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.

• Did you listen to what Dick had to say about gold?
• Dinner and drinks with the world’s largest U.S. dollar holders,
• Plus, Rude Awakening ends THIS WEEKEND, Mayer’s $1 offer is back and plenty more…

Joel Bowman, reporting from Taipei, Taiwan…

A Korean and his Scottish girlfriend and a Norwegian-born American and her Aussie boyfriend sit down for Japanese barbeque in Taiwan. If only we had a punch line…

Last night your editor joined a visiting couple for dinner at our favorite restaurant here in Taipei. After liberal helpings of marble beef, buttered scallops and spiced, seasonal vegetables – and enough warm sake to melt the polar caps – we wandered over to one of the local jazz bars. The area is popular with visiting Japanese businessmen, so we weren’t surprised to find it packed.

After a few more sakes and we found ourselves talking to Atsushi, a Taipei-based businessman originally from Tokyo. Pretty soon, the conversation turned to stock markets and the direction of the east versus that of the west.

“I have most of my money invested in the Japanese markets,” he informed us. “But it hasn’t done much for…well…a long time. It just kind of sits there…

“Maybe the Yen is too strong, right now,” Atsushi continued. “That hurts our exports and makes it hard for our companies to compete. Plus, American’s are cutting back, you know.”

“No kidding?”

“They are saving…but they are saving in dollars. The dollar has already fallen so much this year…it means they are really not saving that much, measured in their own currency.”

“But their debts are in dollars too,” we added, just for the sake of discussion. “It’s hard to go broke if you can pay back debts in a currency you can print.”

“Yes, but that won’t last forever,” Atsushi said with a certain confidence. “Besides, we have quite a few of those American dollars in Japan. Same for China.”

“And Korea,” our friend added. “We have some too!”

Everyone has dollars, Rude reader. They are flooding the world, printed and pushed by the Feds so American consumers can buy Chinese, Japanese and Korean knickknacks and so the U.S. government itself can purchase (on your behalf) Wall Street’s least efficient banking and insurance firms…and the nation’s auto makers…and the citizens’ mortgages…and their student loans and car loans…

French president Charles De Gaulle once described America’s reserve currency status as an “extraordinary privilege,” but, as our Japanese friend observed, it won’t last forever. You’ve heard the warnings and threats from China, Russia, Brazil. You’ve read the rumors that the OPEC nations were going to ditch the greenback…and you saw what it did to the world’s reserve currency in a matter of days. You’ve even seen Chinese students laugh in the face of Timothy Geithner as he assured them that their dollar holdings were safe.

And more recently, as the rest of the world looks for ways to go “ex-dollar,” you’ve witnessed the rise and rise of our favorite precious metal.

In today’s Rude Awakening, our second last issue ever, we bring you another essay from the “remembering Rude” vault. We originally published Mr. Chris Mayer’s remarks on gold back in February of this year and, with gold bumping against all-time nominal highs, readers who took his advice faired pretty darn well. Please enjoy…

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Buy Gold…We Really Mean it This Time
By Chris Mayer

His name was Dick Baker. Mark Twain called him an old friend and wrote about him in Roughing It (1872). He was the pocket miner of Dead Horse Gulch.

Twain and Baker would wander up in the hills of California, panning for gold. Pocket mining was a specific method in which miners hoped to zero in on the richest deposits “whose vagrant grains of gold have escaped and been washed down the hill,” as Twain wrote, “spreading farther and farther apart as they wandered.”

Sometimes all you needed was to find one spade’s worth of gold. That alone might pay $500 back then. “Sometimes the nest contains $10,000,” Twain relates, “and it takes you three or four days to get it all out.” The pocket miners told tales of finding $60,000… even $120,000 worth of gold, a fortune in those days.

Investing in 2009 is a little like pocket mining: A lot of panning around looking for that worthy payoff. But for the first time in a couple of years, the business of gold mining itself looks attractive, for two important reasons. One has to do with the big picture. The other involves the underlying economics of gold mining, which are attractive even if the price of gold goes nowhere.

As to the first, I’ll be brief, because it’s not the most compelling reason to buy gold stocks in my opinion, yet it’s the one most everyone spends most of their time talking about. It’s that the U.S. government is spending money like there is no tomorrow, which is bound to lead to printing a lot of money (read: inflation) and hence a rising gold price. It’s true, though: You couldn’t draw up a better scenario for gold than what’s going on right now.

