Taipei, Taiwan – Laguna Beach, California

Saturday, October 17, 2009.

Joel Bowman, signing off for The Rude Awakening from Taipei, Taiwan…

This is the end,
Beautiful friend.
This is the end,
My only friend, the end.

– The End, The Doors

For many, Jim Morrison’s lyrics were pure poetic genius. To his fans, he was THE American Poet, The Lizard King, the epitome of artistic beauty and romantic tragedy. For others, he was just a glorified, rambling gypsy man in leather pants who suffered an unhealthy penchant for peyote. He was out to corrupt daughters, they said, and to spread perversion of every stripe.

Others  argue that he was really a bit of both and that neither side could exist independently of the other. In his song, The End, Morrison sings about “weird scenes inside the goldmine,” and how “the west is best” before drifting into a kind of murderous Freudian nightmare. One is left to wonder where the genius stops and the peyote begins? Or are the two really one and the same?

Perhaps Morrison himself summed it up best when he said, “There are things known and there are things unknown…and in between are the doors.”

We wax lyrical today because, you see, Rude reader, we have arrived at our end. Today is the final ever issue of The Rude Awakening. As of this Monday, your editors will begin publishing our missives from over at The Daily Reckoning.

Now, we’d be lying if we said we weren’t at least a little sentimental at the thought of lowering The Rude Awakening into the cold, hard earth…

But all things die, Rude reader; grand empires, mighty bull markets and, yes, even fringy, independent financial publications; all eventually run their natural course. It is a phenomenon that requires neither joy nor sadness, and one that will surely persist in the absence of both.

Besides, we can’t complain. We’ve had a good Rude run. We reported from Wall Street when the Dow Jones Industrial Average was en route to its all-time high. We bubble-hopped from Southern California to the U.K. and on to Dubai, watching with amazement as the world built castles on sand then packaged, re-packaged, rated and sold off their promises to the each other as if they were real.

We brought you our thoughts from more than 30 countries over the past few years, under the influence of enough espresso to resurrect Lazarus. We’ve searched for wireless Internet connections from Baltimore to Bahrain, Melbourne to Mumbai, Carthage to Cairo, Taipei to Tallinn. And from the North East to the Middle East and across to the Far East, we’ve watched the mighty fall and the world economy turned upside down.

And all the while, Rude reader, you were right there with us.

You woke us in the night with questions…and sat patiently by our side while we tried to find the answers. You laughed when we missed our flight(s) and scolded our frequent typos. You became our friend in Dubai and then threatened to cancel your subscription from Ha Noi. You invited us to your home for dinner in Phuket, encouraged our writing in Vancouver and kept us company at the bar when our plane was delayed in Doha. You read the local newspapers with us around the globe and raised a skeptical brow when we fell for their tricks. You always demanded more from us, but never hesitated to indulge our requests…

And though the future was uncertain…and the end always near…you were always there by our side.

So to you, Rude Reader, we raise our glass.

Thank you for reading and for keeping us company along the way.

Signing off for The Rude Awakening…

Cheers,

Joel Bowman and Eric J. Fry

aussiejoel@the-rude-awakening.com

P.S. From this Monday onwards, we’ll be taking on publishing duties at The Daily Reckoning. If you haven’t already signed up, here’s a free link to do so. We hope you can join us, along with the rest of the “DR” cast for the next phase of the journey.

• Commodities mount yet another rally as stocks flail,
• Crude: The other inflation hedge (and with room on the upside!),
• Plus, Rude moves house next Monday…Are you joining us?

Eric Fry, reporting from Laguna Beach, California…

For the second day running, commodities made some noise in the trading pits. Gold jumped to another all-time high of $1,064 an ounce; oil surged to a one-year high near $75 a barrel and most of the agricultural commodities bounced to new multi-month highs. By contrast, for the second day running, the stock market did a whole lotta nuthin’.

Two days’ trading action doesn’t make a trend, of course, but it does make a nifty topic of discussion for an online financial column! The specific “nifty topic” that interests us here at the Rude Awakening is whether commodities like oil, corn and wheat might now be much more compelling investments than the S&P 500 Index.

After all, if the economy is genuinely and truly recovering, demand for commodities will also recover. And yet, broadly speaking, the stock market has done a heck of a lot more “recovering” than the commodity markets. The S&P 500 trades for a lofty 19 times expected earnings – earnings, which, by the way, might not materialize as expected. Most commodities, meanwhile, change hands at price well below their highs of the last two years. And so we wonder, “Why not sell stocks and buy commodities?” Specifically, why not buy crude oil and/or the grains?

The nearby chart displays the recent price trends of both crude oil and the S&P 500 Index, since the end of 2007. As fate would have it, their respective zigs and zags have landed these two asset classes in approximately the same spot. Similarly, crude oil and the S&P 500 have both bounced about 60% off their March lows. But here’s where our story takes an interesting turn…

Historically speaking, stocks are very richly priced. On the other hand, crude oil seems very lowly priced, at least in relation to probably supply-demand trends and to the ever-rising cost of new production. Net-net, at the current quotes, the S&P 500 seems like a riskier bet than crude oil…and a MUCH riskier bet than the grains.

As an added plus for the would-be buyers of commodities, the U.S. dollar is looking a little shaky these days. Every time it stumbles, bids show up for the stuff that powers and feeds the world. Every time the dollar trips over itself, the world’s dollar-holders look around for ways to hold fewer of them – like exchanging them for gold, grains or crude oil.

For more on the whys and wherefores of the crude oil trade, please check out the insights below from Chris Mayer, editor of Mayer’s Special Situations. But a quick head’s up…Chris doesn’t get to the stuff about crude oil until about half way down the column. The first half contains what he calls “timeless investment wisdom”…

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Why Oil? Why Now?
By Chris Mayer

Forecasting is a troublesome art even in less confusing times than these. As Edward R. Murrow once said, “Anyone who isn’t confused really doesn’t understand the situation.” We are in uncharted waters in many respects. Nonetheless, we must try to make sense of it all. Herein, a few quick observations on where we are with some timeless investment wisdom and some kind words for crude oil, which looks like something an investor can bank on in uncertain times.

We’ll start with Howard Marks, the chairman of Oaktree, which oversees some $60 billion in assets. At the recent Grant’s Fall Investment Conference, he offered an interesting summary of what happened during the financial collapse of 2008. The story was, essentially, one of too much debt.

A willingness to take risks, easy credit and optimism fueled the boom. The ratio of credit to GDP, which has tended to hover around 140–160% here in the U.S., shot up to 300% pre-2007 crisis. In the years immediately following the Great Depression, this ratio shot up to 265%. So we are well into “ugly” territory.

As Marks points out, much of the apparent improvement in the economy today has had to do with the financial sector, and not the “real” economy. “Business is still terrible,” he says. “Our industrial base is shrinking, perhaps permanently.” Many of the boom’s problems remain unresolved. The potential for more defaults and more bankruptcies is still substantial, he says.

But what is an investor to do? As Marks says, “You can’t always prepare for a 2008. You’d never do anything.”

That is true. Marks shared a few of his favorite investment mantras, which are useful to keep in mind. The first is that “improbable things happen; and probable things fail to happen.” Anybody who lived through 2008 needs no reminder of this. It would’ve seemed improbable that oil prices could fall from $143 to $30 in six months, but it happened. It would’ve seemed probable that inflation would be high by now, but it isn’t.

Second, “It is not enough to survive on average; you have to be able to survive the worst day.” Marks used the example of a 6-foot man drowning in a river only 5 feet deep on average. The lesson: Buy companies that can survive the worst days.

Third: “Being too far ahead of your time is indistinguishable from being wrong.” Anyone who was bearish on oil at $100 a barrel — on its way to $143 — was pretty much wrong, even though they were ultimately right. Timing, sometimes, is everything.

And finally, on forecasting, Marks was brutally honest. He doesn’t believe forecasts, even his own. (“In fact, I don’t believe half of what I just told you,” he said as the crowd laughed. To which Jim Grant, ever ready with a rejoinder, quickly asked: “Which half?”)

With that, we’ll take a stab at the oil market, which seems to exhibit the wisdom of all the above.

The story of oil is one of an increasingly costly supply base and a stubbornly high demand for oil. Andrew Hall told the story. He is chairman of Phibro, a large commodity trading firm. His presentation highlighted all the pitfalls of our precarious oil supply. The U.K., Norway and Mexico are all in decline, and each was a major producer of crude oil not long ago. Indonesia, one of the founding members of OPEC, is now a net oil importer.

True, we’ve had several new discoveries. As Hall points out, though, these are all costly sources of oil. And all the new discoveries will barely offset the existing declines elsewhere. Add in the potential downside risk of delays and cost overruns and Hall believes there is little chance of upside surprises.

The key to his whole argument rests on the current replacement cost curve for world oil. The average marginal cost to produce 84 million barrels of oil per day – the current demand – is $70 a barrel. In other words, if the oil price falls below that level and stays there for a while, marginal production becomes uneconomic…which means that production would be certain to fall.

Furthermore, the cost of production continues to rise. Less than a decade ago, the marginal cost was only $25 a barrel. So the whole curve has been shifting upward over time.

There is also a kind of feedback loop here. The biggest cost to produce oil is the price of steel and the price of oil itself. So as oil prices go higher, it means extraction costs also go up. The return we get on energy invested, or EROEI, is another element in decline. In 1930s, the return was greater than 100:1. By the 1970s, it slipped to 30:1. Today, the “energy return on energy invested” is in the mid-teens. It seems clear we’ll spend even more energy on to get energy in the future.

The great backdrop of demand remains those emerging markets. They are still early in the growth curve for oil demand. As Hall says, the emerging markets are at a per capita level at which oil demand begins to grow rapidly.

That, plus the supply issues, paints a powerful bullish backdrop for oil. It’s why Hall concluded his presentation by saying, “Oil price upside is virtually guaranteed.”

We will see. But how to play it? Hall recommended owning oil in the U.S. or Canada. Also oil field service stocks remain attractive as the picks and shovels of the oil industry. He recommends avoiding the refineries, which should be a terrible business for years to come. He is also not a fan of the midstream assets (i.e., the pipeline stocks), as they won’t participate as much in a rising oil price.

The other thing about oil is that, like gold, it is an inflation hedge. Asked about oil as an inflation hedge, Hall said, “All hard assets are going to perform well in nominal terms. Oil prices quadrupled in the ’70s and then quadrupled again.”

So if we circle back round to Marks’ wisdom, “Improbable things happen.” How about a rising oil price in the face of a weak economy? Improbable, most would say. Inevitable is what Hall’s presentation promises.

