The Aftermath of a Phony Boom

Yesterday, the markets were ready for a countertrend. The dead cats had been tossed out of a 10th floor window. It was time they bounced.

U.S. stocks have lost about $1.5 trillion from their high in October, ’07. Worldwide, stocks are off about $5 trillion. Financials…builders…shippers and retailers…one by one, the sectors are getting hit. And the news is almost all bad: foreclosures, house sales, unemployment, consumer confidence, inflation…losses…declines. In fact, MarketWatch reports this morning, “For all of 2007, the median sales price of an existing single-family home fell for the first time in the 40-year history of the data.” Dun, dun, dunnnnnnn!

“Pain goes through the roof,” said a headline in the LA Times. We don’t know what the piece was about but it recalled the “pain index” figures of the ’70s and ’80s. You just added the inflation rate and the unemployment rate together; the result was a good measure of how people were suffering.

The last 25 years or so have produced falling pain index numbers. Inflation went down, generally. And unemployment declined to such low levels that economists didn’t think it was possible for it to go lower. “Full employment” they pronounced it. But now the inflation rate is back to levels that caused Richard Nixon and Arthur Burns to panic in the early ’70s. They imposed price controls with a CPI of 4.4% – almost the same level it is today.

Today, the pain index is nearly 10, by our calculation…not close to the levels of the ’70s, but rising. (The misery index hit an all-time high under Jimmy Carter at 21.98.) But this time, it is not inflation that is causing the Fed to panic…it’s recession and deflation.

The 1970s were marked by largely symbolic attempts to control inflation. After Richard Nixon’s misbegotten price controls came Gerald Ford’s woebegone “Whip Inflation Now” buttons. Later, Jimmy Carter would say that the cause of inflation was largely a mystery.

But now, the years ahead are likely to be marked by largely symbolic and fraudulent attempts to control deflation – stay tuned.

“I would say that we’re already in a recession,” Jack Rivkin, who oversees $126 billion in New York as chief investment officer at Neuberger Berman, said in an interview with Bloomberg Television. “Odds are earnings are going to be down for 2008.”

Even memories are being downgraded.

“Worries that the good times were a mirage,” comes a headline from the New York Times. Ah ha…the mainstream press is finally catching on to what we’ve been saying for the last five years. The boom was a phony…a fraud…a scam…a mountebank and a humbug. It was a like a polished flim-flam artist who flattered the middle classes with cash and credit – only to pick their pockets. People thought they were getting richer – that’s the illusion that soft money policies are intended to create – so they increased their expenses and went deeper into debt. Now they’re facing a serious recession in the worst financial shape of any generation in history.

Meanwhile, gold and oil had been shooting up like geysers!

“In my view, the commodities and energy bull markets are far from over,” Strategic Short Report’s Dan Amoss tells us.

“China is on the verge of being a net importer of key strategic minerals, including iron ore and aluminum. I think that these factors – along with the global oil supply challenges – will be important in the stock market by the end of 2008.

“Right now, traders are adjusting to the reality that U.S. consumption is slowing. But the world is not ending. Instead, it’s adjusting to the fact that the U.S. is losing its position as consumer of last resort. This will play out over the next decade and be very painful for certain industries, but the most strategically positioned companies should weather the storm just fine.”

Dan has a well-honed and intelligent strategy for making money in a bear market – while everyone else is losing their shirts. For a limited time, you can get his newest service, Strategic Short Report for half the regular price.

Obviously, it was time for a little backflow…a little correction…a little good news, just to keep the lumpeninvestoriat confused and hopeful.

And so, yesterday, the Dow shot up more than 300 points. “The Fed has this thing under control,” the numbskulls said to one another. “Put on the party music…it’s time to buy!”

The toughest thing about the ’02-’07 phony boom was that if you really understood it you generally lost money. Except for gold and oil, which rose as you expected, nothing else cooperated. ‘I wouldn’t buy houses at these prices,’ you said to your neighbor. Then, the dimwit bought a house…and the thing went up another 50%. ‘Stocks are too dangerous at these levels,’ you told your brother-in-law. Then, the fellow went out and bought Google and got rich. ‘I wouldn’t put any money in China,’ you said to yourself (for no one was listening to you anymore)…and then the Shanghai market rose again.

