Great Expectations

The Daily Reckoning PRESENTS: We mentioned in yesterday’s issue that this week is packed with data that could be very telling about the health of the nation’s economy in 2006. Dan Denning explains what we should really be examining…


A whole raft of economic data is supposed to tell us this week what we can expect from stocks and the economy. New construction spending, the Fed’s last meeting notes (what will they do next?), auto sales, payrolls, factory orders, hourly earnings…all new grist for our analytical mill. And all a waste of time. Mostly.

You can learn everything you need to know about the American economy by sitting at the gate of a terminal at Los Angeles International Airport for two hours. On the one hand, diversity. You’ll hear Chinese, Spanish (seemingly the co-official language of California), French, and dialects from the subcontinent that sound musical. A lot of people are coming to America, or at least passing through it and spending money.

But don’t expect to find any good service. The bars and pubs were packed with people and trash, much like the concourse. The service everywhere, almost without exception, was uninspired and shoddy. Now, don’t get me wrong. I’ve not become an elitist in my travels. After all, you’re reading a scribbler who paid his way through college manning the till at a Texaco station.

What I’m getting at are the extraordinarily exaggerated expectations in America over what it takes to get and stay ahead. “States Take Lead in Push to Raise Minimum Wages,” reads a New York Times headline. Do these states not know that 3 billion people are competing with Americans for jobs? Can’t they understand that by that math, wages will fall until Americans catch down with their global brethren?

As a would-be economic missionary over the last few years, I’ve found that the American economic gospel is flawed, maybe even heretical, if you ask Dr. Kurt Richebächer. The economic pagans of the world do not worship the god of consumption. No American will be left unchanged by our inevitable encounter with the ambitions of the rest of the world.

Granted, not all jobs can be outsourced. But what’s really amazing when you travel outside America and then come back is the expectation that the American standard of living is a birthright that doesn’t have to be earned by hard work. I’m generalizing. Of course, there are exceptions.

Lots of people work hard every day. But I wonder if most people have any inkling of the great global wealth migration I described in The Bull Hunter, the one that will punish nonsaving, nonindustrious, debt-laden consumers, but reward certain investors.

Take a look at the world’s stock markets and you’ll see what I mean. The Dow finished down. Up was the Nikkei by 40%. Up was the FTSE by 17%. Up was Australia’s ASX 200 by 17%. Up were France, Germany, and Switzerland.

Say what you will about Old Europe politically. Economically, there are still problems too, namely a lack of consumer spending to drive growth. But maybe most consumers in Europe are less sure than their American cousins that the future will be infinitely better. They are less willing to pile on credit today and pay the interest on it with declining real wages. Americans feel no such compunction, and finance their high expectations with rising interest rates.

But borrowing money does not create wealth automatically. Business investment generally does. And in 2006, like in 2005 and 2004, a lot will come down to whether businesses invest. “U.S. growth may hinge on business.” Duh. The story goes on to point out that with falling house prices, business investment should step in to fill the breach and drive the economy. New investment will create new incomes and everything will be fine.

But wait, there’s more! “Despite high debt levels,” we are told, “it is still safe to say that Americans will somehow continue to buy on credit, and with energy prices falling, wages now diverted to gasoline purchases should be freed up to spend on the array of goods and services that drives the economy.”

That’s right. Energy prices will fall. Higher interest rates will not dent consumer spending. What’s more, higher interest rates will not deter businesses from borrowing either. Quite the contrary. Businesses will spend! Spending and consuming rather than saving and producing will be vindicated as the surest way to wealth in a competitive world.

People who think like this are the same kind of people who took videos of the 2004 Boxing Day tsunami as it rolled toward them. They are doomed.

Now is a good time to become an exception to the rule. If American markets are down, look to foreign markets. If real wages are falling in America, look to higher stock market returns from overseas to drive your portfolio. And when all else fails, buy gold and energy investments. They are going up as a consequence of the tectonic shifts in the global economy.

The yield curve – the spread between short-term and long-term interest rates – inverted briefly last week. No one much seems to care, though. It used to be that an inverted yield curve predicted a recession. Anyone demanding higher interest rates for, say, a two-year loan than for a 10-year loan has some pretty serious concerns about the immediate future. To ease those concerns, they demand compensation through a higher yield on their short loan.

None of that matters anymore, we are told. Why? Well, long-term interest rates are being kept down by foreigners who simply adore U.S. Treasury bonds. This steady bull market in long-term U.S. bonds keeps long-term rates down, while the U.S. Fed raises short-term rates. If it’s a conundrum – as outgoing Fed Chairman Alan Greenspan once described it – surely it must be a pleasant one. Will it end anytime soon?