Joel’s Note: Speaking of oil investments, right now Chris is spending some time over in the Middle East, checking out opportunities for his readers. After that, he’s off to India to get some “boots-on-ground” exposure there. In fact, Chris and Addison, our executive publisher, are amassing an international network of financial minds to help people get a better handle on the many investment ideas abroad. If you’re in any way “bearish on the Empire,” you might want to look at what Addison and Chris are building. You can check out their first briefing right here.

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[Rude Endnote: Please don’t forget, dear reader, that The Rude Awakening is closing at the end of this week. From next Monday onwards, your editors will publish their thoughts, hunches, speculations and guesses from The Daily Reckoning. If you haven’t done so already, you can sign up for free here.

That’s all for another day.

Until next time…

Cheers,

Joel Bowman

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

• What “GLD’s” largest holder has to say about his metal of choice,
• Anti-dollars continue their record breaking streak,
• Trading inflation fears in for hard assets and more…

Eric Fry, reporting from Laguna Beach, California…

The “inflation trade,” which has been building momentum for several weeks, seemed to pick up a fresh burst of vitality yesterday. Gold reached a new all-time high of $1,060 an ounce, oil brushed up against a one-year high of $75 a barrel, and the agricultural commodities finally joined in on the fun…as corn and wheat both soared more than 5%.

So what does yesterday’s effervescent trading action in the commodity pits mean? Does it prove that the threat of inflation is alive and well? Well, “prove” is probably too strong a word. But yesterday’s trading action does, at least, suggest that the threat of inflation is far from dead. Some investors are defending themselves from this monetary assault by piling up ramparts of gold…and oil.

Read on…

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The “Inflation Trade,” as Sexy as Ever
By Eric J. Fry

Is the threat of inflation advancing? Depends whom you ask.

If you ask Bill Gross, manager of tens of billions of dollars worth of investments that would suffer during an inflation, the answer would be “no.” But if you ask the guy who just made a few billion dollars betting that mortgage-backed securities would collapse during 2008, the answer would be “maybe.” So let’s ask that second guy…

John Paulson, a guy who made billions from a variety of bets against the American financial sector, is a bit worried about the prospect of inflation and a lot worried about the U.S. dollar. That’s why Mr. Paulson has been amassing substantial investments in gold and gold-mining companies. As we noted in a recent edition of the Rude Awakening, Paulson’s hedge fund is the largest holder of “GLD,” the NYSE-traded ETF that holds gold bullion.

A couple weeks back, Paulson explained his affinity for gold to the attendees of the Grant’s Interest Rate Observer Fall Conference. Said Paulson: “I lost faith in the dollar as a reserve currency for my assets…What I’m looking at is not were gold is going to be tomorrow, one week from now, one month from now, three months from now. What I’m looking at is where gold is going to be vis-à-vis the dollar one year from now, three years from now, five years from now. And I think with a high probability at each one of those points, gold will be higher than it is relative to the dollar today. That probability increases the further out you go. So when I looked at what the risk is, the risk to me is far more staying in dollars than it is in gold at this point.”

Paulson seems to have a lot of company at the moment…maybe too much. Gold is “overbought” on the short term and is, therefore, vulnerable to a correction. Paulson says he doesn’t care. Perhaps no other long-term investor should care either. Or maybe long-term investors should care just enough to look around at some of the “other” inflation hedges that are kicking around in the financial markets? What about oil, for example?

Jim Grant, host of the above-mentioned conference, and also a bull on the oil price, makes a compelling argument for investing in the gooey black energy source. “Oil is becoming harder to lift,” Grant observes, “even as money is becoming easier to print…Overlaying the first trend on the second, a speculative thinker can imagine a much higher oil price.” Perhaps these trends are overlaying one another already. “The U.S. dollar index, which tracks the dollar against other major currencies, is down 14 percent since early March,” Bloomberg News calculates, “and crude has jumped by about $20 per barrel [during the same timeframe].”

Andrew Hall, chairman and chief executive of Phibro LLC, is also bullish on the oil price…or at least he was when he was presenting his thoughts at the same Grant’s Conference that featured John Paulson. But Hall’s bullish outlook has nothing to do with the dollar and everything to do with the oil supply. The truth about oil, says Hall, is that production is ebbing while demand is rising.

“Today, it is not so much a question of if the rate of oil supply is going to peak,” he explains, “but when…Oil production in many parts of the world has already peaked and entered a terminal decline that even sustained high prices are unable to reverse.”

The International Energy Agency’s latest data seem to corroborate Hall’s analysis. “August global oil supply was down 400,000 barrels a day to 84.9 mb/d, on lower non-OPEC output.” Meanwhile, the IEA also predicted that worldwide demand for crude oil would rise to about 85.7 mb/d next year – or nearly one million barrels per day more than current production.

“But what about all those great big oil discoveries we’ve been reading about recently?” some readers may be wondering. “Won’t those finds compensate for production declines elsewhere?” In a word, no. The recent discoveries off the coasts of Brazil, West Africa and elsewhere might slow the rate of global production declines, but they are unlikely to produce global production increases.  Here’s why: production is falling off rapidly at many of the world’s largest oil fields, most notably the Cantarell Field off the coast of Mexico.

This “super giant” was producing 2.2 mb/d as recently as 2003. Next year it will be lucky to produce 500,000 barrels per day. Furthermore, it is worth noting that Cantarell’s oil lies under a mere 150 feet of water and 3,500 feet of rock. The oil contained in Brazil’s headline-grabbing Tupi discovery lies under about 6,500 feet of water and 16,000 feet of rock, sand and salt. The very first exploratory well into this four-mile-deep deposit cost about $200 million. Subsequent wells will probably cost more than $60 million apiece. In other words, the oil will not be easy to get…which suggest that tomorrow’s oil will be more expensive than today’s.

The considerable constraints on the growth of new supplies should contribute to a steadily rising oil price for several years to come. As Andrew Hall, chairman and CEO of Phibro LLC, remarked during his presentation at the Grant’s investor conference, “Extreme oil price volatility with an upward bias is virtually guaranteed.”

Investors seeking to capitalize on a rising oil price have no shortage of options.  But please check in again later this week as Chris Mayer, editor of Mayer’s Special Situations, highlights a couple of his favorite ideas in the energy patch…

Joel’s Note: Of course, if you simply can not wait to see Mayer’s favorite energy play, you can always just grab a copy to his premium research service here. Just a thought…

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Even if Gold hits $2,000 by the end of this year… here’s a hidden way you can get in for less than one cent per ounce

Over the next two years, you’ll witness the greatest surge in gold prices in market history — at least 119% above where gold sits today, as I write this.

But even better, I’ve just discovered a way for you to sneak into the soaring gold market for next to nothing, with what I call “penny-per-ounce” gold.

That is, doing this is a “backdoor” way to own as much of a position in gold as you like… for the equivalent of paying a single cent per ounce. Learn How Here.

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[Rude Endnote: The end is nigh, faithful (and unfaithful) readers. Only three more Rude issues remain until we retire the ol’ publication…and take up our new post over at The Daily Reckoning.

This change will occur next Monday. If you don’t want to miss an issue, we suggest you sign up for “The DR” – free, of course – right here.

We hope you’ll be able to join us.

Cheers,

Joel Bowman

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

• Gold crashes through the $1,050 per ounce mark…and keeps going,
• V-shaped delusions and sluggish to non-existent re-hiring,
• Plus, day and night…love and loss…paper and metals and plenty more…

Eric Fry, with a few words about life, love and the value of adversity…

“Love is blind,” the poets observe…But no need for dismay; loss of love usually restores complete vision.

Furthermore, lovers never complain about their blindness…at least not until they are squaring off in divorce court. At that point, the now-former lovers possess such acute vision that they can pinpoint flaws the Hubble telescope could not detect.

Blind love is not such a bad thing, however. In fact, it is usually much more fun than 20/20 solitude. But these two extremes go hand-in-hand…or arm-in-arm…or whatever. Without heartbreak; true love holds no value. Until one has suffered the agony of lost love, he or she (but usually, she) cannot fully appreciate the value of rediscovered love. In fact, he or she (but usually, she) might not even recognize true love when it finally arrives.

On the other hand, without having known the euphoria of romance; who would fear its counterpart, lost love? That fear sometimes keeps petty grievances in check…and mutes the inclination to gripe about an open toilet seat.

This interaction between love and loss typifies the bipolar forces that define and influence most of the human experience…including that part of the human experience that unfolds in the financial markets. (Your editor will complete this transition from love to finance momentarily. But patience please; the digression continues…)

A rapturous romance is exhilarating, it’s true; and a ruptured romance is depressing…but oh so illuminating…

“If we lived in a world without tears,” the blues singer, Lucinda Williams, mournfully muses, “how would misery know which back door to walk through? How would trouble know which mind to live inside of? How would sorrow find a home?”

Of course, tears are not merely meant to provide “lodging” for sorrow and misery. They are also meant to evacuate pain and clear the way for new joys or unexpected delights. In other words, some knowledge of failure is essential for creating a love that can flourish. Don’t take your editor’s word for it; just try conducting a long-term relationship with someone who has never been rejected by anyone; try building a loving relationship with someone who has never “loved and lost” – someone whose past is littered with romances that THEY, alone, ended. This individual’s love and devotion will be slightly more reliable than a cat’s…maybe.

But that’s okay. The loss of love produces personal growth, emotional development…and alcohol abuse.  Two of these three results are constructive. The individual who eschews substance-abuse to face the pain of romantic bereavement head-on gains the opportunity to evolve emotionally and to learn important lessons for the next time…like which secrets to reveal or conceal; or which personality quirks in your lover are mere idiosyncrasies and which are psychological disorders.

And once you begin to understand what’s healthy and what’s merely entertaining (for a while), you are on your way to something better…at least in theory. Most of us simply repeat the same mistakes over and over. (Perhaps the native languages differ; but the neuroses remain eerily similar).

Nevertheless, as we hurtle through our existence – buffeted by the extremes of love and rejection – we gain at least the chance to enjoy something better, richer, healthier. That’s what life’s adversity furnishes…the opportunity for something better.

In fact, almost every facet of life unfolds between extremes – between deluge and drought; between war and peace; between wealth and poverty; between no and yes; between No! No! and Yes! Yes!; between prosperity and recession; between darkness and light; between sunshine and rain; between male and female; between sobriety and intoxication; between vigilance and slumber; between toil and rest.

Bipolarity is simply the way of the world.  It’s the way the world works and behaves.  And in many ways it’s the way the world MUST work.  Without both sunshine and rain, crops do not grow.