Even some sharp-eyed value types – usually buried in the footnotes of their favorite companies, rather than speculating on the price of gold – find themselves drawn to the yellow metal. Indeed, some even seem apologetic about it. “We never thought we would ever buy gold or gold stocks,” writes David Einhorn in his latest quarterly letter to shareholders of his Greenlight Capital.

He talks about his grandfather, who was a gold bug and for the last 30 years of his life bought only gold and gold stocks. Since the age of 10, Einhorn heard warnings from his grandfather about the ravages of inflation and the dangers of the government’s printing press. And of course, for most of those 30 years, gold was a lousy investment. “Being patient is one thing,” Einhorn writes. “Being ‘wrong’ for three decades is quite another.”

Today, Einhorn admits to seeing old Grandpa’s ideas playing out. He’s buying gold and call options on a basket of gold miners.

Behind the bigger picture, though, there’s a more compelling reason to buy gold stocks today. First: The price of gold miners as a group is off more than 20% in the last year, even though the price of gold has held firm. Add to that mix falling mining costs in 2009 and you have a recipe for explosive earnings.

As gold analyst John Doody points out, oil accounts for about 25% of the costs of running a mine. Gold miners use a lot of energy to power big shovels and dump trucks and to haul ore. The price of oil, as you need not reminder, has collapsed. It’s down more than 70% from its high in July. For the first three quarters of 2008, gold miners had to contend with an average oil price around $118 a barrel. Barring a huge rally in oil, gold miners will reap a windfall in lower oil costs oil since then. As I write, oil is $36 a barrel.

Not only will gold miners get the benefit of lower oil costs, the currencies of the gold-producing countries have all fallen against the dollar. This means their costs are lower today in dollar terms. Consider, for a moment, where the gold comes from. In the mid-1990s, four countries dominated gold production and made up more than half of global production. They were Canada, Australia, South Africa and the U.S. But by 2006, these four producers made up only about one-third of global production. Today, you see China produce a lot of gold, as well as Peru, Mexico, Chile and countries in Africa. (This according to Frank Holmes’ book The Goldwatcher. The book, by the way, is a must-have manual for gold investors. Part II, in particular, has a wealth of gold investing strategies and insights.)

Many gold mining stocks today have assets in countries where the currency is falling against the dollar. As Doody says, “All the commodity nation currencies – the Canadian dollar, the Australian dollar, the South African rand, the Brazilian real, the Mexican peso – they’re all down 20-40%. When your mining costs in those countries are translated back into U.S. dollars, they’ll be 20-40% lower.”

Those two factors – lower oil costs and currency effects – mean gold profits should be higher in 2009 than in 2008 even if the price of gold goes nowhere.

I’ll add one other reason to like gold stocks here: 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% and 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 of the few stocks to make new all-time highs in 2009.

If Twain were still kicking, I think he’d go look for his old friend Dick Baker, the pocket miner of Dead Horse Gulch, and head for those California hills.

Joel’s Note: Want all of Chris Mayer’s best research for a buck?

Well, here it is: A no muss, no fuss offer to test drive Mayer’s Special Situations for one month…for a single dollar.

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—————————————–

[Rude Endnote: And that’s it…the final weekday edition of The Rude Awakening. From Monday onwards, you’ll be able to catch us at The Daily Reckoning, where we’ll continue publishing our daily missives.

If you haven’t already signed-up to receive the DR (for free, of course), you can still do so right here.

We hope you can join us.

Cheers,

Joel Bowman

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

• Did you buy this argument on March 11? You should have…
• The Mayer’s Special Situations Dollar Offer returns,
• Two more Rude issues and it’s adios! You comin’?

Joel Bowman, trying not to interrupt for long, from Taiwan, Taipei…

It is often said that those who do not learn from history are doomed to repeat it. But who cares about those who don’t learn? What about those who do? And, more importantly, what about those who actually PROFIT from their keen attention to relevant historical details?