The boom years were hard years to be smart. It was better to be dumb; you made more money.

But now, the people who made money in the boom are at it again. ‘The worst is over,’ they say. ‘You gotta buy at these levels,’ they figure. ‘Don’t fight the Fed,’ they chant.

But while phony prosperity rewards stupidity, in real adversity there is a premium on brains.

*** “The current crisis is the culmination of a super boom that has lasted for more than 60 years,” writes George Soros in the Financial Times.

Soros is more right than wrong, in our opinion. He goes on to describe how “market fundamentalism…became the dominant ideology in the 1980s,” leading to a U.S. current account deficit equal to 6.2% of GDP in 2006. Globalism, he says, permitted the United States to “suck up the savings of the rest of the world and consume more than it produced.”

The important point Soros makes is one we keep making: we are now on the downhill side of the credit cycle. For many years to come, real rates of interest will generally be going up.

We say ‘many years’ because we don’t know how many…and because trends in the credit cycle tend to be long. Currently, the real yield on a 10-year Treasury note is negative. Subtract the inflation rate from the nominal yield and you get a number with a minus sign in front of it. The last time that happened was in the run up to Ronald Reagan’s first term – when real rates fell below negative 4%, thanks to inflation over 10%. Then, the credit cycle turned. Real yields on 10-year Treasuries rose to nearly 10% within a couple years. They have been coming down ever since – that is to say, for more than 20 years. Our guess is that they will now go up, after perhaps a further spike to the downside.

An investment involves hope for the future. A man buys a T-note. He gives up sure money now in favor of the hope of more money in the future. All investments work the same way. The more hopeful people become, the more risk they are willing to take. If they think the wind is to their backs, they will invest more…at longer odds. Yields will go down.

But when they lose hope, they keep their money in their pockets and clutch onto it harder. The 4% yield they accepted last year is no longer enough; they want more…to compensate for what they see as the greater likelihood that they will never see their money again.

When Ronald Reagan took hold of the White House in 1980, it was a triumph of hope over despair. It was “morning in America,” he said. He was right. Yields fell for the next 25 years and hope increased.

Now the sun is setting.

*** “A man with a briefcase can steal more money than 100 men with handguns.”

– Don Corleone, The Godfather

If envy sets off class warfare in the United States, we just want to be on the winning side.

– Bill Bonner, The Daily Reckoning

People were hopeful in the Reagan years…and still are…because they believe in the power of money. After a disastrous 100 years dominated by politics, money seemed like not only the lesser evil…but a genuine good. Money could lift people out of poverty. Money could cure illnesses. Money could make people happy. Gradually, almost the whole world came to have faith in money…and then, have too much faith in it. Shareholders, for example, came to believe that the right financial incentives – otherwise known as a huge pile of money – could turn workaday corporate hacks into super-achievers.

One of the most interesting and informative books we have come across lately is one from Barry Dyke called the “Pirates of Manhattan.” The book shows how Wall Street insiders separate the masses from their money.

The most obvious way, of course, is by paying themselves a lot of shareholders’ money and calling it “compensation.” For example, at one point, the book shows that a Mr. E. Stanley O’Neil was paid a total of $38,121,766 from Merrill Lynch in 2005. What was he doing that justified that kind of money? Well, as subsequent events would show, he was doing nothing to add shareholder value. Instead, he guided the great ship right into an iceberg.

So far, the losses reported on Wall Street are staggering. But rumors of much larger losses are being whispered…and at least one source we read suggested that the firms may be bankrupt…crushed by total system-wide losses of more than $3 trillion.

But don’t worry about Mr. E. Stanley O’Neil. He was the first one in the lifeboat when the ship began taking on water. And what a luxury lifeboat it was! His severance was reportedly worth about $250 million…not bad for a man who had just wrecked one of the greatest financial firms of all time.

And now, Mr. O’Neil is in the news again. Alcoa has hired him.

Colleague Byron King blows a gasket:

“Alcoa names Stan O’Neil to its board? What? Huh??? The $160 million man? Mr. ‘Not Enough Internal Controls’? Mr. ‘Whooops, we lost billions’?

