to recapitalize their balance sheets. So in the short term, Steve is probably right that there is plenty of liquidity in the financial sector.

The falling LIBOR rates also suggest that the big banks are not as suspicious of one another as they were a few weeks ago. Underlying the rise in inter-bank lending rates last year was a deep suspicion among the lending banks that the borrowing banks were sitting on tens of billions in unrealized losses on over-valued assets. Most of those assets, of course, were bundles of questionable mortgages and mortgage derivatives.

But big banks have been taking their medicine by realizing losses on mortgage-related assets. Merrill Lynch lost $9.8 billion, Morgan Stanley lost $7.8 billion, UBS lost $14 billion, and Citigroup famously lost $20 billion and was forced to issue bonds with junk-like yields to attract more capital from the Middle East.

So here’s the question…is the credit crisis over? Having reported billions in losses on subprime mortgages, are the banks in the clear? Is it time to consider buying the financial sector, even as a trade?

Before you go rushing off to buy call options on a financial ETF, here are a few things to consider. First, Wall Street banks (and French, German, and British banks) have shown miserable risk-management policies over the last five years. (Here we have a French bank claiming a single trader hacked its systems and managed to lose US$7.2 billion).

Where was the “adult supervision?” Where were the corporate boards charged with protecting shareholder capital? Where were the masters of the universe this whole time?
Do they all work for hedge funds? And most importantly, why should we assume that the financial sector’s ability to manage risk has improved, after fessing up to billions of dollars of losses? Confessions do not automatically lead to repentance. The sinners might simply find new sins to commit.

The temptation to buy the banks for a bounce is obvious and…well…tempting. On a year-over-year basis, 2008’s fourth quarter should look a lot better than 2007’s fourth quarter. The banks should see a big earnings bounce. But you have to wonder who the banks will be lending to this year. Earnings will look comparatively better. But will the real-world business of borrowing and lending money produce lush, pre-crisis profitability?
Doubtful.

Money center banks and investment banks simply never had it so good as they did during the last ten years. We reckon they won’t have it that good again for a very long time. The market for financial products is going to undergo a contraction. This means, we think, lower long-term profits for financial institutions.

Besides, if the banks were so bad at managing risk in the subprime market, how can we be sure they will manage risk any better in the option-ARM market, the credit-default swap market, the insured-bond market or in the market for any other sort of quirky, hyphenated security?

“Bond insurer woes carry major risks for banks as well,” reports CNNMoney.com. “Last week, American regulators tried to put together a bailout in which banks recapitalize the bond insurers and prevent a downgrade by the ratings agencies, which would in turn force the sale of billions in bonds held by institutions which can only buy AAA rated debt.

“If no new capital is forthcoming for bond insurers,” CNN continues, “lenders and other policyholders could end up swallowing heavy losses…Citigroup (NYSE: C), Merrill Lynch (NYSE:MER), Bank of America (NYSE:BAC) and Wachovia (NYSE:WB) are among the most exposed.”

Sound familiar? It’s already been a memorable month, and it’s not over yet. The last few days of rebounding stock prices have provided a welcome respite. But the unwinding of leverage and the deflating of the credit bubble is likely to continue, whether we like it or not. And not everyone likes it, that’s for sure.

“Dear Editor,” a reader of the Australian Daily Reckoning writes, “Please–all you Cassandras out there, get it straight once ‘n for all time that everythin’s gonna be just fine soon as all the excesses are outta the system and as long as money just keeps gettin’ pumped into the system!

“Long live the Fed! They know what they’re doing!

“It all works out, and the dominoes aren’t fallin’ like in 1929 at any rate of speed so just hang in there!…There hasn’t been a single economic/financial mess we haven’t gotten out of since we became a nation, and it’ll be no different this time.

“You all just wanna sell us stuff!”

Let’s be clear. We’re not hoping for the end of the world. But we suspect that the excesses of the credit boom will lead to an economic contraction. Some might call it a recession. Others think it will be a depression, accompanied by a severe financial crisis.

Either way, these cyclical events are nothing new. They are common in the history of Western financial markets. The longer you go without them – or the more the politicians and bankers try to avoid them with stupid policies – the worse they tend to get.

As for Cassandra, Apollo granted her the gift of prophecy, after being smitten by her good looks. She did not return his affections. The scorned Greek god of reason then cursed her: her prophecies, though accurate, would never be believed.

