Disproportionate Derivatives

When the derivatives market alone represents $116,666.66 per each person on the planet, the Mogambo sees it as a sign – the Biblical implications of which may be even scarier than previously thought.

Junior Mogambo Ranger (JMR) Brad W. sent, from the Ludwig von Mises Institute, the essay "Our Financial House of Cards and How to Start Replacing It With Solid Gold", to which I say, "Hahaha! Good luck, dude!", because to think that banks would give up their powers to create money with which to enrich themselves, or that Congress would make banks stop creating more money with which Congress can spend on itself and its nasty little friends, makes me laugh and laugh and laugh, until my stomach hurts and I am tired of laughing, and I realize, "Hey! This isn’t funny!"

Then we read the most astonishing sentence, "Currently, untold billions more of banks’ capital now hinge on the survival of bond insurers striving to insure more than two trillion dollars of outstanding bonds on the basis of capital of their own of roughly ten billion dollars."

In other words, every dollar of insurance on bonds issued by some deadbeat governments and corporations is leveraged 200 times! Man! Talk about leverage!

Now, I am not the biggest math whiz in town, especially word problems, and it was years later that I finally understood the apparently indecipherable equation that someone had written in my high school year book:

"2 ugly 2 be 4 given for being such a creepy little pest and ruining everything for everybody and it’s no wonder nobody likes you." Well, 2 plus 2 two equals 4 I understand… But ugly be given? What in the hell was THAT supposed to mean?

Well, I recognized my mother’s handwriting immediately, of course, but the math thing is still a bit of an embarrassment. But even a dolt like me can see that if that aforementioned $2 trillion in bonds declines in value by one-half of one percent (0.5%) for one reason or another, all of their $10 billion in capital is gone! Wiped out!

And this is only a couple of lousy trillions of dollar’s worth of bonds! The total value of the existing global gargantuan globular glut of derivatives is estimated to be more than $700 trillion! Compare this stupefying fact to the associated fact that global GDP is only about a lousy $50 trillion!

Hell, the population of the whole freaking planet is about 6 billion people, all neatly divided into categories of either "with me" or "them", so the derivatives market alone represents $116,666.66 per each person on the whole freaking planet! Hahahaha! This is incomprehensible!

Naturally, I am drawn to the "666" motif, which has some very appalling Biblical connotations, which makes everything even SCARIER, as if the very idea of that much money being bet on derivatives wasn’t enough to fry your brain neurons at twenty feet.

But there are plenty of things that can fry your brain these days, like CaseyResearch.com reporting that "Occupying center stage yesterday was Bad Ben Bernanke, who for the first time uttered the dreaded ‘R’ word in front of Congress, saying that the possibility of recession cannot be ruled out."

In fact, Mr. Bernanke is quoted as having said, "It now appears likely that real gross domestic product will not grow much, if at all, over the first half of 2008 and could even contract slightly."

I thought Mr. Casey was going to mention the huge increases in prices, but instead reported something that seems so incongruous with rising prices, namely, "Among the day’s data were numbers from the Commerce Department on demand for U.S.-made factory goods, which dropped for the second month in a row in February, as factory shipments hit their lowest level since September 2006. Overall factory orders fell by 1.3%, after dropping by 2.3% in January. That exceeded economists’ expectations for a decline of only 0.7%."

Lower production, higher prices. It can only mean something bad.

Until next week,

The Mogambo Guru
for The Daily Reckoning
April 21, 2008

The Mogambo Sez: I grow tired of saying, "Buy gold, silver and oil!" and let their prices speak for themselves, which cruelly mock you and whisper, "See how much money you lost because you did not buy gold, silver and oil like you should have, you stupid nitwit?"

But I am too, too nice to call you a slovenly, stupid, lowlife, bed-wetting low-IQ nitwit if you don’t buy them in the face of overwhelming evidence to do so. But I’m thinking it!

Richard Daughty is general partner and COO for Smith Consultant Group, serving the financial and medical communities, and the editor of The Mogambo Guru economic newsletter – an avocational exercise to heap disrespect on those who desperately deserve it.

The Mogambo Guru is quoted frequently in Barron’s, The Daily Reckoning and other fine publications.

