The return of the Inflation/Deflation/InDeflation debate…revisited after the will-the-Fed-raise-rates mania of past weeks. Below, Porter Stansberry weighs in with his side of the argument, as presented at the recent Money Show in Las Vegas…

I had an interesting debate last week with Bill Bonner. In front of a large audience in Las Vegas, we discussed interest rates, inflation and the stock market. I hesitate to tell you about it though, because, in Vegas, being right about financial matters isn’t very popular (see my P.S. below about Bugsy Siegel). Gambling, as I tell people, is only entertainment for the statistically illiterate. Nobody ever invites me to their blackjack table.

There were probably 1,000 people in the audience. We were in a large conference room at the Paris Hotel, on the Vegas strip. The debate, between Bill Bonner, Addison Wiggin, Alex Green and myself, was part of the "Money Show," the biggest financial conference I’ll attend all year.

The argument was about the important long-term trends affecting the stock market today. As you probably know, your friendly DR editors Bill and Addison have written a book about why they believe America is destined to follow Japan’s economy into a deflationary spiral, where bankruptcy, falling prices and a decline in business activity have gone on for nearly 14 years.

Market Extremes: Rising Prices Will Trigger Higher Interest Rates

In the January issue of my newsletter, I warned of exactly the opposite: rising prices would soon trigger a move towards much higher interest rates. And, unexpectedly, surging interest rates could cause the stock market to swoon. I even wrote that interest rates would begin to move in late March and would really heat up in April.

Alex Green (investment director of the Oxford Club) contends that forecasting macroeconomics and trying to time the market can’t be done reliably, and therefore shouldn’t be part of any investor’s toolbox. He contends that you should simply buy good companies at reasonable prices and be done with it.

I’m not going to review all of Bill and Addison’s points here – if you haven’t already, you can read their book "Financial Reckoning Day" for their line of thinking. And, while I agree with Alex Green’s approach 90% of the time, when the market reaches extremes it’s critical to pay attention to the bigger macro trends. You can’t exist safely on the wrong side of a runaway train, even if you own very good stocks at reasonable prices. You’ll get killed anyway.

I believe we’re at such a moment in time. My argument is based on the fact that interest rates have been far too low, for far too long. Sooner or later (probably sooner) this will result in runaway inflation, akin to what we last saw in the 1970s. My reasoning is simple: the U.S. economy is backed by paper dollars, which are the world’s reserve currency. By producing too much credit (thanks to super-low interest rates) the Fed has stoked the world’s economy, and it is going to overheat. We’re seeing it happen already in China and it will, in turn, spread across the globe.

Market Extremes: An Apparent CPI Decrease

One of the interesting facts about the dormant inflation we have right now is that by increasing the money supply and lowering interest rates, the Fed has produced an environment that, measured by the CPI, looks like "no-to- low" inflation. That’s because financing costs are a major component of prices. For example, so-called "core" CPI (which does not include food or energy components) dropped 1.6 percentage points between November 2001 and December 2003. This prompted a lot of people to warn about "deflation" or consistently falling prices. But most of that apparent decrease in CPI was caused by falling rents and falling used car prices. These decreases came about directly because of much cheaper than normal financing for new homes and new cars. Why rent an apartment when you can buy a new home (with only 2% down)?

Why buy a used car when you can lease a new one for the same monthly payment?

This competition from new cars (over used) and from new homes (over apartments) was purely a function of lower financing costs – not any permanent increase in our economy’s efficiency. As you know, new cars aren’t really cheaper, and new homes certainly aren’t, either. Only the money got cheaper. And thus, more of it was borrowed than ever before.

Now we’ve begun to see this inflation in the money supply hit the PPI (the producer’s price index) and components of the CPI (look at energy prices). Soon, probably sometime this year, the Fed will have to act to put the brakes on money supply growth to contain these rapidly rising prices. And, when that happens…be ready for a big surprise.

Instead of acting to halt inflation, the Fed’s actions will actually begin to convert the excess money that’s out there into higher consumer prices. As the cost of money increases, so will the cost of almost everything in our economy – housing, transportation, food and energy. The inflation that’s now dormant because of low interest rates will move to the surface, allowing businesses to raise prices for the first time in over ten years.