Cassandara wasn’t a false prophet, so get your metaphors right before you go dashing them off. There are plenty of false economic prophets out there. Most of them work for investment banks and show up on TV telling you everything is going to be fine.

In the end, everything WILL be fine. The world will operate, more or less, as it always has. The sun will continue to rise. The sun will continue to set. And CEOs will continue to parlay massive corporate failures into massive personal fortunes. Everything will be fine. But that doesn’t mean you should ignore the financial dangers ahead, or fail to prepare for them if you can.

—————————————–

[Rude Endnote: Finally today, we’ve been forced to close our $1,500 one-time dividend check offer earlier than expected due to high demand. So, rather than the New Year date, we’ll be closing the doors on Friday, 26th at noon. Please make a note of this. You now have only a couple of days left to grab your $1,500 check. Don’t delay, details here.

Until next time…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com

· The epic battle between the ‘flations gets set for a spectacular climax,
· How Obama’s men are likely to effect the power of the dollars in your wallet,
· A quick first glance around southwestern India and plenty more…

Joel Bowman, reporting from Goa, India…

Inflation is alive and well…at least here in the old Portuguese colony of Goa in India’s verdant southwest.

After we sent out yesterday’s edition of your Rude Awakening, your nomadic editor retired his laptop for the evening and wandered up to the beachfront to sample some of the local fare. The area is famous for its spiced seafood and magnificent sunsets.

Each afternoon, the locals set up their tables and chairs in the sand out front of their restaurants, ready for the evening crowd. Waiters light scented candles and stock the bar while musicians tune their sitars and sing a few notes for the passersby. The coastline stretches along to the north until it runs into a great headland, dotted with the lights of resorts and cafes. To the south the fishing boats return to shore after the long day at sea.

After dipping our toes in the Gulf, we moseyed up to the string of brightly colored eateries lining the coast.

The Lobo Souza Hotel is famous in these parts for its tiger prawn masala and giant kingfisher curries. You can actually watch the local fisherman drag the nets ashore while you enjoy a pre-meal cocktail as the final hours of light slip behind the horizon. It is truly a wondrous experience.

Dinner for two, including a sharing platter of fresh oysters and fried mussels, mains of spiced crab and biriyani rice, marinated vegetables, a few of the local Kingfisher beers and a round of cocktails, came to a little over 1,500 rupees, or about $40.

This might seem like a bargain to those of us more accustomed to the prices in Dubai, New York and London, but here in Goa, it is actually quite expensive. During high season, which lasts from December through March, prices at restaurants like Lobo Souza more than double.

In this way, the visitors act a bit like a central bank, flooding the economy with dollars, euros, pounds and currencies from abroad. The surplus of monies push prices higher and the profits help to sustain the locals through the “deflationary” period from the end of March to November, when monsoons and unbearable humidity keep foreigners away.

In recent times, however, that dynamic has been shifting.

The prices are still drastically inflated for the holiday season, but it is not the westerners who are providing the currency injection. That role now largely falls to the affluent young couples from Mumbai, just a few hours north, who sprawl down here for weekend getaways. Although a few hippies and western tour groups still frequent the seedier bars, it is far more common to see Indian women in saris, draped in gold, shuttled to and from the higher-end resorts.

Westerners suffering under the global economic slowdown are beginning to realize that their lifestyles may need downsizing. The suits of Wall Street and The City are trading in their international getaways for weekend trips to Brighton Beach and Cornwall. Meanwhile, 300 million emerging middle class Indians are spicing up the taste in Goa and enjoying the sunsets and seafood they once sold to the world.

Also interesting is the gradual easing of India’s massive “brain drain”. Faced with fewer job opportunities and lower pay in the contracting economies of the west, the IT experts and medical specialists that India once exported are increasingly opting to stay at home, setting up telecommunication businesses, software companies and clinics to service the growing domestic market.

McKinsey Research estimate India’s middle class will grow from about 5 percent of the population to more than 40 percent over the next two decades, creating the world’s fifth-largest consumer market. That’s a lot of Goan holidays and Kingfisher beers!

As with many emerging markets, India is certainly not without its long list of problems. The stock market, Bombay’s Sensex Index, has lost more than 50% this year, for instance, and many expect the bear market to last at least into early 2009. The country is also in need of a major infrastructure overhaul and, sadly, poverty is still very much a problem.