Economies are no different. They require the pain of recession if they are ever to enjoy the fruits of robust growth.  Without recessions, economies cannot achieve their full potential. They cannot unburden themselves of inefficient industries or sub-optimal regulatory structures, etc. Without recessions, economies cannot clear the way for better, healthier industries.  They cannot kick out the old, lame enterprises, for example, or enable the “younger, hotter” enterprises… so to speak.

The US economy, thanks to the dubious policies of the Federal Reserve and US Treasury, has been clinging to the old, lame companies and industries… instead of pushing them out the door to make way for healthier ones.

“The biggest problem going forward is the U.S.,” billionaire investor, George Soros, recently remarked, “as that’s where consumers are over-indebted and the banking system is basically bankrupt. The U.S. will be very slow in recovery and can’t really get going. The United States has a long way to go.”

You see, dear investor, that’s what happens when you don’t allow bad businesses to fail; they just keep hanging around making your life miserable. They keep blocking the path to newer and better things.

Dan Amoss, editor of the Strategic Short Alert, provides a bit more detail in the column below…

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100% in one day
23.4% in 48 hours
33.24% in 7 days

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Average = 52%
Average holding time = just 3 days

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

——————————————

The Joys of Recession
By Dan Amoss

The big questions of the moment: What kind of economic environment do we face? And more important, what’s already priced into the stock market? Here’s my view on these themes: The real job creators in the U.S. economy, small businesses, will not expand hiring as expected. There are many reasons for subdued hiring plans; an emerging reason to avoid expansion and hiring will be heightened expectations that tax rates will soar in the future to pay for out-of-control government spending.

So I expect over the next several months, mainstream pundits and forecasters will start worrying about tepid hiring, even as the pace of job losses slows. As we “lap” the 2009 corporate cost cutting by early 2010, and top lines fail to rebound, earnings estimates will have to come back down. I’m amazed at how many sell-side analysts are modeling V-shaped recoveries in 2010 earnings. Most stock prices are disconnected from reality.

Another big question is how will policymakers respond to a sluggish-to-nonexistent rebound in hiring? The economically illiterate, and those with preconceived “big government” agendas, will use any crisis as an excuse to expand government. You’ll be ahead of the game if you realize — as many in the media and academia clearly do not — that the government has no resources. It’ll take money out of one of your pockets, skim some off for its cronies, and expect you to be grateful when they put some of it — debased by the Fed’s inflation, of course — back into your other pocket.

The labor market is dealing with a structural imbalance fueled by government-sponsored housing and credit bubbles. Many will call for the government to “solve” this labor market problem, which will cause a new type of market dislocation. By early 2010, some will push for the federal government to start hiring the chronically unemployed in “New Deal” type of programs.

Where you stand on this question will determine your expectations for the future performance of most stocks. I certainly don’t enjoy having such a bearish outlook on the economy, but it’s the conclusion I reach after weighing all the evidence about the real economy; the credit markets; and policymakers’ damaging, distorting influence.

For example, corporate CFOs and Treasurers are happy about the recent bull market in risk. They know much more about their prospects than outside investors, so their balance sheet management is revealing. In a word, the approach toward capital structure is “defensive.” Heavily indebted companies are flooding the market with follow-on stock offerings to pay down debts. They’re also taking advantage of the Pollyannaish mood of the corporate bond market to issue risky bonds at attractive rates, as default risk seems to be a distant memory of bond buyers. Many corporate bond investors have taken the Fed’s bait to reach for yield, regardless of credit risk.

Amazingly, credit risk is a quaint, distant memory for most, when it should be the first consideration for shareholders — especially shareholders of highly leveraged companies like banks and REITs. In leveraged companies, shareholders’ claims can evaporate very quickly when asset values deflate and cash flow dries up.

For banks in particular, credit risk often accelerates out of nowhere. Remember how many big-time investors bought stocks like the failed Washington Mutual because it appeared to be “well capitalized”?

It’s shocking how many banks the FDIC still deems to be “well capitalized,” despite the fact that foreclosure activity is accelerating.

Foreclosure activity is crucial to the outlook for bank earnings. Mortgage losses will become a big problem for bank stocks in 2010. Mark Hanson of Mark Hanson Advisors does great work on the details behind the headline foreclosure and housing price statistics — the kind of granular, non-ivory-tower research that’s missing in Wall Street and Washington, D.C. In an update a few weeks ago, Hanson wrote:

The chart below shows the national monthly notice-of-trustee sales (late stage) versus foreclosures (last stage) counts from March through August. In that short six-month period, there have been 390,000 NTSs that have not resulted in a foreclosure (circled in red). Many are on trial [modifications].

If we assume that 250,000 of the 390,000 are presently on a trial and 40% fail, then beginning shortly 100,000 new foreclosures will spit out over a short period of time that will be added to the foreclosures that will occur naturally for reasons mentioned previously. If 60% fail, then the number goes to 150,000. With foreclosures only averaging 73,000 over the past six months, this new stream of foreclosures is significant — it has the potential to double foreclosures over a single month.

The banking system has slowed down the necessary process of “working out” unmanageable debts. Deliberately delaying loan foreclosures and write-offs — whether through government edict or smoothing out loss recognition over time — has the effect of backing up the plumbing in the system of credit intermediation. It’s the post-1990 Japan scenario of sweeping bad loans under a rug because “we can just hold on until asset values come back.”

I’ve written repeatedly about the accounting for — and resolution of — toxic assets throughout the banking system, because I see it as crucial to the outlook for both the U.S. economy and corporate earnings. The longer this is delayed, the more likely the U.S. economy suffers a fate even worse than post-bubble Japan. We have a scenario of defensive, undercapitalized banks, combined with a huge population of effectively bankrupt U.S. consumers. This is a problem that requires comprehensive debt restructuring and resolution before we can have a sustainable economic recovery.

Net-net, the outlook for economic recovery is questionable, at best…which means that the outlook for rising share prices is even more questionable.

— From the Desk of Dan Amoss: Strategic Short Report —

Hidden Government “100-F Documents” That Let You Predict Which Stocks Will Go up or Down

Discover how one small group of Americans uses government-mandated “100-F Documents” to easily predict gains or losses for any household-name stock in America…

On at least 58 different dates, each year…

And how you can now use these same “secret” documents to post returns as high as 400 – 600% over the weeks ahead. Learn How Here.

—————————————–

[Rude Endnote: Another record high for our favorite precious metal overnight. Gold punched through whatever “resistance” the $1,050 mark could muster…then added another $8 an ounce by the time we checked it this morning. So, what’s driving the metal? Fear of inflation? Fear of hyper-inflation? Overflows of speculative cash from institutional funds regaining their appetite for risk? All of the above? A and C? Other?

Who can say, really. The specter of runaway inflation has been lurking for some time now, despite assurances from the Feds that they have an adequate plan to mop up all the excess liquidity they created to deal with the credit crisis. Could it be that investors have finally lost faith in the greenback, the world’s reserve currency? What started as a rumor earlier this week about a few oil-producing nations (among others) ditching the dollar has now spiraled into all out war against Bernanke’s bills.

Indeed, a large part of gold’s rise is due to the poor performance of the battered greenback. The dollar index made fresh two-week lows overnight as recovery hopes drove investors into the arms of higher yielding assets, including foreign currencies. The Aussie dollar, for example, is galloping toward parity with the U.S. dollar once again after a not-that-surprising interest rate hike from the RBA earlier in the week. Compared to the Aussie dollar’s gains, gold’s 18.1% for the year looks somewhat tempered. The Aussie is up about 24% against the greenback from Jan. 1.

The question now, of course, is what happens to these “riskier” assets – gold, emerging market indexes and foreign currencies – if “the recovery” dies on its derrière? Do investors still trust the greenback as the ultimate save haven? Will they scamper back to ol’ Uncle Sam’s unloving arms? Or will movie gangsters of the future produce suitcases full of reals, Aussies, or renmimbi to buy the world’s onscreen supply of drugs and firearms?

Stay tuned.

Until tomorrow…

Cheers,

Joel Bowman

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

• Mr. Market gallops ahead…all the way back to last Wednesday,
• Gold posts an all-time (nominal) record as the dollar slides,
• And remembering the ethos that brought Wall Street to its knees…

Joel Bowman, reporting from Seoul, Korea…

Investors were off to the races again yesterday, and the galloping Mr. Market did not disappoint.

The Dow Jones Industrial Average bolted ahead another 130 points before Tuesday’s race was over, taking this week’s gains to…well, back to where we were last Wednesday. Still, it seems no amount of real economic data can hold the bucking bronco back…at least not for more than a few days.

Gold too is making headlines after the precious metal smashed through its record (nominal) high and now threatens to break the $1,050 barrier for the first time in history. (In real terms – adjusted for inflation – the metal is still well below its record of around $2,150, achieved back in 1980.)

In any case, it seemed as if everyone had backed a winner by the day’s end…except those who placed their bets on the flailing greenback, that is. The dollar sank against all major currencies yesterday save for the pound, with the dollar index ending the session down 0.6%. Indeed, so poor have her results been this year that, if it weren’t for her dubious status as the world’s “reserve currency,” she’d likely be off to the glue factory.

All in all, it seems increasingly true that a dollar just ain’t what it used to be.

Be that as it may, we are still no less opposed to anyone seeking to claim more than their fair share of dollars…or Korean won…or United Arab Emirate dirhams…or, for that matter, any other currency.

Take, for example, the CEOs of some of America’s top finance firms. During the bull market euphoria that led up to the spectacular crash of 2007-08, CEOs lavished on themselves some truly absurd bonuses.

According to one report, CEO pay rose 45% between 1996 and 2006, during which time the average pay for an American worker grew just 7% (minus inflation!).

That same study revealed that CEOs at 386 of the Fortune 500 companies took home $10.8 million in total compensation in 2006, more than 364 times what the average worker earned that same year.

Now, your editors would never claim that ALL of those high-flying CEOs did not deserve their high-flying paychecks…only that SOME – maybe even MANY – of them didn’t. Names like Dick Fuld, Stan O’Neal, Chuck Prince and Angelo Mozilo spring to mind, among others.

If these companies were growing, or even preserving shareholder wealth, then some of their exorbitant remunerations might be warranted. In reality, sadly, these men were awarded their staggering bonuses as the companies they were charged with overseeing nosedived.

In today’s “Remembering Rude” column, we revisit the heady days of January 2007. Wall Street’s wizards had not yet been exposed as hyper-leveraged hucksters and, given that the worldwide bull market was still galloping towards the cliff – and not yet plunging from it – few people even thought to make sure these guys were actually earning their big bucks honestly.