On March 11 of this year – a mere 48 hours off what is still the year-to-date market low – we published in this space an article by Rude favorite and part time financial historian, Chris Mayer. In his column, Mayer boldly made the case for stocks, arguing that the then fresh market collapse had ushered in a “bull market in buying opportunities.”

There was plenty of blood on the streets when Chris and his readers waded back into the market. It takes a lot of courage to do that…but it also requires an astute sense for the lessons of history, the kind of sense Chris brings to his research service, Mayer’s Special Situations.

Today, as part of our “remembering Rude” series, we present the original column, with lesson intact. Please enjoy…

—- Chris Mayer’s Special Situations $1 Trial Offer —-

URGENT ALERT: Latest research points to early November as the final window of opportunity…

You Can Struggle and Sweat to Make a 74% Gain… or I Can Show You the Easy Road to 234%

Three powerful, irresistible forces are set to drive up this asset by 74% in as little as 18 months…

You could harness these forces to generate 234% gains in even less time than that…

And I’ll show you how today for just $1.

———————————————-

A Bull Market in Buying Opportunitiesv
By Chris Mayer

Wall Street trader David Feldman lived through the Great Depression. In 1997, at the age of 87, he set down his thoughts in a little memoir entitled, “The Ups and Downs of a Wall Street Trader During the Depth of the Great Depression of the 1930s.” Interesting that he felt the need to apply “of the 1930s” to his title, so as not to confuse it with others that would follow.

In this memoir, I find some parallels to today. As an investor, the key takeaway for me is to proceed in 2009 with a great deal of caution. If I could sum up a game plan for 2009, it would be to stay with cash-rich and debt-light investments.

Let’s begin with the aftermath of 1929, which is not so dissimilar from the aftermath of the 2007-8 selloff. There was nearly universal optimism after the crash of 1929. When the pundits peered into their crystal balls for 1930, they were bullish to a man.

Feldman writes: “My research has uncovered nearly 50 prophesies the country’s leading businessmen, bankers and government officials contemplated as we slid into the worst economic calamity in the history of the United States. With the exception of a single one, every prediction of conditions in the cheerless year of 1930 was optimistic, even considerably upbeat.”

You could make the case that we see the same sort of thing today. Last fall, the legendary Warren Buffett was urging investors to buy stocks. He even published his bullish musings in a New York Times op-ed piece. Meanwhile, many longtime bears on the stock market were turning bullish. “This is the time to buy,” they said. But it was not EXACTLY the time to buy. The Dow has shed another 2,000 to 3,000 points since these various declarations of “the bottom.”

Most high-profile investors from the late 1920s behaved similarly. The lone exception Feldman found in 1930 was an editorial in the Times by a group of German financiers in Berlin. They predicted that “stocks may enjoy a big temporary recovery, but no prolonged bull movement is considered likely for several years to come.” Bull’s-eye!

Stocks slid to new lows by 1932. A short table of some issues selected at random by Feldman shows the damage:

After the crash, people and businesses did cut back, even though their financial leaders saw a rebound. And we’re seeing this now in our day. Consumer spending is falling. Capital spending is dropping. Another writer on the Depression, Frederick Lewis Allen, notes how the crash also wrecked the credit system. It endangered “loans and mortgages and corporate structures which only a few weeks previously had seemed as safe as bedrock.” Debts that once seemed bearable become a worrisome and heavy burden. Again, we’re seeing this unfold today as companies try to wriggle free of suddenly oppressive debts by trying to raise and conserve cash.

Statistics alone, fail to capture the economic devastation of the 1930s. But the statistics are breathtaking. The amount of money paid out in salaries dropped 40% from 1929-1932, according the National Bureau of Economic Research. Dividends fell 56%. The unemployment rate was about 25% in ‘32.

One thing we haven’t seen yet, but probably will, is a lot of consolidation among business. In the 1930s, Allen notes how there was “more zeal for consolidating businesses than for expanding them or initiating them.” With stock prices low, the cash rich in Corporate America have a chance to steal some things. Why invest in new oil wells when you can buy ‘em in the stock market for less than half of what they would cost you to drill new ones? Why build new factories when you can buy a competitor for 20 cents on the dollar?