But some of these problems also present India’s new middle class with some very real opportunities. Much of the stock market decline here, for instance, is due to the massive withdrawal of foreign direct investment. A report compiled by Astaire & Partners estimates that foreign institutional investors sold a record $13.5 billion in India during 2008, a far cry from the $17.4 billion they invested last year.

Western hedge funds, under stress to cover massive losses in their home countries, have been forced to deleverage speculative emerging market positions at fire sale prices. That leaves Indian’s increasingly sophisticated middle class with a bargain hunter’s buffet of cheap, fundamentally sound stocks.

According to Astaire & Partners, the average bear market since the 1991 economic reforms – when India really began to “open up” to western capital – lasted around 15 months and typically bottomed out when shares hit about 10x earnings. Today the Bombay Sensex sells for about 9.9x earnings.

It’s not quite kingfisher-fillet-in-July prices just yet, but it’s getting pretty cheap.

While we set off to roam this neck of the woods a little more, Dan Denning takes a look at the epic battle between inflation and deflation a little closer to the U.S. Please enjoy his column below…

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All the President’s Men
By Dan Denning, Australian Daily Reckoning

It’s been a tough market to trade. There’s no real momentum. No one really knows what’s going on. One day, you’re up three percent. The next, down four.

Who knows why these things happen. The story making the rounds in the papers is that traders “cheered” the news that Tim Geithner, President of the New York Fed, would be Barrack Obama’s new Treasury Secretary. He’d replace “Bazooka” Hank Paulson.

No word on whether Geithner is as good for Goldman as Paulson. But he has been one of the three big wheels behind the various bailout plans engineered by the Wall Street/Treasury Axis. He’s a known known, as Donald Rumsfeld might say. And since we’re going with the Roman metaphor, we’d say Geithner has been Caesar to Ben Bernanke’s Pompey and Paulson’s Crassus.

Of course the first Triumvirate coincided with the beginning of the end of the Roman Republic. It was never official. Just three men calling the shots from behind the scenes.

But it certainly marked the beginning of the Empire and dictatorship. Crassus was one of Rome’s richest men. He’d put down the slave rebellion led by Spartacus in 74 BC (still one of Kirk Douglass’ best performances, if you ask us). But he died fighting the Parthians at the edge of Empire at the Battle of Carrahae in 53 BC.

Pompey lasted longer. He gained fame in Rome after defeating pirates in the Mediterranean in 67 BC. He formed an alliance with Julius Caesar in 59 BC and cemented it by marrying Caesar’s daughter Julia.

But when Caesar famously crossed the Rubicon in 49 BC and brought his armies into Italy for Civil War, he put Pompey on the run. Caesar chased Pompey all over Italy for a bit, eventually defeating him in battle and driving him to Egypt, where he was promptly assassinated by his own friends and beheaded.

Tough place, ancient Rome.

But back to the modern world. There are no financial Rubicons left to cross that we can see. They’ve all been crossed already. And we believe they all lead to inflation in 2009. The New York Times reports that Senator Charles Schumer wants the new stimulus plan to be around U.S. $700 billion. That would match the TARP, providing some classical symmetry.

Gold must’ve noticed. After some magnificent weekend rallies, it’s back up over, $820 in the sport market. By the way, Australian gold production fell by 8% in the third quarter, according to Bloomberg. Australia is the world’s third largest gold producer. But high production costs are biting.

In the bigger picture, gold traders and investors realize that the Great Fiscal Stimulation of 2009 is being prepared as we speak. President-elect Obama is conversing with his fiscal and monetary generals. He is marshalling his armies of inflation to go forth and multiply the money supply.

If gold investors are right (and we think they are), the upcoming war on deflation should unleash the epic inflation we’ve all (except for Bob Prechter and Marty Weiss) expected.

Obama and his Consuls Geithner, Summers, and Bernanke are preparing the public for operation GFS 2009. “We now risk falling into a deflationary spiral that could increase our massive debt even further,” the President-elect told Americans in a speech a few weeks back.

He’s right. The rising value of cash (in a deflation) makes debt harder to pay back (especially when you plan on adding so much more). That’s why all governments everywhere prefer the policy of soft, slow-motion inflation. Obama does not represent change here. Just more of the same borrowing and spending we’ve had for years.