Yes. There are two reasons why. First, Asian central banks have supported the dollar by buying U.S. bonds and keeping rates low. They’ve done this to recycle trade profits back into the American economy and to keep Americans solvent. They also had the nagging problem of what to do with huge dollar trade surpluses.

As the returns on U.S. investments decline (stocks, bonds, trade profits that fall as interest rates rise and consumer spending declines), it will make more sense to begin investing in their own markets. That kind of investment will do what it always does: create demand, i.e., spending. In other words, the whole purpose of Asian macroeconomic policy will shift from producing cheap goods for America to promoting more balanced growth at home (the Money Migration again).

Why bonds when you don’t need to support the dollar anymore? Why, indeed. Long-term rates will move up as the world’s dependency on U.S. growth wanes. And then there’s OPEC.

As you may know, huge petrodollar surpluses have supported the U.S. bond market – and more and more of them are being directed toward investment in local markets, not the U.S. bond market. Granted, building a city from scratch in the middle of the desert, as the Saudis plan to, might not be the most efficient kind of investment. But then again, what do I know about Saudi investment needs?

I do know that the rest of the world often looks at America with a suppressed and knowing grin. They know the gig can’t last when it’s financed with their money or borrowed money. They know living standards aren’t a cultural birthright. And many of them are willing to work harder, for less, and for longer.

You can’t make easy generalizations about how an entire country or region behaves economically. But if there is any use of statistics, they at least tell us what people are doing with their money. That, in turn, tells us what kind of choices they’re making. And if we can go one step further, we can try to figure out why a person makes one kind of choice rather than another.

We won’t get very far doing this, of course. Why does a housewife in L.A. buy a second SUV instead of buying Japanese banking stocks? Why does a merchant in Bombay buy a gold bracelet instead of Google? We can’t know their intimate motives. But we can know that some people find consumption to be the natural role at the top end of the global food chain, while others delay consumption, save, and invest.

What does all this mean for the bond market, the yield curve, and the stock market? It means that competitive firms listed on U.S. exchanges that derive profits from a growing global market will be great investments. It means firms that rely on continued American consumption and low energy prices will not be great investments.

It also means that there is an inherent spring-like nature to long-term rates right now. They are coiled for a rise. It’s as if a benign-seeming fat man has been sitting on them, looking for a cool place to rest after a hot day toiling in the sun.

The man knows he can’t sit there forever. That he must get up and find more productive things to do with his time and his money, take them places where they can keep his wealth growing and his children prosperous, or at least better off than he.

When he gets up – when the deliberate foreign buying of long-term U.S. bonds slows down or dries up – then rates will skyrocket. The spring will be sprung. This is an ugly proposition for those who have a lot of debt. And if you’ve read Empire of Debt by now, you know who I’m taking about. It is a beautiful proposition for gold, however.


Dan Denning
for The Daily Reckoning
January 3, 2001

Editor’s Note: Dan Denning is the editor of Strategic Investment, one of the most respected “big-picture” investment newsletters on the market. A former specialist in small-cap stocks, Dan has been at the helm of Strategic Investment since 1999 – where, drawing from his network of global contacts, he has designed an investment strategy that takes into account global political and economic trends.

It is a New Year…and a New World.

But the view of most analysts and forecasters is that both look surprisingly like the Old World and the Old Year we just left.

We have been reading predictions and forecasts for the coming year. Almost without exception, the experts see a year coming that’s not very different from the one that just went. The consensus view is that real estate will weaken in the nation’s hottest markets…that stocks will be a decent, but not spectacular, place for investment…and that the economy will be okay, but not great. Oil, inflation and interest rates, too, are expected to be about the same in 2006 as they were in 2005.

Usually, the consensus view is right. That is not because the group of analysts and experts whose views are amalgamated to form the consensus is especially bright or perceptive. To the contrary, mostly numbskulls and poseurs shape the consensus view. These fellows can’t really read tomorrow’s headlines any sooner than the rest of us. Instead, their forecasting talent can be traced only to a lack of imagination; they cannot imagine that tomorrow will be much different from today. Since tomorrow usually is like today, they generally turn out to be correct.

If that were all there were to the story, you could make your investments based on the consensus view and you would be okay. But anytime you make a decision you have to consider not only the likelihood of the consequences…but also the gravity of them. You can cross the highway blindfolded. Most likely, the cars will see you and stop. But who would do such a thing? The gain is so marginal…and the potential loss so great.

Likewise, it may be true that in 2006, stocks will be alright and real estate will not be a disaster, but what are you likely to gain from them? And what is the risk that the consensus is wrong?