We first went to press with Eric’s “Bonus Envy” column on Thursday, January 18, 2007, when the Dow Jones Industrial Average was still around 12,500. We republish his thoughts today as Part II of our Remembering Rude series. Please enjoy…

[Ed. Note: Why are we suddenly “remembering Rude?” you ask. Because as of Monday, October 19, your editors will no longer publish their coffee-stained insights in these pages. The Rude Awakening as you know it will cease to exist…

...BUT, you are invited to join us over at our new home, The Daily Reckoning. In fact, you can even sign up for free here to ensure you don’t miss a single issue.]

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Bonus Envy
By Eric J. Fry

The rain falls on the rich and the poor alike. That’s symmetry. But after the rain lands, the rich receive a much larger share of the water than the poor. That’s asymmetry. Indeed, some of the rich funnel as much water as possible toward their own personal reservoirs…even though they have more than enough water already. That’s greed.

…And some of the rich drain the wells of their neighbors and clients to water their golf courses. That’s Wall Street.

Greed is one reason why brokerage stocks might be dangerous stocks to own at their current lofty valuations. [Our colleague, Jeff Clark, examined a few other reasons in the January 12 of the Rude Awakening, "Time to Sell Short?"]

No automatic connection exists between greed and poor stock market performance. But bad things just seem to happen to the common shareholders of companies that greedy managements oversee. Names like Enron, Tyco and Worldcom come to mind.

In this context, names like Merrill Lynch and Morgan Stanley do not yet come to mind. But the big brokerage firms of Wall Street have veered perilously close to the shoals of excessive greed. And this course endangers shareholders because it squanders capital that could be funding productive activities, or providing a balance sheet buffer against future unanticipated “adverse outcomes.”

As long as the financial markets remain robust, however, no one will care how many billions of dollars might slosh into the brimming bank accounts of elite traders and top Wall Street insiders. But financial markets are not always robust. The same Citigroup that is today lavishing billions on its top employees was once the Citibank that flirted with bankruptcy in the early 1990s.

Bank and brokerage stocks are already risky enough, thanks to the perennial risks of falling financial markets, rising interest rates and exploding derivatives books. Avaricious management teams do not lessen these risks.

The owners of brokerage shares, therefore, do well to remember that Wall Street is forever and always about money. It is about making as much money as humanly possible, in as many different ways as legally defensible. Wall Street is not about charity or altruism or the “greater good.” Wall Street is also about survival of the fittest – the “fittest” being those who maneuver themselves into obscenely overcompensated positions. Do these alpha-bankers and alpha-traders deserve their millions? In a primal sense, yes…just like a great white shark deserves a slow-moving harbor seal…or a falcon deserves a hapless bunny…or a coyote deserves the neighbor’s dozing Pomeranian.

But these metaphors become a bit sinister when one realizes that the “hapless bunny” and the “dozing Pomeranian” are the common shareholders.

The big brokerage firms make most of their money by speculating with capital that does not belong to them, or by levying fees and commissions on capital that their clients put at risk in the financial markets. In other words, shareholders and clients bear most of the risks. Yet whenever any form of success arrives, Wall Street’s elite always garner an outsized share of the rewards. That’s asymmetry. And in this case, asymmetry might just be another word for “greed.”

Consider the case of Morgan Stanley. The firm posted net income of $7.4 billion in 2006 – an impressive $3.7 billion more than 2003 earnings. But at the same time, total compensation at Morgan Stanley last year topped $14.3 billion – a whopping $5.8 billion more than in 2003. Does it not seem odd that employee compensation is nearly twice the firm’s net income? And does it not seem odd that employee compensation has jumped 60% more than net income since 2003, even though the number of employees has barely increased at all? In fact the employee count has DROPPED since the end of 2002.

Most of the individual recipients of year-end bonuses are not to blame, of course. They are simply blessed. And as blessed individuals, they enjoy the privilege of sharing their wealth in altruistic and charitable ways…or not. Likewise, the stockbrokers who toil for these firms deserve no scorn. They earn their keep like entrepreneurs, and must conduct their activities in a very open and competitive marketplace.

But the leaders of Wall Street – those who perpetuate the status quo – might consider taking a minute of “quiet time” to consider the propriety of their practices. Do these folks honestly believe that they deserve their multi-million-dollar bonuses, simply for presiding over bull market trading activity? And do they honestly believe that “star” traders deserve their multi-million-dollar bonuses, simply for speculating with someone else’s capital.

To re-phrase the question: Isn’t it possible that Wall Street’s elite employees should receive a somewhat smaller share of corporate cashflows than they do currently…and that the common shareholders should receive a somewhat larger share?

“Nobody who is hired help and who plays with other people’s money ‘deserves’ to earn $100 million,” gripes Steven Pearlstein in a terrific article for the Washington Post. “That’s certainly true in a moral sense. But it is also true economically…Let’s start with the fundamental asymmetry of risk in the investment business.

“If you were putting your own money at risk,” Pearlstein continues, “there’s the possibility of making lots more, but there’s also the possibility you could lose it all. The same, however, can’t be said if you are an investment banker, a hedge fund manager or a trader in credit default swaps. In that case, if you do well, you get a percentage of the winnings or the value of the deal. But if you do poorly and your clients lose money, the worst that happens is that your bonus is zero. You never have to give back anything from the bonus you earned last year. And you still get a base salary comfortable enough to keep up payments on the Upper East Side townhouse, the summer place on Nantucket and the tuitions at Brearley.”

No one cares about over-the-top compensation schemes when business is booming…and when share prices are rising. But on the downside, everyone cares. During the Great Bull Market of the late 1990s, almost no one bothered to question the exorbitant option grants that Silicon Valley companies lavished on their employees (and on their board members!)

But once the Great Bull Market ended, and the Nasdaq imploded, a new bull market in recrimination and litigation began. Class-action shareholder lawsuits erupted from the smoldering remains of former Wall Street darlings, as desperate shareholders tried to recover some small fraction of their losses.

Would it not have been much better for these abused shareholders to sell when the selling was good? Would it not have been better to have raised a skeptical eyebrow toward the questionable corporate practices of the era and headed the other way…even though questionable corporate practices were producing rising share prices?

“Excess compensation in one area leads to excess compensation in others, “Pearlstein concludes. “And that, in the end, is how this arms race in executive pay comes about. It’s more about envy than economics. The corporate executives complain they should make as much as the investment bankers, the bankers are upset if they don’t make as much as the private-equity guys, the private-equity guys demand to make as much as the traders, and the traders won’t sit still until they are paid like hedge fund managers.”

Excess compensation also leads to sub-optimal shareholder returns. Greed and capital preservation just don’t seem to mix very well, especially when the greed belongs to someone else and the capital belongs to you.

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[Rude Endnote: With our flight leaving early tomorrow and only one night left to enjoy the delights of Seoul, we’re going to get out of here early today.

We’ll see you again tomorrow when we’ll have more of our usual musings.

Until then…

Cheers,

Joel Bowman

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

• Stocks trading at 19 times FALLING earnings…whaa?
• Remembering Rude…with one of the calls of the meltdown,
• What to make of all this effervescent trading action and more…

Eric Fry, reporting from Laguna Beach, California…

To judge from the stock market’s effervescent trading action, all is right with the world. But to judge from the “Business Section” stories of almost any newspaper, there’s almost nothing that isn’t wrong with the world.

Unemployment is rising; activity at factories is falling; and consumers aren’t doing much of anything. All of this adds up to a sluggish economy…much more sluggish than the bulls on Wall Street expect.

If the bullish investors on Wall Street are too optimistic, it would not be the first time. Investors are prone to excess, both on the upside and on the downside. We cannot say that today’s upside is excessive, only that it is without any fundamental underpinnings. Stocks are trading at 19 times FALLING earnings, and there’s very little indication that earnings will improve – much less, accelerate – any time soon.

To the contrary, Dan Amoss, the insightful mind behind the Strategic Short Report, believes the U.S. economy remains very sickly, mostly because the banking sector remains infected with toxic assets.

“The backlog of [mortgage] foreclosures is building like water behind a dam,” Dan observes in a recent missive to his subscribers. “Once the dam gives way, the market may be shocked at how quickly the headline foreclosure numbers accelerate. Are the quant funds currently bidding up the price of financial stocks incorporating this foreclosure backlog into their models? I doubt it.

”The Sept. 23 issue of Amherst Mortgage Insight is the best attempt I’ve read to quantify the ‘shadow inventory’ of houses,” Dan continues. “It leads with a sober estimate of the residential housing supply situation:

The single largest impediment to a recovery in the housing market is the large number of loans that are either in delinquent status or in foreclosure that are destined to liquidate. This creates a huge shadow inventory. We estimate this housing overhang at 7 million units, 135% of a full year of existing home sales.

“Amherst Securities has been ahead of the curve,” says Dan, “in warning about the deterioration in mortgage securities and this market’s impact on the health of the banking system.”

Truth be told, Dan has also been ahead of the curve. In the May 21, 2008 edition of the Rude Awakening, Dan observed, “”Billions of dollars of future write-downs and losses are still buried inside Wall Street’s balance sheets. Lehman Brothers (LEH) appears to be among the most vulnerable of all the investment banks.”

Just a few months later, Lehman was a zero and Dan’s subscribers were walking away with gains of 400%, or more, on the Lehman put options he had recommended.

In celebration of Dan’s analytical mastery, today’s edition of the Rude Awakening will present his dead-on analysis of Lehman Bros. from May 21, 2008 – just four months before Lehman’s collapse. The title of that day’s issue was, “What If the Worst is Not Over?”

Good call, Dan!

— From the Desk of Dan Amoss: Strategic Short Report —

Hidden Government “100-F Documents” That Let You Predict Which Stocks Will Go up or Down

Discover how one small group of Americans uses government-mandated “100-F Documents” to easily predict gains or losses for any household-name stock in America…

On at least 58 different dates, each year…

And how you can now use these same “secret” documents to post returns as high as 400 – 600% over the weeks ahead. Learn How Here.

——————————————

What if the Worst is Not Over?
By Dan Amoss

Since the rescue of Bear Stearns on March 17, the Amex Securities Broker/Dealer Index has rallied 20%. The shares of Lehman Brothers have rocketed more than 30%. These dramatic rallies support the popular thesis that “the worst is over” for the financial sector.

But these dramatic rallies also provide attractive short-selling opportunities for every investor who believes that the “worst is yet to come.”