Inflation gradually erodes the value of accumulated debts by allowing you to pay them off in an increasingly weaker currency. If you’re having trouble with that idea, think about this way. Say you borrowed $1,000 twenty years ago. Twenty years ago, $1,000 had more purchasing power than it does today. If you inflate steadily enough, it gets easier to pay back your accumulated debts. $1,000 ain’t what it used to be.

The United States also enjoys the luxury of paying off its debts in a currency it prints. So inflating the debt away is easier than, say, defaulting on it because you don’t have enough of the currency in which the debt is denominated. There is no reason to default, in fact, when you can print the currency in which your debts are owed.

This is why we increasingly think inflation is coming. Up until now, the best laid plans of Paulson and his team have been focused on recapitalizing banks and keeping the financial system from imploding. Deflating financial assets have chewed up that new capital, and prevented it from becoming new lending in the economy.

But the next step is the reflation of household balance sheets. Wall Street got its bailout. Now it’s Main Street’s turn.

Already, Obama’s team has indicated it will let the Bush tax cuts expire naturally in 2011, rather than repealing them now. Expect an expanded foreclosure mitigation effort too. And eventually, a new government-backed refinancing plan will be floated to try and put a floor under U.S. house prices.

Yep. 2009 is shaping up to be quite the year if you love big spending government with big plans.

Here are a few problems to think about until next time. First, if you’re a large owner of U.S. dollars and a major creditor to the U.S. government, and you see that the U.S. won’t default on its debt but instead, inflate it away, what do you? What policy levers can you pull to exert influence on your debtor?

Second, what happens to the world’s stock of available savings when governments start hoovering it all up to be used as fiscal stimulus? Does it crowd out private investment, leading to fewer new jobs, and a prolonged crisis? In other words, is the big government push to “fight the crisis” actually setting it up to be much longer and more painful than it otherwise might?

— Bulletin Board Elite – Final Positions —-

The first time, I called it beginner’s luck…

When it happened again, I called it a coincidence…

But after 9 stocks in a “secret” market one ace analyst was screening JUMPED to major exchanges – and major profits – in just a 12-month span, I knew he was hunting in the right place for huge gains.

In just the first six months of 2007, the AVERAGE top-tier stock in this all-but-unknown universe of securities gained 25,498%! Just $100 invested in the best of these on New Year’s Day would’ve handed lucky shareholders gains of $409,900 before the Fourth of July…

Starting RIGHT NOW, I’m offering those who respond to this dispatch a chance to turn even a small investment into a small fortune on this ace analyst’s best picks in this overlooked market

But you must act quickly: Only a few spots remain in this revolutionary services ranks. Details Here

—————————————–

[Rude Endnote: Could yesterday’s decision by the Fed to slash rates to the 0-0.25% range be the turning point in the war of the ‘flations we’ve been writing about recently? Will “quantitative easing” be the death knell for the once almighty buck?

The greenback slipped against most major currencies, with the exception of the British Pound, which was lashed by news of a greater-than-expected rate cut by the BoE. Gold also sensed the dollar vulnerability, rocketing to near $860 per ounce.

Profit-taking took some of the sheen of the precious metal, as it fell off to around $845, before rising again to trade at $858 as we write this morning.

The stock market, as usual, took news that money is now cheaper as a good thing and rallied 4.2%.

Here we go again!

Until next time…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com

· How today’s market compares to histories worst bear runs,
· Greenspan’s reputation tracks the crisis he helped orchestrate,
· Send us your favorite “chicken longs” and plenty more…

Eric Fry, reporting from Baltimore, Maryland….

Greenspan says he is “shocked”…which is utterly shocking…if not also appalling. The former Fed Chairman appeared before the House Oversight Committee yesterday to testify about the causes of the credit crisis. His testimony in brief was as follows:

“It wasn’t my fault.”

According to Greenspan’s tortured explanations, the unregulated finance companies (that he repeatedly refused to regulate), combined with the unbridled issuance of adjustable-rate mortgages (that he publicly extolled), combined with the astronomical growth of complex derivatives (that he enthusiastically encouraged), combined with the lack of governmental oversight and control (that he actively thwarted), had NOTHING to do with the resulting financial disaster.