Friday brought news that the Royal Bank of Scotland was looking to raise another $10 billion. This came amid news that the City (London’s Wall Street district) faced its "blackest day in almost 20 years," according to the Daily Telegraph, and would lose 3,500 jobs. Which just goes to show how sunny the financial business has been for the last two decades. A little rain would do it good, in our opinion.

Meanwhile, over on the other bank of the Atlantic, Citigroup (NYSE:C) has issued storm warnings and Merrill Lynch (NYSE:MER) says that it is reconsidering. Citi says it has about 9,000 employees too many; it says a flurry of layoff notices is about to go out. As for Merrill Lynch, the company went on record saying it needed no additional capital. But that was before announcing another $10 billion write-down of subprime debt. Now, the bank says it is "open to" further capital raising.

The price of oil hit a new high of $116 on Friday. The dollar stuck at $1.57 per euro (EUR). Gold got whacked – down to $915.

As we mentioned last week, there is a whole lot of flation goin’ on. Our guess is that it will inflate prices of commodities and gold…and that it will deflate (if only relatively) prices for stocks and houses. But you couldn’t prove it based on last week’s market action.

Friday, the Dow rose another 228 points. The stock market is said to ‘look ahead’ and see things that we mortals can’t see. The index went down about 10% since last October, but lately seems to want to go up. What does it see?

We think it sees inflation. But the conventional thinking is that it sees a boom. ‘The negativity has been severely over-done,’ goes the gist of popular opinion. Finance has bottomed out…homebuilding has bottomed out…the dollar has bottomed out. What’s more, the authorities have taken quick and resolute action to cure whatever was bothering the markets. Central banks have injected hundreds of billions into the banking system. The Fed has cut rates sharply. Congress is considering measures to help out homeowners…and here comes the Bank of England, which (according to the BBC) is preparing a $50 billion mortgage bailout plan. Well, that settles it as far as we’re concerned. It should be onwards and upwards from here on out!

As we pointed out last week, the newspaper headlines may be negative, but sentiment is not. Most people think this is a good time to buy a house – meaning, they still think ‘you can’t go wrong in property.’ And stocks at 20 times earnings are no bargains. At real bottoms, you can buy stocks at 5 to 8 times earnings.

At real bottoms, people have stopped looking for bottoms. Our old friend Marc Faber sent a convenient list of quotations from the crash of ’29. A chart of the market action looks like a mountainside, with ledges…followed by more sharp downturns. But on each ledge…at each pause on the way down…there was some notable figure telling the world that it was over:

"This is the time to buy stocks," said R.W. McNeal in the New York Herald Tribune after the first leg of the crash. "This is the time to recall the words of the late J.P.Morgan…that any man who is bearish on America will go broke."

It is the "long slope of hope," says Marc.

As it turned out, anyone who was bullish on America in October of 1929 went broke. Stocks did not return to their ’29 high until the 1950s – after more than 1,000 banks had gone bust…a quarter of the workforce had lost its jobs…and the Dow had given up 89% of its value.

And now, dear reader…the press may talk about depressions, bear markets and credit crises, but we ain’t seen nothing yet. When we get a real bottom, they won’t be talking at all – they will have lost interest. That’s what happens. When we get a real bottom, people won’t be interested in buying stocks; they’ll come to regard stocks as a rich man’s game. And they will once again view houses as a consumer item, not an asset class. As for depression…they won’t need the newspapers to tell them how bad things are.

We think that day is coming. How far out it is, we don’t know. As we often say, we don’t have a crystal ball.

What we do know, however, is that this day of reckoning for the U.S. stock market is going to require some fancy footwork from those wanting to protect their already existing assets…and still be positioned to turn a nice profit. There are at least seven ways you can do this, even if the markets continue to tank…stocks continue to fall…and even if the entire world economy goes up in flames.

*** More and more indications suggest that there is a kind of decoupling happening. That is, the new economy of the Far East (and to a lesser extent Latin America and Africa) is separating itself from the old economy of Europe and North America.

Prudential Insurance, Britain’s largest insurer, says that Asian sales are now more than half its business. The company can grow, it points out, even with falling revenues from Europe and North America.

Meanwhile, colleague Manraaj Singh tells us that China’s latest growth announcement masked an even more important detail. The headline number – GDP growth over 10% – is breathtaking. But what is more interesting about it is that it is happening while exports to the developed world are actually going soft. That is, the growth is being fueled by domestic demand not foreign buying. This is not to say that emerging markets no longer need their Old World customers. Just that they don’t need them as much as before.