As it turns out, the early 1930s were a good time to buy stocks, with one very important caveat: Avoiding companies that failed completely. As Feldman points out: “Stock prices [in the 1930s] were so low that so long as a company did not go out of business, practically anything you might buy was certain to go up, if not sooner, then later.” (Emphasis added). We might call this “Feldman’s Law of Depression Investing.” That caveat was not as easy to avoid as it may sound. By the end of 1933, more than 5,000 banks had failed. Thousands of businesses had also failed.

Feldman lost a lot of money in the crash and its aftermath, like almost everyone else. So what did this brutal experience teach him? “One thing that this experience taught me was that, in investing, you should never cry over spilt milk,” he writes. “Only the future is of importance.”

I don’t know if we are headed for another 1930s-style Depression or not. I think we are close to a precipice where that is more a possibility than at any time since the 1930s. Whatever the case, it will be critically important to stay with the cash-rich and debt-light companies. That’s where my focus is. “Cash was king,” Feldman writes of the depth of the Great Depression. “If you happened to have any, you were really in the driver’s seat.”

I want to be sure that I stick with the survivors and companies that can continue to build wealth, even if it doesn’t show up immediately in their stock prices. When we come out of this contraction, it is the stock in these companies that will pay off big.

Though the bear market of 2008-9 may seem like a calamity now, it may prove otherwise over time. As that great 17th-century wanderer, Jack Casanova, wrote in his memoirs: “My ill fortune, no less than my good, proved to me that…good comes from evil as evil comes from good.” Likewise, 2009 may be good fortune in disguise, as it allows us to pick up new ideas on the cheap.

Joel’s Note: If you would like to take a gander at exactly the kind of work Chris does, you can now do so for only $1. That’s right, back by popular demand is the Mayer’s Special Situations one-month, $1 trial offer.

So go ahead, kick the tires for thirty days before you decide whether it’s right for you or not. You get full member access to all his reports, the complete portfolio and a month worth of his service for a buck. Interested parties can proceed directly to the sign up page here.

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[Rude Endnote: Today is the second last Rude issue! Only tomorrow to go then we’re off to publish our insights in The Daily Reckoning. Have you signed up yet? If not, you can do so here for free.

That’ll be all…

Cheers,

Joel Bowman

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

• 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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[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

• The ultimate contrarian indicator: Greenspan declares recovery,
• Gold goes ballistic…but beware the Roosevelt years ahead,
• The long, slow death of the dollar continues and more…

Joel Bowman, reporting from Taipei, Taiwan…

Watching these markets is a bit like watching a game of Jenga, only the pieces are real economies, made up of real companies that employ real people…none of whom are particularly well equipped to suffer a fall from great heights.

But still the blocks come out from the foundation…and still the tower grows higher.

Under the spellbinding influence of recovery rhetoric, investors again piled into equities last week. The Dow Jones Industrial Average had grown 4% by Friday’s close. The 500 companies averaged by the S&P index did even better, finishing the week higher by 4.5%.

How long can they use fragments from the foundation to build higher the spire? The Feds can keep the illusion running for a while, but the structure grows more fragile with every passing day. We wouldn’t hold our breath…but we wouldn’t breathe too hard either. Having retraced over 50% of their initial selloff, stocks look mighty wobbly any way you dice them.

“If the bullish investors on Wall Street are too optimistic,” Eric Fry observed in this space last week, “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,” Eric continued, “and there’s very little indication that earnings will improve – much less, accelerate – any time soon.”

Meanwhile, it is the gold/dollar story that has everybody in a real frenzy at the moment. The yellow metal is forging ahead. The greenback is taking a beating. A few more months of this kind of punishment and they’ll have to have a closed coffin service for the world’s reserve currency. By then, not even a founding father will be able to love its beaten mug.

Only two weeks ago, just after the G20 shindig in Pittsburgh, Timothy Geithener reiterated Washington’s “commitment to a strong dollar.” Then, last week, The Independent ran an article claiming that certain countries – China, Russia, some OPEC nations – were looking to ditch the greenback as their currency of crude trade. The news cleared the dollar store like a cigarette clears a room of pregnant women. Evidently, the word of the Treasury Secretary of the United States is worth nothing next to a few – later discredited – inches in an English newspaper.