No, these influences did not cause the problem. And neither – we are led to infer – did the former Fed Chairman’s carreer-long penchant for nurturing asset bubbles, cause the problem. The real culprits, Greenspan argued, were all those bond investors who were demanding high-yield securities. If these nasty bond investors weren’t trying so hard to get high yields, Wall Street would have never created so many mortgage-backed securities. And obviously, if Wall Street hadn’t created so many mortgage-backed securities, it wouldn’t have needed as many mortgages from Main Street. Ergo, fewer bad loans would have come into existence. It’s simple, really…and utterly absurd.

Even if we were to accept Greenspan’s preposterous post-mortem, the inquiring mind would want to inquire, “Why were bond investors seeking high yields?” Hmmm…could part of the reason have been that Greenspan was continuously suppressing short-term interest rates, even when economic conditions did not seem to require them. “Greenspan is maintaining emergency interest rates without an emergency,” James Grant explained at the time.

According to classic economic thought, artificially low interest rates create “mal-investment.” They cause and enable individuals to do things that they would not otherwise do – to take risks that they would not otherwise take. If you could borrow money at 1%, for example, why not do so and invest in something – anything – that yields more than your cost of funds? Why not buy a funky, mortgage-backed security (MBS) that yields 4% and pocket the difference? After all, how risky could the MBS be?

Such was the approximate analysis that inspired trillions of dollars worth of leveraged speculations. But after you peel away the arcane language of the mortgage derivatives market, and the bad math that validated values in this market, and the Greenspan-speak that imparted an air of legitimacy to this market, you find a Superfund cleanup site.

The rest of us will spend the next several years cleaning up this toxic waste.

But let’s not rush to judge Alan Greenspan. He is “in a state of shocked disbelief.” He said so himself. He never dreamed that finance company chieftains would dare to endanger their shareholders. He never imagined that corporate officers – unimpeded by the annoying constraints of regulation, or leverage limits – would EVER try to enrich themselves by putting the shareholders’ capital at risk. Wall Street CEOs have always been model citizens, haven’t they? So why bother regulating them?

We can certainly understand Greenspan’s bewilderment. Haven’t finance companies successfully regulated themselves throughout the generations? Let’s see, let’s count all the times this has occurred in history. There was…um…that time….um…let me think…um…that time when…um…Well, I’m sure there must have been a time when this happened. Why else would Greenspan have been shocked?

After Greenspan concluded his Oscar-worthy performance on Capital Hill, the stock market tanked more than 400 points from its high to its low. How UNLIKE the olden days when every utterance from “the Maestro” inspired a robust rally. Those days are gone…especially now that the former chairman’s reputation is tracking the trajectory of the slumping stock market. We fear that Greenspan’s reputation has much farther to fall before hitting its true, mark-to-market value. Let’s hope, therefore, that the stock market bottoms out much sooner than the Maestro’s plummeting public image.

But trying to gauge the bottom of any bear market is an inexact science, at best. In fact, it is not a science at all. It is a game of pin-the-tail-on-the-donkey. It’s fine to play the game, but don’t expect to hit the donkey the very first time. Dan Denning of the Australian Daily reckoning offers some thoughts on the matter in the column below…

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Pin the Tail on the Bull
by Dan Denning

Has this brutal bear market finally ended? Has a new bull market arrived?…Only Warren Buffett knows for sure…The rest of us have to guess. But before guessing, let’s stick our index fingers in the air and try to gauge the direction of recent financial trends…

The good news is that the credit market is unfreezing. The bad news is that no one in the stock market cares. All the hot money being pumped out by central banks is finally starting to de-thaw the inter-bank lending market. You probably now know more about the inter-bank lending market than you ever expected or wanted to know. But the decline in the rate banks charge each other to borrow overnight (LIBOR) really just means that banks have slightly more trust in each other this week than they did last week.

Yet on Wall Street, the Dow merely convulses. The S&P 500 is down 39% year-to-date and 43% from its high last October. You’d think the de-icing of the credit market would have produced a little more joy in the stock market. But investors have other worries on their minds now. Earnings, for one. In the bigger picture, they are wondering just how big this global recession is going to be. How many more layoffs will there be? How bad will it get? Judging by stock prices, pretty bad.

Oil has slumped to less than $70. Gold to nearly $700. These are not the signs of economic vitality. Copper and aluminium are also falling. If you look at the action in these market, investors are pricing in a shocking 2009, not just a run-of-the-mill recession. Are the slumping prices of commodities an indication that inflation poses no threat?