“You have got to be kidding me. And what does a job-slashing financial hatchet-man know about making and selling aluminum?

“Talk about a charmed life! O’Neil drives Merrill Lynch into the iceberg, and floats off with a $160 million farewell kiss. Now he lands in a cushy director slot for one of the largest primary metals manufacturers in the world. Huh? What does he know? Who does he know? What photos does he have on his digital camera?

“With this kind of treatment for managerial failures, American capitalism is doomed.”

*** And finally, we leave you with a note from The 5 Min. Forecast’s Addison Wiggin, reporting from the Sundance Film Festival:

“During one of our screenings at the Prospector Square Theatre here in Park City, we had the pleasure of talking with Mary Milliken, Reuters L.A. Bureau chief. She understood our project to a T… ‘I.O.U.S.A., based on the book Empire of Debt,’ she then wrote in an article about the movie, ‘may be to the U.S. economy what An Inconvenient Truth was to the environment. The Oscar-winning documentary premiered two years ago at Sundance, the top venue for independent film and documentaries.

“‘In An Inconvenient Truth, former Vice President Al Gore offered his touring slideshow on global warming and made a compelling case for people to push their politicians to pass legislation to help clean the environment.'”

“At the same time, the movie was also called ‘the scariest movie in Sundance’ by LA Times reviewer Kenneth Turan.

“When we originally began this project, we were working with a production company that specialized in horror films and teen comedies. Guess that auspicious start was more than prophetic.

“To follow along with reviews and critiques of the movie, see the site we set up to track it.” I.O.U.S.A.

Until tomorrow,

Bill Bonner
The Daily Reckoning
London, England
Thursday, January 24, 2008

The Daily Reckoning PRESENTS: In the world of finance, the most difficult thing can be knowing when to get out of a bad situation. Well, according to Jim Nelson, editor the Penny Sleuth, the key to investing in your long positions is strong vigilance, and not to let fear grab hold of you. Read on…

by Jim Nelson

We all saw it. We all know what happened…

World markets collapsed everywhere over the weekend.

Tokyo’s major index, the Nikkei 225, fell 9%; the FTSE 100, London’s rule of thumb, fell 9.5%; and the Hang Seng Index, Hong Kong’s benchmark, sank 10%. The list goes on and on…

And when we look at what happened to the U.S. markets at the start of business yesterday, we saw some of the largest drops since the market opened September 17, 2001, following the 9/11 attacks. Not even the Fed could stop it with its 75-basis point cut in interest rates.

But what we pay particularly close attention to when we see the market moving so quickly is the Russell 2000. It is our benchmark. It represents the small-cap sector of the U.S. market. And unfortunately for us, we’ve seen that fall even further than the rest. It’s down close to 16% over the past month.

This always happens in bad markets. Smaller companies take larger hits. They live and die on liquidity, and without that, they dry up and fade away. Now, of course there are always exceptions to the rule, which we do our best to uncover here at Penny Sleuth. But finding that needle in the haystack isn’t exactly a cinch.

We’ve laid out strategies, screens and even specific companies to invest in that act as safety nets in bear markets, but that’s just protection…

What would you say if I told you that there was an insurance policy for small-caps that also lets you double your money as everyone else loses theirs?

I’m guessing you’d take it.

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Here is a chart that shows how the Russell 2000 Growth ETF – which is just a way to invest in the performance of the Index – has done over the past month:


With this special strategy, your chart would’ve looked like this:


You can see that with this $4.25 insurance policy, you could have nearly doubled your money, while the Russell 2000 fell about 16%.

Now, I’m not saying that you should bet against small-caps. They are our lifeblood over here at Penny Sleuth headquarters. You should stay vigilant with your long positions. Don’t bail on them out of fear. Remember why you invested in the first place.

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A few of us around the office call this type of strategy an “insurance policy” because it allows protection and profit as markets crash. Others around the office refer to it as a “paddle strategy” because you will have to use it to paddle your way through the flood of falling stocks.

No matter what you call it, it’s still a little known strategy that you should look to take advantage of right away. To help you, we’ve prepared a full report that you can access at no charge by clicking here…


Jim Nelson
for The Daily Reckoning