Fearing the game may finally be up, investors – both man- and country-sized – are looking for a way to “get out of the dollar.” Many have bought gold. The metal crashed through resistance barriers like a prizefighter punching through wet napkins last week. $1,020…$1,030…$1,040…$1,050…

In the column that follows, Bill Bonner raises a few questions about the foundations of any recovery and the future of the world’s reserve currency. Please enjoy…

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Chronic Depression
By Bill Bonner

Last week, the Australian central bank became the first to declare victory. It raised its key lending rate 0.25% and gave a whoop…signaling an end to the slump. The European Central Bank fidgeted and vaguely threatened to raise rates too. But the Americans stayed in their trenches. New York Fed governor Bill Dudley said that even though the economy is recovering, any rate hikes in the United States would be over his dead body.

Then, word came that even Alan Greenspan thinks a recovery is underway.

“This is what a recovery looks like,” said the maestro. That settled the matter as far as we are concerned. Alan Greenspan didn’t see history’s biggest financial bubble until it exploded in his face. In the following few words we undertake to show that Greenspan is as blind as ever.

“Great time for US consumers, America is on sale,” says an item at YahooFinance. The “discounts are unbelievable,” adds a blogger known as Frugal Rhode Island Momma. All across the nation, merchants are no longer selling the merits of their products; they’re selling price. McDonald’s advertises its “dollar meals.” Hotels have cut room prices by 20% in the last year. House prices are down about 30% since 2006. Sellers are offering bargains and they want buyers to know it. “Sold for $365,000 in 2006. Now $195,000,” says a typical house ad.

Foreigners have noticed too. Colleagues in London say they are thinking of moving to Florida where they will get far more for their money. The dollar falls; foreign purchases go up. Stocks, for example. In the first quarter, foreigners were unloading US shares. Now they’re buying more than $100 billion worth per month.

It is a deflationary world, at least that part of the world between the Rio Grande and the 49th parallel. The CPI in the United States is negative and falling faster than at any time in 59 years. Households can only be induced to spend money by cutting prices. “Cash for Clunkers” cut prices on new cars by about 20%. As soon as it ended, so did auto sales. Most new house sales could be traced to a tax credit – which reduced the down payment by at least 20%. That program is scheduled to end in November.

And now, the White House frets about jobs. Unemployment is supposed to be a lagging indicator, but this time it seems to have dropped out of the race all together. Still, Congressional elections are coming up. Unemployed voters are surly and unreliable. So, the Obama administration is considering a $3,000 tax credit to bribe businesses to hire them. If the typical employee costs his firm about $40,000, this effectively reduces the cost of labor by 7.5%.

It’s beginning to look more and more like the Roosevelt years. By the end of this year, all the jobs created during the bubble era – 2002- 2007 – will have been eliminated, making it the first decade with no job growth since the ’30s. We’re expecting a fireside chat any day.

Typically big businesses cut workers in a recession. Then, when the economy recovers, small businesses are quick to take them back. But this is unlike the typical post-war recession. This time, deprived of capital as well as customers, small businesses don’t have a chance. Neither does a genuine recovery.

The authorities still do not understand what is going on. They are used to fooling most of the people most of the time. They think they can dupe them again – with bailouts and boondoggles. But real demand has vanished as households try to pay down their debt. That is not going to change anytime soon. Not while the federal government is sabotaging a genuine recovery. It’s savings – capital – the US economy needs. A capitalist economy in which the capitalist have no capital won’t work. Why is there no capital? Because the feds take it.

Supplying cash-for-this and cash-for-that is an expensive proposition, especially when tax receipts are falling. The money has to come from somewhere. As it turns out, the feds borrow it from the very people who are trying to rebuild their personal balance sheets. Of the $1.6 trillion the US government will borrow this year, the biggest single lender is the private sector, chipping in $700 billion. But instead of being put to use in a way that might stimulate a real recovery – providing credit for small business and consumers – it is taken up by the US government and then frittered away.

The banks are happy to play the government’s game too. They can borrow overnight money from the Fed at only one quarter of 1%, annualized. But lending to small business is hard work. And it is risky. Why bother? The US Treasury will pay them 4 % for lending back to the government, long term. This is practically free money to the banks. Both the bankers and politicians end up ahead – with a bigger piece of the economy under their control.