“History shows that recessions solve inflation problems, so much of the world is about to have their inflation problems solved, and pretty rapidly,” an interest rate analyst opined recently. Maybe this analyst is correct, but OTHER history shows you can have rising prices AND a recession. That’s the good old stagflation of the 1970s.

But maybe we’re overly worried about inflation. After all, most central banks target or tolerate annual official inflation of 2% and call it “price stability.” And Jeremy Grantham, who’s been bearish on stocks since at least 2003, seems to think that value will be destroyed in financial asset markets faster than new lending and credit can reflate it into a new bubble. [Grantham is the insightful founder of the investment management firm, Grantham, Mayo, Van Otterloo.]

“Don’t worry at all about inflation,” wrote Grantham in a note to investors. “We can all save up our worries [about that] for a couple of years from now and then really worry! Commodities may have big rallies, but the fundamentals of the next 18 months should wear them down to new two-year lows.”

But Grantham is dipping his toe into equity waters anyway. “At under 1000 on the S&P 500, U.S. stocks are very reasonable buys for brave value managers willing to be early. The same applies to EAFE and emerging equities at October 10th prices, but even more so. History warns, though, that new lows are more likely than not.”

The S&P 500 made its bear market low in October of 2002 at 776. That’s 13.3% below yesterday’s close of 896. And should it decline to that level, it would be exactly 50% below its all time intra-day high of 1,552 (set on October 31st of last year).

By any historical standard, that’s a whopper of a bear market. So Grantham dipping a toe in now is an assumption that this bear market is roughly consistent with similar bear markets of the last 137 years. Take a look below and you’ll see what we mean.

The bear market of 2008 already ranks up there among the all time greats. The only question now is whether the bear market in stocks triggers a bigger recession in the economy that leads to an even greater fall in stocks in the coming years. So is it 1929 or 1974?

It’s tempting to call the massed selling of stocks irrational. But this is based on some investors looking at stock valuations and finding them cheap on an earnings basis, or looking at the cash on the balance sheet. But what we have right now are extremely motivated sellers. We call these sellers, “hedge fund managers.” They HAVE to sell…for many different reasons. They have to sell because almost all of their leveraged bets on stocks, bonds and commodities are blowing up…which means they MUST de-lever to meet margin calls. At the same time, these guys are receiving tens of billions of dollars worth of redemption notices. So that means they have to sell even more to raise the cash to send to their investors. This is not a pleasant situation.

Normally, when a seller has to sell, it’s a very good time to be a buyer, hence Buffett’s chest-thumping op-ed piece. But you don’t want to be a buyer if there’s more forced selling in the pipeline. And that is now the key question in the market. How much leverage is left to be unwound?

Well, before the crisis hit, hedge funds controlled US$2.4 trillion in investor funds. They would have used that capital secure trillions more dollars worth of borrowings (with leverage ratios of 10-1, 20-1, and 100-1). But now, all those assets purchased by hedge funds with borrowed money are being liquidated. And the funds that were not hedged at all (long-only, with massive leverage) are not long for this earth. Who are they going to take with them?

“In a fairly Darwinian manner, many hedge funds will simply disappear,” Emmanuel Roman, co-chief executive officer of GLG Partners Inc., told investors at a hedge fund conference in London. “This will go down in the history books as one of the greatest fiascos of banking in 100 years.”

True that.

Governments want to regulate hedge funds. They’ve already begun to do so by preventing them from shorting. But remember, if a hedge fund can’t short, it can’t really hedge. Performance suffers. Investor redemptions increase. The more hedge fund investors want their money back, the more that the funds must sell. In fact, only the “lock-ups” that hedge funds impose to prevent investors from getting their money back immediately are preventing an even greater pace of redemptions. So it’s easy to see how a new low in the markets is entirely possible.

Our prediction? Stock markets are going to get a hefty global bounce in November. There are at least three events on the horizon that could provide the boost. First, if Obama is elected, you have the end of uncertainty about the U.S. election (and some highly irrational optimism that things will now be different, better, and nicer). Second, you’ll get a new stimulus plan from the Democratic Congress in the U.S., which should give stocks a bit of a kick. And third, the big G20 meeting in Washington. Something that looks and feels good should come from that.

Those three factors may conspire to produce a convincing-looking bear-market rally into Christmas. That would be like the sucker’s rally of 1929-1930 that preceded the stock market’s epic collapse over the ensuing two years. Or, we could be dead wrong and deleveraging may simply overwhelm everything else and take the market down to much lower lows right now, without much of a bounce at all.