The economy will be great. Earnings growth will be spectacular. Employment will remain robust. But stocks will take a beating, as long-term interest rates go above 7% and bonds become much more attractive, relative to stocks, which are still yielding record-low dividends and trading at record-high multiples to earnings.

This is the case I made for the group in Vegas. This is the case I’ve been making since January of this year. This is what I see happening now. I hope you’re prepared.


Porter Stansberry
for The Daily Reckoning
May 26, 2004

P.S. On June 20, 1947, Benjamin Siegel took a bullet in his right eye and four more shots to his body. Better known as "Bugsy," Siegel built one of the largest and most luxurious hotels in the world – the Flamingo. And he did it in Las Vegas, where previously the largest structure was the train station. Despite huge cost overruns and a three-month delay to its opening, Siegel’s Flamingo would earn $250,000 in its first year and become spectacularly profitable.

Today, the intersection where Siegel built the Flamingo is one of the most popular tourist destinations in the world, surrounded on four sides by Caesar’s Palace, the Bellagio, Paris and the all-new Hilton Flamingo. This is the heart of the Vegas strip.

Bugsy was right: People would come to the desert to gamble. Man’s love of vice is far more powerful than his discipline or reason. Unfortunately for Bugsy, being right also meant he was a dead man. The mob wasn’t going to let Bugsy run the joint – it was making far too much money.

P.P.S. The next few years will not be suitable for the more traditional investing methodologies, as rising interest rates make it next to impossible for the broad market to move higher. So, after hours and hours of painstaking research, I’ve found a different angle…it’s called Rebound Investing, and it might just be the only way to make money in equities right now.

Editor’s note: Porter Stansberry is the founder of Pirate Investor LLC, a financial publishing group dedicated to providing high-quality research for high net-worth investors. The former editor of several well-known financial letters, including Latin American Index, China Business and Investment, and the U.S. edition of The Fleet Street Letter, Mr. Stansberry is regularly quoted in leading financial journals, such as Barron’s and World Money Analyst.

It hovers like an alien space ship over the U.S. capitol building. People don’t know what to make of it; they can’t believe it is there. So they say nothing. It is business as usual. ‘Stay the course,’ say Americans to each other, keeping their heads down.

But it changes everything…and threatens to blow all our illusions to kingdom come at any moment.

We refer to the astonishing fact that we reported several years ago…and again yesterday. Over the last quarter of a century, supposedly the greatest wealth-building period in history, the average American man’s earnings, in real terms, actually went down 6%.

No one wants to believe it. No politician discusses it. No stockbroker brings it up in conversation. No CNBC presenter mentions it.

Yet, it is the most important little bit of information that you never heard about. Wages – earnings – are the real measure of whether a company, an individual, or a society is getting richer. Stocks and bonds can go up all they want; people will not be a penny richer. It is the ability to earn money that defines wealth. Without it, you are poor.

How could it be that in the world’s most dynamic, most capitalistic country people get poorer?

We have an answer. In two parts.

Because the American model of late, degenerate capitalism – supply-side, consumer-led, credit-induced – is a fraud. After the Nixon administration reneged on the last vestiges of the gold standard on August 15th, 1971, America gradually shifted from making things to buying them…on credit; from saving to borrowing; from manufacturing to retail…and then to finance. The nation’s biggest company used to be a manufacturer, GM. Now, it’s a company that sells Chinese-made goods to Americans, Wal-Mart. GM is still in business, but it earns most of its money not from making things, but from financing them.

Alas, you can’t actually get rich by spending money. We knew it all along; now it is being confirmed by a quarter century of wage figures.

Meanwhile, globalization – goaded to excess by the Fed’s artificially low interest rates – has put American workers in direct competition with Chinese and Indians…and millions of others who are willing to work for $5 a day.

Labor is about 75% of total costs in most industries. And labor, worldwide, is in a huge, multi-generational deflationary cycle. The only hope for workers in developed countries is to race ahead of their third world rivals in training, skills, and capital investment. That is why, while the average American man earns less, at the top of the earning curve, men earn more than ever before.

