Red October

Uh oh…maybe it will be a Red October after all…

Two important things happened yesterday, both of which cast a crimson light on things.

First, the Dow dropped again; it has only gone up one of the last 7 days. It went down 203 points. Could be nothing. Could be something big…the beginning of the long awaited ‘next leg down’ for the bear market…the opening day of a bloody Red October.

Charts of oil, commodities, copper, the dollar, and Treasury bonds tell us the same story. The greed investments are topping out. The fear investments are headed up.

What’s a ‘greed investment?’ It’s anything that benefits from an improving outlook for the economy and inflation – oil, commodities, and stocks, mainly.

What’s a ‘fear investment?’ It’s something that goes up when people begin to suspect the boom is a phony – namely the dollar and US Treasury bonds.

The dollar is rising. So are Treasuries. Yesterday, 30-year US Treasury bond yields fell below 4% for the first time since April.

And what about gold?

Well, that’s the other important thing that happened yesterday. Gold held above $1,000.

So what?

So what?? Well, dear reader, you are in a prickly mood this morning, aren’t you?

This is important because gold could go either way. Gold is a refuge in times of fear – especially when people fear inflation or a falling dollar. Gold is also a target of greedy speculators sometimes, even when the going is good. According to a study done by the World Gold Council, you never know what gold will do. That study was a great comfort to us here at The Daily Reckoning; we thought we might have missed something. But no. We may not know what gold will do, but neither does anyone else.

Looking around, we see no sign of consumer price inflation. So gold’s recent rise must have been driven by optimistic speculation – along with oil and stocks. Now, when oil and stocks go down… we have to wonder whether gold will go down too. The answer, given yesterday, was what we expected – yes, but not as much.

There’s substantial risk in gold as well as stocks. The ultimate low for the Dow should be below 5,000. That is, let’s say, about a 50% haircut from current levels. And let’s assume that gold does what it did yesterday…let’s suppose that it goes down only 40% as much as stocks. That would still be a drop of 50% of 40%, or 20% – to the $800-an-ounce level.

If you would be gravely upset by a drop of that magnitude…you probably shouldn’t buy gold at this level. And, of course, you should have sold your stocks already. Stick to cash – and gold, if you’re long-term oriented – until this next phase is over.

The economic news was mixed, as usual…with nothing to make us think that our basic outlook is wrong.

On the optimistic, bullish side…consumer spending rose in August. Pending homes sales went up too.

But on the pessimistic, bearish side… “September auto sales plunge,” says a Reuters headline. Yes, auto sales drove off a cliff last month – just like we said they would. GM reported a 47% drop.

What happened? The clunkers program was an economic fraud. Like all attempts to boost consumption, it merely shifted sales from the future to the present (now the past). Which is a big reason why August consumer spending looked good too.

But wait a few weeks for the September consumer spending numbers. Especially if the stock market continues to fall… Then we’ll find out how sustainable those retail sales numbers really are.

As you know, here at The Daily Reckoning headquarters…in the building with the gold balls on the south side of the Thames…we are often accused of ‘pessimism.’ We deny it. We’re optimistic about the fate of mankind. But we are pessimistic about many of his current pretensions – such as health food, enlightened central banking, contemporary art, mass education, global climate control and progressive democratic government.

But maybe we are wrong to be optimists. Pessimists always have the last laugh – when the optimists die. “I told you so,” they say, under their last breath.

Meanwhile, from Phoenix comes news that a new wave of defaults is about to slam into the mortgage industry. Commercial properties, retail space, office complexes, apartment buildings are hard to rent. You can see why. In 2007, America was already outfitted with far more retail space than it actually needed. Americans had gone on a shopping spree for the previous ten years…prompting builders to add more and more space. By 2006, the United States had 10 times as much retail space per person as France. This was the bubble phase of a boom in consumer credit that began in 1945.

When you get to the bubble phase, few people stop to ask questions. Instead, everyone assumes that the trends in place will remain…and even intensify. So even into 2008, in Phoenix as well as other growing areas – principally in the sand states – the building continued. And now it is 2009. Where are the shoppers? Where are the renters? Alas, they are thinner on the ground than anticipated…and the developers are having trouble paying their mortgages. Commercial mortgage backed securities are carrying 5 times the unpaid balances they had in June ’08, says Bloomberg.

Imagine how disappointed lenders will be when these loans default. And then, imagine how American investors will feel when a new wave of mortgage defaults and foreclosures is hits the commercial property market.

A new wave of foreclosures and falling house prices may be approaching the housing market too. Alan Abelson, in this week’s Barron’s, reports on the outlook as described by Amherst Securities. The research group estimates an overhang of ‘hidden inventory’ of some 7 million units. These are properties owners would like to sell – if and when the market strengthens. Trouble is, the market may not strengthen soon enough. Then, many of these hidden properties could come right out in the open, as mortgages are reset, marriages break up, and people move on. Amherst says these people are in the “delinquency pipeline” which eventually flushes out the market. And it calculates that another 300,000 properties enter the pipe every month.

Falling prices have reduced ‘owners’ equity’ – the part of the house the homeowner owns free and clear of a mortgage – to only about 43%. This number includes people who have no mortgage at all – more than 50 million of them. Abelson speculates that the actual equity in the hands of the ‘owners’ of mortgaged houses must be substantially less. Pushed by joblessness…not to many life’s other, normal hazards…many of these people are surely going to default. Of those in the “delinquent pipeline,” nearly 10% haven’t made a payment in more than two years. Sooner or later, the banks and mortgage holders will be forced to take action…and more houses will come onto the distressed property market.

Eager to put this recession behind us? Hey, don’t be in such a hurry. Recessions do good work. Depressions are even better (see below….)

More and more people get something from government. Fewer and fewer are net taxpayers. This is the basic formula that bankrupts democracies. The political system becomes skewed towards spending; then, there’s no stopping it. Once the majority of voters and special interests has an interest in increasing spending – even by borrowing – rather than in limiting taxes and debt, the game is practically over.

USA Today reports on the number of children whose lunches are furnished partly at taxpayer expense. The figure rose from 24 million in 1990 to 31 million today. That is, the welfare program increased by a third during the biggest boom in history. Think what will happen during the bust.

The Daily Reckoning