Most of Wall Street’s money-making machines have shut down. Mortgage-securitization activity has gone kaput, while IPO and M&A activities are sputtering. Even worse, Billions of dollars of future write-downs and losses are still buried inside Wall Street’s balance sheets.

Lehman Brothers (LEH) appears to be among the most vulnerable of all the investment banks. The stock has rallied hard since the Bear Stearns rescue. Because its business model closely resembles that of Bear Stearns, Wall Street thought Lehman was next. And it might have been, if not for the Fed.

The Fed instituted a lending facility allowing the investment banks to temporarily swap the ugliest “alphabet soup” assets for Treasuries. These alphabet soup assets – mortgage-backed securities (MBS), asset-backed securities (ABS), collateralized loan obligations (CLO), and others – had been smothering the brokers to the point that Bear Stearns was hours from declaring bankruptcy.

In the hopeful words of Lehman Brothers CEO, Dick Fuld, the Federal Reserve’s lending facility “takes the liquidity issue for the entire industry off the table.” Sure, the Fed’s actions may have forestalled a modern-day “bank run” on Wall Street. But the Fed has not solved the bigger, longer-term crisis.

The Fed’s new facility allows Lehman to temporarily swap its garbage assets for Treasuries. What it doesn’t do is protect Lehman shareholders from losses on these securities. Lehman shareholders will be the first to absorb these losses. Shareholders are in the most junior position in every company’s capital structure. So the more leverage – or debt – a company employs, the quicker shareholders get wiped out when assets sour.

As the chart below shows, Lehman’s equity (in red) supports just a tiny sliver of Lehman’s towering liabilities. Lehman’s gross leverage ratio amounts to about 32 times equity. This means Lehman’s assets can fall only about 3% in value before equity is wiped out.

Lehman is scrambling to reduce leverage and raise capital by selling illiquid assets into a weak secondary market. Unfortunately, illiquid mortgage-backed securities aren’t a particularly hot item these days. There are few buyers for such assets – even at steep discounts.

According to Bernstein Research, Lehman’s “troubled” residential and commercial mortgage assets amount to nearly three times its tangible equity. That’s danger level for Lehman shareholders. And the danger is growing…

Last year, the investment banks, including Lehman, adopted a new Financial Accounting Standards Board rule called “FAS 157.” This new accounting rule segregates balance sheet assets according to their liquidity and marketability. “Level I Assets” have readily available market prices. “Level II Assets” can be valued by comparing them to prices of similar assets. But “Level III Assets” lack any observable market price or price inputs. They are “marked to model” – not “marked to market.”

So how many Lehman assets are Level II and III? According to its latest 10-Q, Lehman categorized $60.5 billion and $23.8 billion of its mortgage securities as Level II and III assets, respectively. This adds up to $84.3 billion – or more than four times tangible equity per share! Therefore, if just 12% of Lehman’s $153 per share in Level II and III mortgage assets were written off – a reasonable assumption – such losses would eat through half of Lehman’s tangible equity.

The odd thing about Level III assets, also know as “mark-to-model” assets, is that the owner of them gets to decide how much they’re worth. I’m not kidding. Lehman management determines for itself the value of the Level III it owns. Therefore, no one can really know what the true value might be. There’s no way to know, for example, what models management uses to value its Level III assets. Hopefully, they are not using the same badly flawed models that predicted smooth sailing for subprime mortgage-backed securities.

This lack of pricing transparency (or pricing reality) can be management’s strongest ally…for a while. But eventually, the truth will out. Eventually, the Level III assets will make their way from the dark recesses of Lehman’s balance sheet into the unforgiving light of real-world pricing. Eventually, living and breathing buyers will determine the value of these assets, not some mainframe computer in the Lehman back office. And as these real-world transactions occur, Lehman might face billions of dollars of additional write-downs and losses.

Lehman management has not been terribly forthcoming about reporting quarterly losses and write-downs. Brad Hintz from Bernstein Research hinted that fuzzy math produced Lehman’s “strong” March earnings report: “We believe the quality of these earnings was weak, as the firm benefited from a lower tax rate and enjoyed a $600 million mark-to-market gain on its liabilities.” That’s a polite understatement.

Believe it or not, accounting rules allow investment banks to book a profit when the value of the bonds they have issued FALL. Follow along with this crazy logic if you can: Because the holders of Lehman’s bonds became fearful that Lehman would declare bankruptcy, the bondholders dumped the bonds at very low prices. Therefore, because Lehman’s bond prices tumbled, Lehman could, theoretically, buy back the bonds at prices much lower than the stated value of those bonds on Lehman’s balance sheet. As a result, this bizarre accounting rule concludes, Lehman can book a “profit” on the difference between the issue price of its bonds and the depressed market prices. Taken to an extreme, Lehman could probably post one if its most profitable quarters ever, just by declaring bankruptcy!

Obviously, falling bond prices indicate financial stress, and certainly do not produce sustainable, high-quality earnings. Such “earnings” do not generate cash or create any value of shareholders whatsoever.

Net-net, Lehman is still facing the likelihood of losing tens of billions of dollars over the course of the next few years. As losses pile up, Lehman will have to raise capital. That means flooding the market with LEH shares. Lehman may have to issue hundreds of millions of new shares at a discount to rebuild its capital shortfall, severely diluting the existing shareholders.

David Einhorn, an accomplished hedge fund manager, recently explained why he’s still selling short Lehman shares. In a speech at the April 8 Grant’s conference, he said that Lehman may have to boost its capital by as much as $30 to $70 billion. If Einhorn’s guesstimate is anywhere close to the mark, Lehman’s shareholders are in for a very rough ride.

The worst might be over for the financial sector, just like so many investors seem to believe. But a lot of bad stuff is still rolling our way. For the rest of 2008, therefore, investors might want to take their cue from Credit Suisse CEO Brady Dougan when he said, “The number of times people have seen the light at the end of the tunnel, it turned out to be a train coming down the tracks.”

Joel’s Note: Dan’s Strategic Short Report offers one of the best bear market strategies we know of. Simply put, his track record speaks for itself. If you are interested in learning more about his Ultimate Bear Market Strategy Report, please read on Right Here.

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[Rude Endnote: No doubt you’ve heard by now that The Rude Awakening is closing its doors. (Notice that nifty banner add up top of your mailing…?) So, we thought it might be nice to intersperse a few “remembering Rude” columns in with your regular insights over the coming weeks. Today was the first in that series. We hope you enjoyed it.

Be sure to catch your editors at their new home, from Monday October 19, over at The Daily Reckoning. In fact, you can sign up for free right here, if you like, just to ensure you don’t miss a single issue.

We’ll be back with more this time tomorrow.

Cheers,

Joel Bowman

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

• The growing risk in Treasurys and four ways to bet against them,
• The trouble with separating man from the economy he builds,
• It’s only the end of the world, why waste time worrying? And more…

Joel Bowman, reporting from Taipei, Taiwan…

Super typhoons, an earthquake and a tsunami; to put it mildly it has been a devastating week for the Asia Pacific region. Now another typhoon, Parma, is closing in on our doorstep. We await quietly its wrath. In the Philippines, the Catholics pray for deliverance. Here in Taiwan, the Buddhists batten down their hatches…

…and yet, from the shiny towers of modern economic theory, there pours forth a deluge of pure idiocy that threatens to drown us all.

In the aftermath of last week’s natural disasters, a few misguided economists have rushed forward to assure a battle-weary public that there will be “minimal economic impact” on the effected nations. Some, evidently suffering from a most unfortunate case of myopia, even suggest that the region will be “better off” for having suffered so at the hands of Mother Nature.

“Rebuilding has an accelerating effect on GDP,” Wai Ho Leong, Barclays Capital’s senior regional economist in Singapore, remarked in an interview with Bloomberg. “Typically, it more than makes up for such shocks. The overall impact on the economy might even be positive, if we factor in rebuilding programs.”

Such abuse of logic leads the unthinking person to assume that all our economies would be far better off, if only we were fortunate enough to be visited on by regular and extreme natural disasters.

One might have thought that such specious reasoning would have gone the way of the dodo after Frederic Bastiat elucidated for us its inherent flaw in his 1850 essay, “That Which is Seen, and That Which is Not Seen.”

In his famous example, “The Broken Window,” Bastiat examines opportunity cost, the cost of that which is “unseen.”

Suppose, Bastiat’s example goes, that a careless son breaks a windowpane in his father’s store. Witness that the bystanders will placate the shopkeeper with such statements as, “what would become of the glaziers if panes of glass were never broken?”

The idea here is that the “seen” effect of the broken window is a net positive, i.e., a glazier will be paid 6 francs (the figure in the example) to fix the window. What is left unseen, however, is not only that the shopkeeper must furnish 6 francs for a new window, but that he now has 6 francs less to spend on those things he might have purchased had his careless son not damaged his property in the first instance. (In Bastiat’s second supposition, where the window is not broken, the shopkeeper spends his 6 francs on shoes and enjoys, in addition to his new kicks, an unbroken window in his store.)

As Bastiat correctly concludes, “Society loses the value of things which are uselessly destroyed.”

The message is simple enough that one might think even a mainstream economist would be able to grasp it. Alas…

The misguided Leong continues: “We have seen the experience of Sichuan and more recently in Taiwan. Over an extended time period, there was no discernible impact on gross domestic product on a net basis.”

[It is true here that Mr. Leong has enslaved his reasoning capacity to the dubious metric we know as gross domestic product. And it is true that this measurement tends to paralyze the inquiring mind, often beyond resuscitation. But that debate is for another day...]

More than 3 trillion yuan ($440 billion) was committed to rebuild houses, highways and railways leveled by the earthquake that struck Sichuan back in May, according to Vice Provincial Governor Wei Hong. We can easily understand, therefore, that this money will not now be used by either individuals – to purchase new machinery for their farms, for example – or by the local government – to cover other expenses.

That 3 trillion yuan is an “unseen” cost, but a cost nonetheless…and quite a discernible one at that.

Even of we forgive Mr. Leong this error, we might have expected him to count the cost of the 87,000 people who perished in the disaster. Even if he wishes to separate these individuals from the economy, he must admit that such a tragedy represents a massive loss of productivity. You know…for the “economy.”

Such egregious remarks might be considered comedic fodder if the (lack of) thinking behind them was not so pervasive in modern economics, where spending – any kind of spending – is seen as an absolute and unchallengeable positive for all and sundry.

In the same article, Song Seng-Wun, an economist at CIMB-GK Securities Pte, assured us that, “For now, this is a human rather than economic story. In fact, there could be a mild boost from reconstruction works.”