Meanwhile, the real economy staggers. “Drought of credit hampers recovery,” summarizes The Wall Street Journal. The United States needs to create a million and a half new jobs each year just to keep up with population growth. Currently there are 15 million people without jobs already…and a couple hundred thousand more unemployed every month. And if this recovery continues long enough there won’t be a single person left in America who still has a job.

Even if the economy could be stabilized, it will leave millions without jobs – more or less permanently. Add the people working reduced hours, and those who have been looking for work so long they are no longer counted, and their families, and you have a quarter of the population without money to spend. That’s why this slump is not going away any time soon. As in Japan in the ’90s, we may have to live with this depression for the rest of our lives.

Joel’s Note: Word came in over the weekend that the updated, second edition of Bill and Addison’s book, Empire of Debt: the Rise of an Epic Financial Crisis, was back atop the Amazon bestsellers list. Could it be that people are beginning to wonder about the foundations of the Great American Jenga Economy? One can only hope. You can grab a copy yourself for a nice little discount right here.

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[Rude Endnote: Don’t forget, this is the last week we will be publishing our daily missives in this space. From next Monday, October 19 onwards, you ca catch us over at The Daily Reckoning. To ensure you don’t miss a single issue, sign up free here.

Until tomorrow…

Cheers,

Joel Bowman

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

• A bull market in vacancies sweeps Midtown Manhattan offices,
• Corporate cutbacks continue even as commentators declare recovery,
• And we invite you to kick off your shoes and drift off to paradise…

Joel Bowman, reporting from back in Taipei, Taiwan…

A friend called us from New York City recently with the news: “That’s it, buddy. They finally let me go…along with another 20% of my department. Frankly, I’m surprised I lasted this long.

“But it’s a good thing,” our mate continued, “It really pushes me to get this [new] thing up and running.”

Our friend is an entrepreneurial young man with goals of owning and running his own business one day. He’ll probably succeed, too…which is why we were happy to see him made redundant from his soul-destroying job at a large, Manhattan-based financial services company.

“Have you seen the movie Office Space?” he asked, trying to explain the corporate life to your gypsy editor. “It’s just like that. Everyone has ten bosses and every boss has another ten of his own. You spend your whole life going out for drinks with these people, schmoozing and trying to get a foot on the next rung of the ladder. Everyone does it…and everyone hates it. Then, one day you just look around and think, ‘God, it this all there is?’”

Our friend’s story is not at all unique. According to Kenneth McCarthy at brokers Cushman & Wakefield Inc., 80,000 pink slips were handed out in New York over the past 18 months alone. Last month the unemployment rate there rose to 10.3%, the worst in more than 15 years. And, despite parroted proclamations of recovery from every necktie on every news channel, firms up and down Manhattan are still cutting back.

As these firms “streamline” their workforce, they also find themselves with plenty of unnecessary workspace. Back in the bubble days, companies might have just converted the unused area into a cigar lounge for the tens of tens of bosses…or a ping pong room to get the creative juices flowing…or another conference room to execute their backlog of deals. But now, those deals have dried up. Times are tough and cash-strapped companies are squeezing every dollar they can from every inch of available carpet space. Ergo, a new bull market has arrived in Midtown Manhattan, as the chart below illustrates.

Vacancy rates are at their highest since the third quarter of 2004, according to research from Cushman & Wakefield. Meanwhile, rents fell 5.2 percent from the second quarter to $57.08 a square foot and were down 22 percent from a year earlier.

All in all, it’s a pretty tough time to be hocking real estate in New York City. Fortunately, not everywhere is New York City. And, as we are prone to say, it’s always happy hour somewhere in the world.

So rather than regale you with sob stories and hobo harbingers, we thought we’d dedicate the rest of today’s issue to a place where the happy hour bell is ringing rather loudly these days.

See if you can guess the locale with these few hints:

• The local currency is appreciating against the dollar and the government has amassed an impressive $255 billion in foreign reserves…
• A recent oil discovery has drawn billions of dollars in trade deals and loans from countries eager to do business there…
• Already the world’s largest producer of sugarcane and coffee, this country is also a net exporter of cocoa, soybeans, orange juice and tobacco…
• Half the country is covered in rainforest…
• Its beaches are almost as world-renounced as the bronzed, lycra-clad woman (and men) who adorn them…
• The local drink is an intoxicatingly refreshing mix of cachaça, lime and muscovado sugar served over crushed ice…
• They just added the 2016 Summer Olympics to their list of upcoming festivities, which also includes the 2014 World Cup…
• And finally – and rather conveniently – the cost of real estate there is not so dissimilar to the kind of severance package a downsizing New York finance firm might pay out…

We are talking, of course, about Brazil, one of the so-called “BRIC” economies (Russie, India and China being the other three).