The trouble with investing along with the consensus is that there is little profit in it. You are merely going along with the great mass of lumpeninvestors; you are betting on the favorites. Stocks are still near all time highs, even though 2005 was a losing year for the Dow. And property? It depends on where you are.

In the nation as a whole, reports Paul Krugman in the New York Times, the cost of owning a home is still only 23.7% of income, not much different from where it has always been. But in the bubble areas on both coasts the cost of homeownership varies from 38% of income in New York to 42% in Miami to 55% in Los Angeles.

The consensus view is that these markets will soften, but not collapse. Yet, the last time the United States saw such expensive housing was in the late ’70s – and then, they did collapse. In 1978, there were more than 2 million housing starts. Four years later, there were only half as many housing starts…and house prices were far below their peaks in many areas. But the damage was not limited to housing; the nation fell into the worst recession since that Great Depression of the ’30s…with unemployment over 10%.

Today, investors and analysts look back at last year and the year before. They think they are looking forward as well as to the rear. They see no risk. They see no change. They think they can invest on yesterday’s favorites for tomorrow’s profits.

Alas, life is full of surprises. And it is the surprises that make money…or lose it. Who would have thought – in 1978 – that the rate of housing starts would be cut in half? Who would have thought, back then, that the 40-year trend towards higher rates of inflation and higher interest rates was soon to reverse? Who would have thought that housing would crash…and from the wreckage a new bull market in stocks would begin, taking the Dow from under 1,000 to over 10,000? Or, that a real estate bubble on both coasts would surge up just as the Dow finally began to lose momentum?

Who would think now that those trends, too, have exhausted themselves? Most years, investors can cross the road as blindfolded as consensus analysts. Most of the time, things work out one year as they did in the last. But at every turning point they get run down. We don’t know what will happen in 2006. The consensus view may turn out to be right. But we see little profit in the consensus view…and much risk. More on 2006 tomorrow…

More news, from our currency counselor…

Bill Bonner, with more views and opinions from London…

*** Vladimir Putin is choking Ukraine. Yesterday morning, Russia cut off gas exports to Ukraine after Ukraine refused to pay four times the 2005 rate for gas.

“Is there a better example of how vulnerable the world’s supply of cheap energy is to geopolitical machinations? Well, not yet,” says Dan Denning. “But there is the Strait of Hormuz, the Suez Canal, the refinery at Ras Tanura, and the Strait of Malacca.”

“Yes, it’s nice that it’s happening in Russia and not Rhode Island. But don’t think for one minute this is a huge geopolitical exercise in proof-of-concept. Energy is economic leverage. Energy is geopolitical leverage. Energy is also heat and light for people.

“The world’s energy producers have leverage. The world’s energy consumers don’t. The tension between the two is playing out. It won’t be pretty. But the nearly inevitable result will be higher energy prices, which is why energy is such a large element of my current recommendations.

[Ed. Note: More from Dan and his predictions for 2006, below. In the meantime, you can learn more about “oil chokepoints” that have the potential to not just make the U.S. oil outlook grim, but to spell the end of our world, as we know it.

*** Of course it is the same old world in all the ways that really matter. But here at The Daily Reckoning…our beat is money. And money doesn’t really matter very much – unless you don’t have enough of it. And the world of money is always both new and old …just like it always has been and as it never has been before…every damned day… forever and ever…amen.

What are we trying to say?

We don’t know. Yesterday, we were disoriented by travel and time zones. We could have fought against it. We might have rallied quickly and gotten to work. We should have shaken it off…and immediately jumped back into the rhythm of London work life.

Instead, we wallowed…we wandered…we wondered about the whole thing. What’s new about 2006? What is likely to happen this year that didn’t happen the last? Who really cares? Why didn’t we simply stay down at the beach?

Instead, we got up this morning before dawn. We got ready for work…we crowded on the ‘Tube.’ We got to the office (in the building with the gold balls). We’ve been at our desk for two hours. Still no dawn. This is not because it is so early. It is because it is London. We will probably see no sunlight all day. A whole week…or even a whole month…will go by without sunshine.

Last night, we took the family out to dinner and a movie, King Kong. The evening cost us about $250. In Nicaragua, we couldn’t spend money. Here in London, we can’t stop spending. We wonder why we left.

Oh, yes…work…school…business…commerce…improvement…money!

Ah, but it really is a new world, isn’t it? We can now work anywhere. Just give us an Internet connection! And if we can work anywhere…we can earn money anywhere. So why not earn it where the sun shines everyday…and where the cost of living is only a fraction of the cost of living in London?

Our guess is that more and more people will ask themselves these questions in the years ahead.

*** King Kong…poor monkey.