Here we can see the pernicious misconception in higher resolution; that is, the assumption that economy and man are isolated entities. Of course, there is no “economy” without humans and any attempt to separate the two is, at best, a grossly sophistical error. From fascism to communism, all tyrannical and oppressive regimes have this mendacious claim at their heart.

Whether in response to natural or manmade disaster, beware the message, “good for the economy,” if it deviates in any way from what is good for the individuals who build it.

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23.4% in 48 hours
33.24% in 7 days

_________________________________

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Average holding time = just 3 days

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

——————————————

And the Rest of Your Rude Reading…

The Last Bear
By Bill Bonner

Personal conversions sometimes mark dramatic turns in history. Saul of Taursus saw a vision so bright it left him blind. The next thing you know, he had changed his name and was pushing Christianity all over the world. According to Gibbon, the Roman Empire fell as a consequence. Then, on the advice of his mistress, Gabrielle, Henry IV became a Catholic, leading to the Edict of Nantes and its subsequent revocation.

How to Relax and Enjoy the End of the World
By Bill Bonner and Addison Wiggin

The world as we have known it is coming to an end. But what do we care? We smile and vow to enjoy it. It took the Roman Empire hundreds of years to fall. During that time, most people did not even know their world was coming to an end.

Kinder, Gentler…and Perverse
By Eric J. Fry

The kindlier, gentler version of American capitalism that has come into fashion since last year’s credit crisis is neither kind nor gentle… at least not to capitalists. The “new capitalism” visits the sins of an imprudent minority on the backs of a prudent majority.

The Sun Sets on the West
By Chris Mayer

What will the global economy look like in 2050?…and should we care about that now, forty years before the fact? Dr. Marc Faber, the 63-year-old Swiss editor of the well-regarded Gloom Boom & Doom Report, recently addressed both questions.

Risk-Free is Not Without Risk
By Eric J. Fry

“All things must pass,” George Harrison mournfully crooned on his 1971 album of the same name. “All things must pass away…Sunrise doesn’t last all morning. A cloudburst doesn’t last all day”…and neither does a superpower’s global economic hegemony.

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[Rude Endnote: Your editor is off to Seoul, South Korea, this week to catch a glimpse at the world’s second most populous metropolitan area. If you’re in the city and want to grab coffee, drop us a line below.

Until next time…

Cheers,

Joel Bowman

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

• GAAP standards point to one “mind-blowingly large debt load,”
• Five specific ways – of varying risk/reward – to bet against U.S. Treasurys,
• Suffering death by one thousand familiar cuts and plenty more…

Eric Fry, examining the perils of familiarity, reports…

Familiarity breeds contempt, according to a well-known saying. But familiarity also breeds comfort…and comfort is a very dangerous emotion for any investor. It’s okay to love financial assets, for example, but dangerous to trust them. A little discomfort is helpful. A little discomfort leads to the insight that sidesteps harm.

Here’s the problem: Financial assets are as capricious and untrustworthy as an impassioned lover. One moment you’re feeling pure exhilaration; the next moment you’re learning that your “precious angel” has “too much love for just one person.”

In such cases, forewarned is better. Conducting a bit of honest, critical analysis ahead of time could suggest a variety of alternatives to “blind affection” – any one of which might dampen the adverse effects of sub-optimal outcomes…like unexpectedly finding your angel in bed with the local devil.

But enough about purely theoretical financial principals. Let’s move this discussion into the real world of financial infidelity. To start from the beginning, familiarity is dangerous because it anesthetizes. It conceals flaws. Therefore, familiarity does not equal safety, nor desirability.

As we explained in an ancient edition of the Rude Awakening, “Familiarity breeds contempt…but not right away. In the beginning, familiarity breeds desire, which then becomes mere comfort, then only tolerance, then resignation…and THEN contempt.”

Since familiarity anesthetizes critical analytical functions for a long while, it can produce a selective myopia – 20/20 vision toward positive traits, but total blindness toward imperfections.

In most cases, familiarity and its attendant myopia cause no harm. For example, it may not matter, for example, that the bubbly beverage of choice for most Americans is Coca-cola, not champagne. And it may not matter that our preferred appetizer would be Cheese-Whiz on a Ritz cracker, not Beluga caviar on a blini. And it probably doesn’t matter at all that most Americans are happy to eat a hodge-podge of overcooked meat and vegetables, as long as the hodge-podge is called “stew,” and not “pot au feu” or “feijoada.”

But it might matter that most American investors prefer a 10-year Treasury bond to a 10-year Brazilian bond. We might want to reconsider this habit. Read on…

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Risk-Free is Not Without Risk
By Eric J. Fry

“All things must pass,” George Harrison mournfully crooned on his 1971 album of the same name. “All things must pass away…Sunrise doesn’t last all morning. A cloudburst doesn’t last all day”…and neither does a superpower’s global economic hegemony.

America’s dominance of the global economy is falling victim to self-inflicted wounds – namely, extreme and rising indebtedness. America’s recent flood of red ink would make a banana republic blush.

As a result, risk-free Treasury bond may not be as “risk free” as they used to be. A few days ago, the highly regarded hedge fund manager, Julian Robertson, revealed that he is purchasing long-term put options on long-term Treasury bonds. His reasoning is persuasive.

“If the Chinese and the Japanese stop buying our bonds,” Robertson explained during a CNBC interview, we could easily see [rates] of 15% to 20%…It’s a question of who will lend us the money if they don’t. Imagine us getting ourselves into a situation where we’re totally dependant on those two countries. It’s crazy.”

Crazy, yes, but true.

The US financial markets, especially the credit markets, benefit greatly from both familiarity and reputation, more than merit; past reputation, more than future reliability. But “reputation” doesn’t pay the bills.

The growth of emerging economies is “symbolic of the relative, less dominant position the United States has, not just in the economy but in leadership, intellectual and otherwise,” Former Federal Reserve Chairman Paul Volcker said in an interview with Charlie Rose this week.

“I don’t know how we accommodate ourselves to it,” Volcker continued. “You cannot be dependent upon these countries for three to four trillion dollars of your debt and think that they’re going to be passive observers of whatever you do.”

The U.S. government, like one giant General Motors, is technically insolvent. And yet, it borrows at AAA rates because of its long-term legacy of world-beating economic success. NOT because of its recent history of extreme indebtedness.

The fiscal condition of the United Sates has deteriorated dramatically during the last several years. On the basis of current obligations, U.S. indebtedness totals “only” about $12 trillion. But when utilizing traditional GAAP accounting – the kind of accounting that every public company in the United States MUST use – U.S. indebtedness soars to $74 trillion. This astounding sum is more than six times U.S. GDP. (GAAP accounting includes things like the present value of the Social Security liability and the Medicare liability – i.e. real liabilities.)

Perhaps this mind-blowingly large debt load would seem less mind-blowing if it were DE-creasing. But it is not. Instead, the current U.S. administration is amplifying the long-standing American habit of spending money it does not have.

The chart below tracks the federal budgets for both America and Brazil as a percentage of each country’s GDP. Back in 1998, the US ran a budget surplus, while Brazil was running a deficit equal to 9% of GDP. But the two nations have traded places. At last count, the U.S. budget deficit totaled an astounding 9% of GDP, while Brazil’s deficit totaled only 3.3%.

And yet, The U.S. government pays only 3.28% in interest per year to borrow money for 10 years; while the Brazilian government must pay 5.05% to attract investors to its 10-year bonds. Thus, the yield spread between these two borrowers is 1.77 percentage points – or 177 “basis points.”

A brief tutorial may be in order at this point…

Like a polite dinner guest, the bond market does not express its opinions in absolute terms. Rather, it renders a relative judgment. Its prices specific bonds relative to other bonds, or specific credit instruments relative to others. This relative pricing is known as the “yield spread.” (A very common yield spread comparison is made relative to Treasury bonds). So for example, if a certain 10-year bond issued by a corporation or a foreign nation’s yielding 6.50% at the same time that the U.S. 10-year note is yielding 4.50%, that bond is said to be trading 200 basis points (i.e. 2.00%) over Treasurys. The higher the spread over Treasurys, the riskier the debt is perceived to be.

But this is where our story takes an interesting turn. The yields on foreign sovereign bonds (i.e., government bonds) have been falling closer to U.S. yields for several years. This process has been unfolding gradually, and in fits and starts. But over time, the trend is clear. What’s not clear is who is moving closer to whom. Are foreign sovereign issuers becoming MORE credit-worthy or is the U.S. government becoming LESS credit-worthy? Or is it a little bit of both?

Whatever the case, the nearby chart illustrates the result. Using a four-year rolling average of yields (to smooth out the trend), it is easy to see that Developed World interests rates are converging toward U.S. rates. Canadian and French sovereign 10-year interest rates, for example, have been moving closer to U.S. rates for several years. (And in fact, French rates have dipped below US rates several times during the last several years).

This narrowing of yield spreads is not only evident among issuers like Canada and France, but also among emerging market issuers, especially the rapidly emerging market issuers like Brazil. Some investors might infer, therefore, that emerging market bonds are too expensive, relative to Treasurys. We would take the other side of that trade.

Risk-free Treasury bonds are not as risk-free as they used to be.

A reader asked recently how one might go about betting against long-term Treasury bonds. As it turns out, there are a number of ways to place this bet, either for the long-term and for the short term. An investor could, for example, simply sell short a Treasury bond, just like he would a stock. An investor code also bet against long-term Treasurys by executing one of the following trades:

1) Buying put options on Treasury bonds

2) Buying a mutual fund like the Rydex Inverse Government Long Bond Strategy Fund (RYJUX). Price: $14.02. This mutual fund provides a total return that inversely correlates with the daily price movement of long-term Treasury bonds.

3) Buying an ETF like the ProShares UltraShort 20+ Year Treasury Fund (NYSE: TBT). Price: $99.42. This ETF functions like RYJUX, but with much higher volatility. That’s because TBT produces a total return that corresponds to twice the inverse of long-term Treasury bonds.

4) Buying long-term put options on the iShares Barclays 20+ Year Treasury Fund (NYSE: TLT). For example, the Jan 2011 put on TLT with a strike of 100, costs about $12.00. The Bloomberg symbol on this option is VJL+MV. The Bloomberg symbol for the 90 strike from the same series of options expiring in Jan 2011 is VJL+ML and sells for about $6.70. We are not recommending these options, merely pointing them out for illustration purposes.

Joel’s Note: Please remember, Rude readers, that as of Monday, October 19, the Rude Awakening will cease to exist.  Instead, your editors will begin publishing their regular market insights, like this one from Eric, from our new home over at The Daily Reckoning. Loyal Rude readers might like to sign up – for free – here to ensure they don’t miss an issue. We hope you can join us.