Stocks are very cheap. That makes them a buy. Unfortunately, they might get cheaper. That makes them a sell. And so we defer to the seasoned wisdom of Jeremy Grantham, an investor who is BEGINNING to buy, but fully expecting prices to fall even lower.

[Joel's Note: Avid readers will recognize the value of what have come to be known at Rude H.Q. as our “Group Research Projects.” Every so often, your editors offer the floor to the inimitable readership. Tapping this brain trust has, during its brief and under-celebrated history, produced some outstanding insights.

And so, once again, we head to the fountain of Rude wisdom for some thoughts. This time, we ask the reader to submit his or her favorite “chicken longs.” In other words, these ideas would be for stocks that are both cheap now but, in the possible event that the Dow plunges another 2,000 points, won’t be totally laid to waste. These stocks might derive their insulation by paying a very high yield, like the investment trusts we offered in Tuesday’s column, or from some other large margin of safety.

Please submit your ideas, along with a brief explanation as to why you chose them, to the address below. We’ll unveil the very best chicken longs in future issues.

In the meantime, here’s a special Bear Market Strategy Report our colleague Dan Amoss forwarded to us. Unless you’re Warren Buffett and you know precisely when the bottom is in, this report could prove very useful to you. It shouldn’t take more than five or ten minuts to read through and, given that Dan’s average cosed position during this whole crisis is up a whopping 94%, we reckon that’s a few minutes well spent.

Until next time…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com

• The Paulson Bill heads back to the house for Round II,
• A financial Frankenstein even a mother couldn’t love,
• Why no bailout plan in the world can force banks to lend and more…

Joel Bowman, reporting from Muscat, Oman…

Organisms, political theories, markets…all things eventually die.

Even marriage, with its “’till death do us part” clause, provides a convenient glimpse at post-mortem freedom for those faithful to both God and partner during life. (We wonder then if, given the infinitely weightier commitment required from an atheist, they are more reluctant to walk down the aisle?)

Strangely comforted by this fait accompli, we refrain from yet again lamenting capitalism’s inexorable march toward the grave. Today, just for a change of pace, we mourn not the death of that which will eventually come to pass, but for the life of that which never will be.

Had the process of natural selection in the marketplace been allowed to proceed unhindered, what new species of lending and borrowing might exist today in place of the wealth destroying institutions in line for Paulson’s handouts? In lieu of blatant and forced transfer of wealth from the prudent to the insanely profligate, what path of lesser resistance would this capital now find itself on? Without a protracted period of uncertainty built upon an unsustainable period of exuberance, what solid footing would the moribund currency of the world’s largest economy now stand atop?

In other words, what is the opportunity cost of continually retarding the natural evolution of the economy with self-congratulatory intervention and back-patting do-goodery?

“If we consider the current banking system as a patient on the operating table who has suffered massive head trauma and internal bleeding, it’s easier to see what should happen,” observes Dan Denning, editor of the Australian Daily Reckoning.

“Paulson wants your blood for continuous transfusions. The patient is kept on life support, although his brain is likely to remain permanently dysfunctional and his heart utterly corrupt.

“Meanwhile, in the waiting room, there are private investors happy to buy a liver, a kidney, some corneas, and maybe even a lung or two. But you can see the problem. For the buyers to be interested, the patient has to die.

“Paulson, Bernanke, Bush, and Congress need to pull the plug and let nature take its course. That’s not what publicly elected officials do, though, especially so close to an election. So we will get Frankenstein. And you know what happened to that poor, unnatural creation of human hubris don’t you?”

In today’s issue, Dan offers a few more thoughts on the monumental misadventure of economics underway right now. Please enjoy and send any comments to the address below…

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Why the Paulson Plan Won’t Work
By Dan Denning

$700 billion will flush through the U.S. banking system faster than [insert preferred metaphor here]. In other words; the bailout won’t work.

The crux of the bailout is that it’s designed to keep banks from failing by recapitalizing them. It’s like a massive financial organ donor program where the Treasury, like a live organ donor, replaces the malignant guts of the current system with its own, healthy ones. But of course, live organ donors don’t usually swap their healthy organs for failing ones. The Treasury is breaking new ground here.