At this point, we’d like to ask you to “X-out” of your excel spreadsheet for a second, grab a cup of coffee and take your shoes off. Lee Harrison, editor of International Living, shares some details from paradise in today’s column. Please enjoy…

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The Hidden Side of My Brazilian Island
By Lee Harrison

I sped across the causeway and penetrated the lush, tropical landscape of the island of Itamaraca. But instead of continuing through the hills to the popular beaches, I veered left…toward the mysterious “north end” of the island.

It’s the end that few people ever see, and even fewer buy property in.

I got off to a quick start on the nicely-paved road, but the paving only lasted 100 yards. After that, it was a jarring, bumpy dirt road that continued for the next half hour, during which I traveled less than four miles. I drove through a lush forest preserve, skirted winding rivers, climbed hills, and even passed an old prison with its odd museum inviting passers-by to stop in.

But when I crested that last hill it was worth it, as I looked down on the small village with the shimmering blue Atlantic stretched out beyond.

The “north end” of Itamaraca is a hidden jewel. In fact it’s so well-hidden that I’ve never been here before…even though I live on the same island, just a few miles away. There are three main areas that draw people to this part of the island: Praia do Sossega, Enseada dos Golfinhos, and Ponta da Ilha (aka Pontal da Ilha).

Praia do Sossego is the only one of these areas that I’d consider a town. And even then, I use the term loosely. The village has a general store or two, a restaurant, a bar, and a couple of other businesses. Otherwise, it’s a mixture of small vacation homes, luxury villas, and a handful of fairly new condos. A couple of small beach bars and a long stretch of white-sand beach round out the amenities. Praia do Sossego (restful beach) is the first landing you’ll make on the north end, whether you’re arriving by road, or by the ferry crossing. The ferry costs about 50 cents at high tide, and half that at low tide. But don’t plan on taking your car on the voyage…

As you travel up the fine-sand beaches to the north, the next populated area is Enseada dos Golfinhos (inlet of the dolphins). This sector feels fairly new, and consists mainly of vacation homes; some of which are quite luxurious. Amenities here are even slimmer…a small general store and a couple of beach bars that serve fresh seafood and cold beer.

At the top of the island, it takes on a more upscale feel as you enter Pontal da Ilha (Point of the Island). This part of the island seemed to have the highest concentration of nice homes, the widest, calmest beach, and the most well-kept surroundings. The roads were in good shape, I saw no litter or disrepair, and they even had a neighborhood watch association to keep an eye on things.

Pontal da Ilha faces north instead of east, so it does not see the head-on wave action of the Atlantic. So the waters here are deep blue and very calm. The beaches enjoy views of the ocean to the right, the estuary to the left, and the hills and homes on the mile-distant neighboring mainland.

And property prices are amazingly low for a haven with such peace and natural beauty. I saw two lots on the beach at Pontal da Ilha selling for right around $30,000 (they were on the beach pictured above.) In Enseada dos Golfinhos or Praia do Sossego, a nice vacation home (not beachfront) will set you back between $32,000 and $45,000. A two bedroom, one-bath condo in a small, new beachfront project is going for $47,000.

But remember, this area is remote, and there are few amenities. If you come to the north end of Itamaraca, don’t come for the nightlife…come for the peace, tranquility, and natural beauty.

Joel’s Note: Are you interested in the lifestyle and investment opportunities that South America has to offer? As it so happens, your senior editor, Eric Fry, will be presenting at an investment conference in Buenos Aires next month and the hosts have asked that we extend a warm welcome to our Rude readership. For more information on the event, see here.

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[Rude Endnote: Yeah…there’s no hope of us doing any work now. We’ve got about ten screens up, all searching for beachfront real estate around the world. Markets…you can wait until next week.

Until then…

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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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 —

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[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