*** Our India expert, Ajit Dayal, paid us a visit last week in London. In the first two and a half months of this year, the Indian stock market got hit hard – the BSE 200 lost 32% of its value. We checked Ajit’s wrists for signs of slash marks and found none.

"I’m not the least bit worried," he told us. "The India Thesis still stands. Indian GDP should post average growth of 6% per year for the next 10 years. Our stocks will give investors a risk-adjusted return of 15% to 20% per annum. That will make it possible for an investor to multiply his investment 4 to 6 times over the 10 year period."

Ajit points out that while Indian stocks dropped sharply, they were coming down from a crazy high. A big rush of foreign money in 2007 had sent the BSE skyward. Even after correcting by 30%, Indian stocks are still ahead for the 12 months ending March 19th by 45%.

"Look around your house," Ajit suggests. "You will find few things labeled ‘made in India.’ India gained little from the housing boom in America. And it will suffer little from the housing bust."

What does affect Indian equities, though, is the movement of foreign capital. But foreign investors are generally light on Indian shares, while local investors – especially mutual funds – are taking bigger and bigger positions.

Like Ajit, colleague Chris Mayer is optimistic about India. In fact, he points out that investing in India today is very much like investing in China 13 years ago. Imagine how wealthy you’d be if you’d started investing in China in 1995.

Find out why Chris says India is the place where you could make two times, five times… even 10 times your money in the next two or three years.

*** Pity the working man. Last week, we pointed out that the average working stiff in America now earns less than his counterpart in France – $38,000 in the United States as compared to $41,000 in France. Presidential candidate Barack Obama says the masses in Pennsylvania are "bitter" about it.

Pennsylvania is an industrial state with plenty of unions. We remember visiting our Pennsylvania cousins in the ’50s. They worked in the steel mills south of Pittsburgh and enjoyed a lifestyle that seemed luxurious compared to our own. At the age of 10, it appeared to us that there was a lot more money in factory work in Pennsylvania than there was in the tobacco fields of Maryland.

But factory work peaked out in the late ’70s…says the New York Times, when an hourly manufacturing worker could expect a wage of $20 an hour (adjusted to ’07 dollars). Ever since, factory wages have been going down. So have hourly wages generally. Now, a factory worker cannot really expect to live a middle class life, reports the NYT, unless he brings home $41,600 (about $20 an hour). But fewer than 20% of them do.

*** Seeing the handwriting on the wall, people flooded the colleges and universities in the last half of the 20th century. If you got a degree, you wouldn’t have to work in the mills, threatened parents. You could go to work in the office – where it was air-conditioned and you got to flirt with the secretaries. But now comes news that even people with four years of college often do not earn enough for middle-class status. And worse – a study reported in the NYT says that even a degree from an elite college is no guarantee of higher wages.

Which raises a good question – why bother to pay for an expensive college…or even, why bother to go to college at all?

We raised the issue with Henry – our 17-year-old.

"What would I do if I didn’t go to college?" he answered. "And besides, if I want to be a doctor, I have to go to college. And if I do go to college and discover I don’t want to be a doctor, at least I’ll have the choice to not become a doctor. But if I don’t go to college I won’t have the choice to become a doctor."

Good point.

But what about the people who have to scrimp and save to send their children to college? Student lenders are becoming tight, say the papers. And the old Bank of Home Equity has closed its doors.

Wherever they get the money, there will surely be some disappointments in the results. The New York Times mentions a couple whose boy wanted to go to a private college rather than the State U., because the private school had a "good pre-law program." For that, the family was willing to pay an extra $80,000 – over the four-year program.

We don’t know what they think they got for their money. But we have a strong hunch it was – zero. We spent three years in law school. As far as we can tell, there is no such thing as "pre-law." In the beginning it’s all reading, writing and thinking – which any education should prepare you for – then, you move on to advanced hoodwinking, contractual obfuscation and ambulance chasing.

"Do you deny the allegations?" the judge once asked The Kingfish in an episode of the ’50s TV show, ‘Amos & Andy.’

‘Not only does I deny the allegations," replied The Kingfish. "I resents the alligator."

Until tomorrow,

Bill Bonner
The Daily Reckoning