Even if Paulson can come up with $700 billion from Congress, many of the banks are going to fail anyway. They borrowed money short term to buy long-term assets (mortgage backed securities and collateralized debt obligations). Now, the money must be paid back but no one wants to lend short term. Why? The assets are falling in value.

When the assets fall in value, it wipes out equity capital. You have a small amount of capital controlling a large amount of assets. If you take a write off on the assets, it wipes out your capital. You’re insolvent.

Here’s the thing…$700 billion is not going to be enough to remove the troubled assets from bank balance sheets. But then, Paulson must know that. He’s hoping that the Treasury’s buying kick starts the market by establishing a price for the stuff.

Then, he’s hoping, private equity, hedge funds, and others with cash come in from the sidelines to make deals with the banks and get the assets off the balance sheet so the banks don’t fail. Trouble is, the price Paulson wants to pay for the assets seems likely to be higher than what the market is willing to pay. Kick-starting the banking system won’t work if the first bidder (the government) comes in and pays a price the market has already said no to.

The financial markets may believe, for a day or two, that the passage of Paulson’s bailout plan fundamentally alters the dynamics of the U.S. financial system. But it does not. Not one jot.

Borrowed money has to be paid back. Assets that were bought with that borrowed money are falling. That is how all credit bubbles end. This one is no different.

The new Senate version of the bailout bill has some new bells and whistles not included in the version that failed to pass the House. Two of the main measures added seem aimed more at shoring up political support for the bill, rather than improving the chances that the plan will actually work. But let’s take a look at them anyway.

First, the Senate wants to temporarily increase Federal insurance on deposits in U.S. commercial banks from US$100,000 to US$250,000. You might wonder what an increase in Federal deposit insurance does to improve the quality of assets on bank balance sheets.
The answer is, “It doesn’t.”

But the increase in what the FDIC can offer is designed to make the Paulson plan more difficult to oppose in the House. Who is against providing ordinary savers more insurance for their life savings? Anyone? There is also the question of confidence.

By increasing FDIC insurance to $250k, you reassure (hopefully) people that there’s no need to remove their money from the bank. Here the Feds aim to prevent a run on banks by depositors that leads the bank to fail. This is what happened first at Indy Mac in July and at Washington Mutual earlier this week.

Depositors took out a whopping $16.5 billion from WaMu between September 15th and the end of the month. That kind of run is a serious drain on a bank’s capital. It’s a scenario the Congress wants to avoid by increasing FDIC insurance. It does nothing to improve bank balance sheets, unless, by restoring confidence, it prevents a huge drawdown in a bank’s assets (its deposits).

Meanwhile, to address the value of those damaged assets that Henry Paulson can’t wait to get his hands on, the SEC clarified its stance on Tuesday with regard to mark-to-market accounting rules. This move is designed to give banks some wiggle room when it comes to valuing their damaged assets. The higher the banks can value the assets, the less likely the banks are to have to take losses on those assets, or to sell them to meet capital requirements. They can stay in the game.

In essence, the new SEC dispensation permits the management’s of financial institutions to legally inflate the real-world values of many balance sheet assets. The new ruling provides a delicious array of valuation metrics that will enable financial firms to elevate the stated value of their troubled mortgage-backed securities far above what any actual human being would pay.

Granting these new powers of deception is good, we are told, because telling the truth would be too darn painful and would put many banks out of business. This process is a little bit like providing a trophy from Little League as collateral for a $1 million loan. No one actually believes that the trophy is worth $1 million, but since the borrower may legally assert that the “fair value” of his trophy is $1 million, the lender cannot foreclose. Everyone is happy, right?

No bailout plan in the world is going to convert a Little League trophy into a $1 million asset…or a defaulted mortgage into a AAA security. And no bailout plan in the world is going to reverse the fall in American house prices (or even arrest in). Therefore, no bailout plan in the world is going to force banks to lend, if the assets on their balance sheets are both overvalued AND falling in value. Until someone comes along with a plan that severs the connection between residential American real estate and the banking system, the system itself remains on the edge of crisis.

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[Rude Endnote: “Paradoxical as it may seem to some, it is just as necessary to the health of a dynamic economy that dying industries be allowed to die as that growing industries be allowed to grow. The first process is essential to the second.”

- From Henry Hazlitt’s Economics in One Lesson, ignored by politicians since 1946.

Please send your thoughts to the address below.

Until next time…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com