Moronic politicians see the earnings gap as an affront. It is ‘unfair,’ they say. Yet, it is merely a consequence of a consequence – only at the upper levels are workers still untouched by low-wage competition.

John Kerry says he has a plan to deal with globalization and its discontents.

George Bush says he doesn’t need one.

Neither dares to look up at the spaceship above his head or wonder what it really means. The only possible way to meet the challenge of Chinese competition is to do the exact opposite of present policies. Americans would have to cut back spending, save more…and spend more time learning difficult skills. Instead of studying sociology and gender politics, they would have to study machine tools and languages, for example. (See Byron King’s note, below). Instead of buying a new SUV on credit, they would have to hold onto their money and invest it in capital improvements that would increase their output per hour. If they want to earn 10 times as much as a Chinaman, they have to produce 10 times as much. But who’s going to tell them that? Instead, they are told that they will always be on top of the world because their economy is more "dynamic," more "creative," more "flexible," or more "free."

And they believe it.

Of course, no one is more easily deceived than ‘investors.’ Yesterday, they came back and drove up the Dow over 10,000.

Gold went up, too. Now at $388, it seems to be inching its way back towards $400.

Consumers are becoming more confident; they are buying more houses.

Companies are once again going public with neither profits nor products.

And all over the country…investors, central bankers, politicians and consumers keep the heads down. ‘Stay the course,’ they tell each other. ‘Let’s pretend we are all getting richer.’


Addison Wiggin, Back in Baltimore…

– Your editor was with James Boric in a Latin nightclub this weekend, called Latina Caliente. We weren’t dancing; we couldn’t. We didn’t know how. Instead, we drank wine and watched. The music was loud and the conga beats made the table vibrate. Only we weren’t in Havana or Buenos Aires, we were in Ottawa. And we weren’t the only ones who couldn’t dance…apparently, the Latin groove has not made it into the genetic makeup of our friendly neighbors to the north.

– We were in Canada’s capital for the latest Supper Club soirée. And after a day full of meetings, we were trying to relax. But watching the unfortunate kanuks around us try to follow the foreign salsa beat conjured a familiar image of a different dance into our head…the terrible tango of lumpen investors trying to follow the improvisation of maestro Greenspan.

– Greenspan runs the economy like a jazzman. But experimental jazz just doesn’t cut it in the discoteca. There, the frenzied dancers live on rhythm, thriving on a good, steady beat…and faltering when improvisation takes the lead.

– But Greenspan doesn’t seem to worry about this…he just keeps riffing on the groove, jamming along to his own beat. His silver clarinet shakes and bobs as he puffs harder and harder into his instrument. Only the crowd can’t keep the rhythm; they don’t understand this music. But how could they? The Maestro obviously makes it up as he goes along.

– Greenspan has told us to be concerned about deflation and an "unwelcome fall in prices." He and the rest of his outfit have spouted off about near-permanent low rates, helicopters with cash, printing presses and brand new SUVs, preferably Navigators. Says Robert McTeer, picked up by Doug Noland on the Prudent Bear website: "Today, every time we have a major emergency, you know, the first thing we do is get on the microphone and open up – you open up a spigot. I mean look at what happened in 9/11. I mean on 9/11, we just flooded the markets with liquidity…"

– But there was no deflation. Instead, everyone danced to a different beat…that of inflation. The lumps ran up the prices of stocks, bonds and houses. Then they ran up all the base metals, gold and silver. And still Greenspan’s tune blasted out, and still investors ran wild in response…Now, they are buying everything from milk and steaks to frozen orange juice, and prices are rising everywhere, especially when it comes to oil and gasoline. Even the favored Fed indicators are starting to take notice of inflation.

– Greenspan’s fellow band members play Jazz, too. Says McTeer, "We know how to handle those things better now, not well enough but not bad." (This is the guy who’s tipped to be the next Fed chief, we note with a vague sense of dread.) Bernanke says that much of the credit tightening has already been accomplished by the market on its own, and they won’t need to do much else, too soon. Greenspan’s in no hurry to raise rates, either. The tune still hasn’t changed; the band continues to improvise.

