The Calm Before the Financial Storm?

Is the rally over?

Not at all! The world’s bankers say the economy is recovering. Investors believe them; they’re bidding up stocks.

The Dow rose 155 points on Friday. And today, stocks are rising in Asia. Oil is over $74. Gold rose $13 on Friday…to close at $954. And the dollar is killing us softly…sinking to $1.43 per euro on Friday.

Stocks and oil are at their highest levels so far this year. With such profits at hand people figure they don’t need the dollar. Investors run to the safety of the greenback when financial storms approach. But now…they think it will be clear sailing.

“Worlds bankers suggest rebound may be under way,” says a headline at The New York Times.

Is the world economy really recovering? Should you buy stocks now to take advantage of this new bull market?

You already know the answer, dear reader.

After a fall comes a bounce. And along with the bounce come a lot of silly ideas. You see how it works? “Markets make opinions,” say the old timers on Wall Street. When stocks are going up investors find reasons why they are going up. Pretty soon, they’ve convinced themselves that they’ll go up forever.

But bounces do not last forever. They aren’t giant turtles…they’re moths. After a few months of flitting around bright lights, they dry up. When exactly this summer of winged love will end, we don’t know. September or October is our guess. But we have little doubt it will come to an end soon.

Ultimately, stock prices depend on earnings. People compare the rate of return they can get from stocks to what they can get from other investments. Rising earnings signal higher rates of return, so investors pay more.

During the great credit expansion of 1945-2007, businesses could anticipate, generally, rising earnings. People were buying more and more things on credit. In a national economy, businesses pay wages and then the employees use the wages to buy products. The wages are a ‘cost’ to the business…but they are also the source of business revenue. When sales come from credit, on the other hand, businesses have the revenue but no wage cost. Profits go up.

Now, the cycle has turned. Businesses still have the wage cost. But instead of using the money to buy things, the employee uses it to repay loans for purchases made last year or the year before. Now the business has the cost but not the revenue.

As they say in the economic textbooks: bummer.

The process of de-leveraging will be slow. Maybe five years. Maybe 15. Maybe 25. It will go up and down…with high unemployment (businesses will cut their wage costs as sales fail to recover)…low prices (at least in real terms)…low profits…and slow growth, or none at all.

Is that bad? No, not at all. It’s good. Economies need to adjust to the new realities of the post-credit bubble world. It will take time. And with the world’s financial authorities fighting it every step of the way…it could take a LONG time. As we’ve explained in these daily reckonings, government is a profoundly conservative, parasite-protecting enterprise. It cannot draw forth the future – it has no idea what the future will be. Instead, all it can do is to try to recover the past. That’s the idea of the ‘recovery’…to try to coddle, protect and pay-off yesterday’s success stories. From Wall Street to welfare…governments attempt to prevent correction.

Of course, it makes sense. Government’s only real function is providing protection and order. What can it protect? Only what is…not what is to be.

And so the feds try to forestall and prevent the future from ever happening. Will they succeed? Of course not. The future will happen whether they like it or not. They can’t stop it. The future will come.

But they can still make a mess of it.

The Obama administration announced that it expects $9 trillion in deficits over the next 10 years. One of the great mysteries of our time is: where will the money come from? As we pointed out last week, even if every dollar of US savings is applied to the task, the feds will still be short. And if they make up the difference with funny money – from their quantitative easing scam – the Chinese vigilantes are likely to get cheesed off and dump their US Treasury bonds.

The evidence shows that the Chinese…and other Asians…are already trying to lighten up on their US debt holdings. This from The New York Times:

“Figures released by the Treasury Department this week indicated that China reduced its holdings of Treasury securities by $25 billion in June, the most China had ever sold in a month.

“Monthly figures can be volatile, and can be revised, so it is risky to draw conclusions from one month’s data. In May, China increased its holdings by $38 billion, according to the Treasury figures.

“Nonetheless, the decline highlighted a fact…Asia’s appetite for Treasury securities is not growing as fast as it once did. That means the United States will have to turn to other buyers, including American citizens, who are now saving as they did not do during the boom years, to finance the deficits… In the first half of 2009, China and Hong Kong acquired only 9 percent of the more than $800 billion worth of Treasuries that were sold.

“Japan, which was replaced by China as the largest foreign holder of Treasuries last year, has been a larger buyer this year, taking up 11 percent of the new supply of Treasuries.

“Ownership of US Treasuries by China, Hong Kong, Japan, South Korea, Singapore, Taiwan and Thailand – since 1994 – rose to 25 percent, from less than 8 percent. Since then, as budget deficits in the United States grew, the share has fluctuated within a narrow range. In June, it was 24.7 percent.”

If Asians don’t finance US debts, who will? We don’t know… But the fewer bonds Asians buy…the more they are bought with funny money by the Fed. And the more the Fed buys with funny money the fewer Asians want to buy with real money.

How will this end? Badly…we keep saying. There is no way out. Either the feds cease spending more than they can raise honestly, by taxation and reasonable borrowing. Or, the system runs into chronic, mega deficits…like the chronic deficits in the private sector during the bubble years. Then, it blows up.

That is why we caution readers against the dollar and against Treasuries. Most likely, they will both go up this autumn…as investors flee to safety from the next market downturn. But the chances of them blowing up completely are too great. That’s why we stick with gold – even though we would not at all be surprised by a period of weakness in the gold market.

Until tomorrow,

Bill Bonner
The Daily Reckoning