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[Rude Endnote: What happened? A 200-point selloff in the Dow just like that? Well, reader David M. was right on the button when he sent this email, earlier this week:

“When you wrote ‘we expect a sudden bout reality – followed by a violent bout of bulimia…’ I got a chuckle. Don’t know if you’ve seen the lists of fractured words with humorous definitions, but “BULLEMIA” popped into mind…

“Definition: Nausea caused by excess market exuberance followed by purging of assets. Bullemia: new market terminology suitable for what I expect the markets to do in the relatively near future.”

Thanks David.

And thank you for reading.

Until next time…

Cheers,

Joel Bowman

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

• A closer look at U.S. banks’ “imbalance sheets,”
• The credit recovery and assorted other myths and frauds,
• Plus, the “Prudent Man” gets violated and other cautionary tales…

Eric Fry, examining the DNA of illusions and deceptions, reports…

In the September 11, 2009 edition of the Rude Awakening, we observed that the “recovering” credit markets might not be recovering as completely as advertised. Sure, credit spreads are narrowing, we admitted, which typically coincides with improving access to credit. On the other hand, we pointed out, total bank lending is clearly in decline…sharp decline.

These two trends “seem to contradict one another,” we observed. “First, credit spreads are contracting. I.E. the yields on high-risk debt, relative to Treasury yields, have fallen dramatically since last fall. Taken at face value, this phenomenon means that creditors have become increasingly willing to finance high-risk borrowers. But here’s the problem with this simplistic analysis: credit spreads merely depict the pricing of bonds that ALREADY exist; spreads tell you nothing about the volume or terms of new issuance. Bank balance sheets tell that story…

“Guess what? Bank balance sheets are contracting,” we continued. “In part, this contraction has resulted from events like foreclosures and writeoffs. But this contraction has also resulted from the simple fact that banks are not lending…‘Banks tightened standards on all types of loans last quarter,’ Bloomberg News reported recently, ‘and said they expect to maintain strict criteria on lending until at least the second half of 2010, the Fed said in its quarterly Senior Loan Officer survey published on Aug. 17…’

“The quantity of loans and leases on the balance sheets of U.S. banks have been declining for months,” we wound up. “At the same time, however, credit spreads have been narrowing. How could this be? Here’s your editor’s guess:…Spreads are narrowing because speculators are speculating and arbitrageurs are arbitraging. At the end of all this speculating and arbitraging, Goldman Sachs reports robust profits but Mr. and Mrs. Average still can’t get a car loan.”

Nothing much has changed during the 19 days since we first presented out pet theory. At last report, bank lending to businesses and households had declined for five straight weeks. Meanwhile, consumer credit outstanding has fallen for six straight months.

“Credit remains scarce and expensive for all but the largest – or most government-coddled – of borrowers,” Lena Komileva, head of G7 Market Economics at Tullett Prebon, observes in a recent Financial Times column.

“The economic benefits of stabilizing financial conditions and recovering wholesale market liquidity are being distributed unevenly,” Komileva asserts. “Governments, financial institutions and large investment-grade companies have attracted the bulk of finance from risk-conscious investors…[Meanwhile], asset-backed and mortgage-backed security markets epitomize the ongoing financial crisis of global finance. Securitization issuance remains depressed, down 50 percent over 2008 volume, in spite of support from the Federal Reserve’s term asset-backed securities loan facility (TALF) and the ECB’s covered bond purchase program.

“In a normal economic cycle,” Komileva concludes, “a flood of capital market liquidity would fuel a recovery. However, there is nothing normal about this cycle as major channels of finance in the real economy remain blocked…Rebuilding the liquidity arteries in the real economy remains a pre-condition for ending this crisis and ensuring a healthy and sustainable recovery into 2010. Without credit, global markets awash with liquidity will start looking bubbly.”

Even WITH credit, the markets are looking a little bubbly.

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Kinder, Gentler…and Perverse
By Eric J. Fry

The kindlier, gentler version of American capitalism that has come into fashion since last year’s credit crisis is neither kind nor gentle… at least not to capitalists. The “new capitalism” visits the sins of an imprudent minority on the backs of a prudent majority.

Instead of causing the members of the imprudent minority to atone for their sins by forfeiting the wealth, status and employment they deserve to lose, the prudent majority must make atonement by suffering a growing burden of regulation and taxation.

But won’t the guilty parties also face rising regulation and taxation?

“Not really,” is the short answer. Congress will pass punitive and restrictive measures with the offenders in mind. But the offenders still retain the mega-million-dollar operational budgets that provide armies of securities lawyers, tax lawyers, tax accountants and compliance personnel to repel the effects of regulation and taxation.

Therefore, the burden of increasing regulation and taxation becomes a kind of regressive tax that falls disproportionately on those with fewer resources at their disposal. For example, an independent brokerage firm with 30 employees faces the same regulations as Goldman Sachs. But the relative cost of compliance is MUCH higher for the small firm that lacks Goldman’s resources, budget, connections etc.

And woe to the independent firm that fails to comply with the letter of each regulation. That firm will likely be audited, fined and/or prosecuted into extinction by regulators. Conversely, no regulator would dare to threaten the survival of a large firm, no matter how often and egregiously that large firm may have violated the spirit of every applicable securities law.

Didn’t the large securities firms just spend the last several years violating the spirit of the “Prudent Man” rule that has guided professional investment practices for decades? And didn’t these large firms just lose hundreds of billions of dollars in the process? But other than Lehman Bros., none of the offending firms went out of businesses. Nor did any of the offenders’ officers go to jail…or even lose a country club membership.

Instead, the offenders received trillions of dollars of bailout funds and guarantees, while also retaining their access to preferential financing, selective securities laws exemptions, highly placed friends in government and “too-big-to-fail” status. These perversions of capitalism serve to slant the playing field toward those who least merit preferential treatment. Therefore, these perversions of capitalism serve to destroy – or at least erode – the all-important “right to fail” that has enabled American capitalism to flourish for generations.

Gone are the Absolute Laws of economic cause and effect.  Gone are the Darwinian processes that reward prudence and punish recklessness. Most of the “fittest” still survive, at least to those who can endure the burdens of regulation and taxation, but so too do many of the “un-fittest.”

Individuals, investors and corporations continue to produce the same range of successes and failures that their predecessors made over the preceding decades. Thus, the capitalistic processes of wealth accumulation, reinvestment and/or speculation continue to spit out winners and losers, just like they always have. But in the modern era, the losers don’t always lose…or, at least, they don’t always lose completely. Instead, the rule-makers sometimes change the rules midway through the game…or start the game all over from the beginning.

Unfortunately, changing rules to avoid a crisis has the unintended drawback of perverting the simplistic process of cause and effect.  And if you change the rules often enough, nobody wants to play anymore.  The participants either figure out ways to cheat, or they refuse to play the game at all… and search for some other game where the participants “play fair.”

A buyer of common stocks, for example, might begin to prefer Russian securities over the American variety. After all, if neither jurisdiction will reliably and equitably apply securities laws, why not invest in the Russian issues that carry much lower valuations and much higher growth prospects? Or to put it another way, if both jurisdictions will behave capriciously – handing out favors to cronies, while bending long-standing laws and regulations in the name of expedience – why pay a premium for American equities?

Similarly, the buyer of global sovereign bonds might begin to ask himself why he should prefer a low-yielding U.S. Treasury bond to a higher-yielding bond from an issuer like Brazil. This bond buyer might begin wondering why he should continue investing in the dollar-denominated securities of a government that is on track to pile up a massive $2 trillion deficit this year, rather then investing in the real-denominated securities of a government that is running a primary budget SURPLUS.

Brazilian bonds aren’t risk-free of course, but neither are Treasury bonds, despite their flattering AAA rating. At the very least, the yields on these two credits might converge, providing a much higher return to the buyer of Brazilian debt than to the buyer of Treasurys.

Why do we bother musing about these subtle changes unfurling across the global macroeconomic landscape? Simply because these changes influence investor behavior over time… and as investor behavior changes, so do financial asset prices, for better or worse.

Most changes occur very slowly, of course, and proceed in nearly invisible increments… like a glacier that carves a path down a granite mountain. But the results of these incremental changes are no less dramatic for having occurred very slowly. In fact the opposite is true. The thing that almost no one notices is the thing that moves mountains… often until the mountains land atop the unsuspecting and the unaware.

U.S. Treasury bonds are a “Sell”…now more than ever.

To be continued in the Friday edition of the Rude Awakening…

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[Rude Endnote: The Dow Jones Industrial Average celebrated the one year anniversary of its largest, single-day point loss in history yesterday…by edging 0.5% lower. The broader S&P 500 and the Nasdaq faired slightly better, losing 0.2 and 0.3% respectively.

Things were just getting kicked off here in Asia when we wrote these notes…and Europe was still asleep. So we’ll have to wait to see what their days bring.

In the commodity pits, crude had inched a bit higher when we checked, back up over $67 per barrel. Gold too was closing back in on the $1,000 mark, three bucks shy a few minutes ago.

We’ll be back tomorrow with more Rude views.

Until then…

Cheers,

Joel Bowman

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

• Just look at who’s buying our favorite yellow metal now…

• A cheap gold miner to keep an eye on for your portfolio,
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Eric Fry, faithfully holding a flame for his beloved, articulates his passion below…

“Gold is rising because the post-Breton Woods exchange rate system doesn’t work,” Eric Roseman, our colleague over at the Commodity Trend Alert, matter-of-factly declares. “More than ever, governments are piling up debts, as a result of bailing-out their respective banking systems. There is a price to pay for this profligate spending. And gold sniffs trouble.”

It’s true; gold has become noticeably less unpopular during the last few months. It is still not as popular an investment as, say, AIG or the shares of almost any other incompetent financial institution. But some investors have actually begun to admit that they’ve purchased some gold.

A couple of the most conspicuous gold-buyers – the Chinese government and hedge fund manager, John Paulson – represent quintessential examples of the “new” gold buyer. This new type of buyer does not also buy ammunition, bottled water and Lynyrd Skynyrd tank tops. Nor does this new gold buyer spend Saturday nights sipping Gallo Hearty Burgundy in his La-Z-Boy, while flipping through binders full of Walking Liberty gold coins.

These new gold buyers do not LOVE gold nearly as much as they FEAR paper. But they are buying aggressively nonetheless…and leaving their tracks everywhere.