– The band used the threat of ‘deflation’ as a smokescreen to keep bond prices up, while pumping liquidity into the system. Then, they managed ‘expectations’ like a PR exercise. Now the’re at it again. They don’t want to raise rates, but must appear like they do…and if Bernankes can be trusted, the threat of action alone might be enough to do the Fed’s work.

– But could the Fed’s smokescreen be on the verge of dissipating? Currency traders thought so yesterday – they added a cent to the euro, pushing the single currency over 1.21. The yen also gained against the dollar, moving from 113.2 to 111.8. Oil, meanwhile, settled 58 cents lower, closing the session at $41.14 a barrel. The inventory data comes out today, and is expected to have a big influence on prices. Dollar bulls are worried that high-energy costs will wreak havoc on the U.S. recovery and its trade deficit, says the FT.

– Stock market investors kept dancing yesterday, pushing the Nasdaq up over 41 points, or 2.17% – the tech-heavy index closed at 1,965. Perhaps the lumpen suspect Greenspan may not be so eager to raise rates, after all? For its part, the Dow added 159 points to close at 10,118, up 1.6%. The S&P gained 18 to 1,113.

– Gold continues to rally from its recent lows. Today the barbarous relic added $2.70 to close at $388.7. When the music stops, and it’s time to pay the piper, will he accept plastic? We doubt it…true musicians prefer gold, they always have.


Bill Bonner, back in Paris…

*** "Borrowing bonanza will end in tears," says the Financial Times. Who can doubt it?

*** Poor Robert Cromer. If we could somehow put an adjective in the future tense, we would do so. For Mr. Cromer is not poor today…at least, not insofar as he is aware.

Mr. Cromer is featured in a report on CNN. He is a ‘tycoon in the making,’ says the story. The man earns only $50,000 per year. But he’s leveraged real estate into $3.2 million worth of assets. Against this, he has $2 million in debt. So far, the math is pretty simple; he’s ahead $1.2 million.

But all his properties bring him only $3,100 in net monthly rental revenue. This amount is not nearly enough to cover the interest on his loans.

Thus is America’s real estate bubble illustrated and its future foretold. As long as prices rise faster than the gap in operating costs, Mr. Cromer remains on the make towards tycoondom. When prices level out…or fall…he becomes another dumb schmuck who over-extended himself.

*** Personal bankruptcies are rising, says the Detroit Free Press.

*** And even retail companies are making their money from speculative finance: "As more and more people shop on credit," says a headline from yesterday, "stores rack up profits on high interest and fees."

*** Is it worth the bother of voting? This from our friend in Quebec, Pierre Lemieux:

"Does it matter which political party is brought to power by the coming federal election? Do political parties matter?

"Consider the case of Quebec where, over the past 40 years, three political parties of apparently different persuasions have been in power: the Quebec Liberal party four times, for a total of 21 years; the Parti Québécois two times, for a total of 16 years, and the Union Nationale (a conservative party) once for a four-year term. "In constant dollars, public expenditures by the provincial government have gone from $1,031 per Quebecer in 1961, to $7,299 in 2001, a seven-fold growth rate which is equivalent to a compounded 5.0% per year. As the gross provincial product has grown at half this rate, the proportion of provincial expenditures in the economy has doubled.

"What is remarkable is how little difference it made whether the Liberals or the Péquistes (or whoever) was in power. Remember that, for most of the period, the Liberals were deemed to be more conservative, while the Péquistes were the avowed social democrats. On average, over the four decades, real expenditures per capita grew 5.2% per year under the Liberal Party, and 3.2% under the Parti Québécois. The difference is partly due to the fact that the Liberals were in power during the 1960s and 1970s, a period when state expenditures exploded everywhere in the world, while the Péquistes came to share in the loot when the growth of the state was slowing down everywhere. At any rate, there is no correlation between the party in power and the growth of government spending."

*** "I have heard it said that: ‘Rome was built on hydraulic cement,’" writes Byron King, our unpaid correspondent from Pittsburgh. "That is, the secret of burning lime and mixing it into a hard-drying, waterproof concoction that would bind stone together, was key to the expansion of Roman power.

"Not the least of Rome’s accomplishments were the aqueducts. These engineering marvels carried more water, further, to more locales, to serve more people than any other water diversion system in history, excepting only what has been accomplished in California in the past forty years or so."