Earlier this year, for example, Paulson & Co., the hedge-fund firm run by billionaire John Paulson, became the largest holder of the SPDR Gold Trust (NYSE: GLD), an ETF that buys gold bullion. The New York-based firm owned 8.7 percent of the fund, as of March 31. Paulson has also taken very large stakes in several gold mining companies – in particular Gold Fields Ltd., Kinross Gold Corp. and AngloGold Ashanti Ltd.

Paulson has lots of company among mom and pop investors who are allocating some of their capital to gold. As the nearby chart illustrates quite clearly, the SPDR Gold Trust ETF has been accumulating ever-rising quantities of gold bullion – all in response to investor demand.

Although this chart is a bit dated, the trend it illustrates remains firmly entrenched. As of September 21, this ETF controlled 1,563 tonnes of gold, making it the world’s fifth individual holder of gold. The Swiss central bank, by comparison, holds only a little more than 1,000 tonnes of gold.

Meanwhile, the Chinese doubled their official gold holdings last year, and have been making a lot of headlines with some very public gripes about the dollar. A couple weeks ago, Cheng Siwei, former vice chairman of the Standing Committee of the Chinese Communist Party, complained, “If [the Fed] keeps printing money to buy bonds, it will lead to inflation, and after a year or two, the dollar will fall hard. Most of our [Chinese] foreign reserves are in U.S. bonds and this is very difficult to change, so we will diversify incremental reserves into euros, yen and other currencies…Gold is definitely an alternative.”

No wonder rumors were running rampant last week that the 403 tonnes of gold the IMF is selling will land in a Chinese vault.

Interestingly, while investment demand for gold inexorably rises, mined production of gold inexorably declines. Apparently, the folks who coax this precious metal from the earth can’t coax as much of it as they might like.

According to Grant’s Interest Rate Observer (citing statistics from the World Gold Council), worldwide gold production has dipped over the last seven years. Gold production since 2002 has declined from 2,590 metric tons to 2,486 metric tons through June 30.

These divergent trends – demand up and supply down – do not guarantee a rising gold price, but they do suggest that a rising gold price may become the path of least resistance.

Obviously, substantial above-ground supplies of gold – in bank vaults, around fingers, in belly buttons, etc. – will find its way into the gold market if/as/when prices rise. Nevertheless, a powerful inflationary trend would produce enough investment demand for gold to easily absorb all sources of supply…and ALSO push the gold price higher.

“There is a growing distrust of paper currencies amid a deluge of massive government deficits since late 2008,” Roseman concludes. “The dollar might be the biggest drunk at the bar, but the euro and other currencies are also drinking their way to devaluation against gold.”

Chris Mayer, editor of Capital & Crisis, agrees with Roseman…and offers a few sobering words about gold in the column below…

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Gold, the Newest Old Thing
By Chris Mayer

Since the U.S. government seems committed to sacrificing the dollar to prevent ANY economic downtick, investors should become committed to owning a bit of gold.

During the last several months, the Federal Reserve, along with other central banks around the world, have been trying to combat the forces of deflationary recession by adding trillions of dollars to the money supply. In other words, they’re pulling money out of thin air, thereby eroding the spending power of the dollars already in circulation.

This process is also known as “inflation”…and forward-looking investors should increasingly seek a defense against it. Already, inflation-phobic investors have bid gold’s price to $1,015 an ounce. But it’s not hard to imagine that four-digit might be here to stay. In fact, it’s not hard to image that the first digit of the four might become a “2” or a “3” over the next few years.

What happens as even more U.S. investors, pension funds and foreign banks move into this trade? Gold prices could easily double from where they are right now. Let’s take a quick look at some key factors that could shoot gold higher, before focusing on what I think is the single best gold stock right now.

Everyone worries about China ditching dollars. Can you blame them? The Chinese, too, are gold buyers. The Chinese central bank has already doubled its gold holdings this year.

I think it could even touch $1,200 or $1,300 during the next few months. If so, you’d do pretty well just holding bullion. I even hold some gold myself. But here’s why I like gold stocks now: They did pretty well in Great Depression I. And history may repeat. Even at their lowest prices in 1933, the stocks of Alaska Juneau Gold Mining and Homestake Mining were still well above their 1929 highs. At their highest prices, they were 230% –300% higher, respectively.

Old Bernard Baruch was a principal stockholder in Alaska Juneau. It was his largest holding in 1931. Baruch was a savvy old trader and investor. He knew where the soup would stick to the spoon after Roosevelt’s New Deal policies. It would mean a devaluation of the dollar and a rise in the gold price.

Eventually, gold did surge, and so did gold stocks. “Baruch reaped an especially large profit,” his biographer James Grant writes, “for he had been buying stock and bullion.”

Obama’s stimulus plan smells a lot like Roosevelt’s New Deal. And if this is the greatest financial test we’ve faced since the Great Depression — as I believe it will ultimately be — then gold stocks may also be among the few stocks to make new all-time highs in 2009.

One of my favorites is New Gold (NGD: Amex). This company cranks out a substantial amount of gold — closing in on half a million ounces per year, plus 1.3 million more ounces of silver and 15 million ounces of copper. Yet, it’s small enough to give you the huge upside most majors can’t offer.

Right now, New Gold is pulling gold out of the ground for as little as $370 an ounce. That alone could pump up this company’s cash flow high enough to send shares soaring past $12 per share. That’s a solid triple from where it stands right now.

New Gold (NGD:amex) in its present form has been around only since June 2008. It was born of a three-way merger between the old New Gold, Metallica Resources and Peak Gold. Then, in March of this year, New Gold announced a merger with Western Goldfields.

Western owns the Mesquite mine in California, which is a stable mine with good cash flow. The key here is that before the merger, New Gold could not fund the development of its New Afton gold-copper development project without help. Now, with Western’s cash flow in the mix, it can.

The newly fortified New Gold is also significantly bigger. The new company has 12.1 million ounces of gold (measured and inferred). It is what we call a Tier II producer, usually defined as miners producing between 250,000–1 million ounces of gold per year. In today’s gold market, these intermediate producers offer some of the best risk-reward opportunities.

New Gold wants to become a million-ounce producer by 2012. It will need acquisitions to get there. But even without acquisitions, New Gold has a nice runway — a 27% increase in production, to 440,000 ounces, by 2013 just with what it’s got already. Add in a 36% fall in total cash costs and you have a potential 83% increase in profit margins in the next three years. This is one of the most appealing parts of New Gold.

New Gold has three producing mines. I’ve mentioned Mesquite, which alone should contribute about half of cash flow next year. Cerro San Pedro is in Mexico. It is a gold and silver mine. Peak in Australia produces gold and copper. New Afton is a development project in Canada that could come online by 2012.

It will produce gold and copper as well. In addition to its gold production, New Gold produces about 1.5 million ounces of silver and 15 million pounds of copper annually.

Based on the cash-flow from its current production, New Gold seems quite cheap, relative to its peers. Including Western Goldfields, New Gold should generate around 35 cents per share in cash flow. At $4 per share, New Gold shares go for only 11 times cash flow. That’s cheap compared with many of its mid-tier peers, who carry valuations in the teens. The average for Tier II gold companies is closer to 20.

So by these measures, you get some discount for owning New Gold. Some of that may well be justified given the mergers and relative newness of New Gold. But over time, as (or if) the company hits its marks, these gaps should narrow.

Insiders and management own 10% of the stock. Goldcorp, a large gold miner, owns a 4% stake. That could prove important, as New Gold is itself also a potential takeover target.

New Gold has a strong balance sheet. Total long-term debt is $272 million against cash of $141 million. That’s not much debt for a company with a $1 billion market cap. New Gold also generates good cash flow.

The allure in New Gold is not only in what a rising gold price would mean for the share price, but also in the potential “rerating” as New Gold grows and lowers its risk profile. As it delivers on its projections, lowers its cash costs, boosts reserves and builds up its financial strength, New Gold will command the higher valuation afforded such gold stocks.

Even without that boost, though, New Gold could produce 60 cents per share in cash flow by 2012 — just over two years from now — assuming only $900 an ounce for gold. Even 10 times that cash flow would give you a $6 stock.

Of course, I wouldn’t own it if I thought gold was only going to be $900 an ounce by 2012. I just show you that to give you an idea of the kind of room you have to make some money here.

You can always have fun with numbers when it comes to this kind of thing. A $1,200 gold price means nearly $1 per share in cash flow. Slap a 10 multiple on that and you get a $12 stock. New Gold trades around $4 as I write.

The usual caveat applies with gold shares — they are speculative. Mining is a tough business. So be careful how much you buy. I always liked writer James Grant’s phrasing, that gold is the “investor’s guilty pleasure.”

Joel’s Note: Chris is a Rude favorite and we feature his insights as often as we can…but, in deference to his paid subscribers, we can’t give away all his best ideas. For instance, a little while ago Chris alerted his readers to a way they can gain exposure to commodities with a special royalty kicker. It’s a way to tap the upside potential of resource plays, without many of the complications associated with what is, traditionally, a very tough sector to invest in. For more information, check out his resource royalty overview right here.

— Urgent: From The Desk of Addison Wiggin —

Major News Outlet Calls This the “Next Crisis”…

THE GREAT AMERICAN”RECOVERY RIP-OFF!”

America on the mend? HORSE HOCKEY!

Here’s what’s real: Brace yourself for what’s about to go down as the BIGGEST FINANCIAL SWINDLE in world history, engineered by none other than Wall Street and Washington, D.C.

How does their scam work? It’s a crafty “triple-swindle” just clever enough that most Americans won’t even see it happen… until it’s too late!

The short of it is, every three days, these flim-flam artists use this strategy to secretly suck wealth out of your savings account. Don’t Be Fooled. Read On Here.

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[Rude Endnote: Here’s some news for the Rude faithful (and unfaithful alike).

We’re moving to a new home!

Yes, Rude reader, the time has come to move to a bigger, more accommodating abode. So, as of Monday, October 19, your editors will be publishing their daily missives under a headline you may already recognize: The Daily Reckoning.

We’ll have a bit more room to move over at the DR H.Q. and we’ll be able to bring you more insights from a wider range of authors. But don’t worry, the coffee-stained edge will come with us. (We couldn’t leave that behind if we tried.)

So, how does this impact your daily dose of Rude? Well, for now, the best thing to do is to simply visit the Daily Reckoning home page where you’ll be able to familiarize yourself with the content there. You can sign up there too, just to make sure you’re on board when the big switch happens.

We’ll send plenty of reminders before the change but, for now, that is a good place to start.

More information about our big move will be forthcoming before October 19^th …so keep an eye on this space as we update it.

Enjoy your weekend…

Cheers,

Joel Bowman

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