The Crack-Up Boom

Too often we ignore the lessons of the past…we forget that there is much to be learned from dead men, and move forward without thinking of what is behind us.

In today’s guest essay, Ed Bugos writes, “The recent history of financial crises suggests that real estate prices could go much higher within a few years, but only because the value of the dollars in your pocket will go much lower. In other words, as the dollar loses value, the prices of tangible assets like real estate will go up. We call this phenomenon ‘inflation,’ and it doesn’t make anyone richer.

“The U.S. Federal Reserve has signaled its intention to pump as many dollars into the U.S. monetary system as necessary to ‘maintain liquidity.’ No one really knows what ‘liquidity’ is exactly, but like Supreme Court Justice, Potter Stewart, once said about pornography, ‘I know it when I see it’…and we will see it too (liquidity, that is).”

Ed Bugos
September 14, 2007

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The Crack-Up Boom

Over to Short Fuse, reporting from Los Angeles…


Views from the Fuse:

A reminder from Kevin Kerr (by way of The 5 Min. Forecast):

“The building boom in ethanol plants is likely to go bust by the end of 2007,” writes Kevin Kerr from Italy, “and the whole industry will probably peak sometime in 2008.”  Before jet-setting over to Milan, Kevin wrapped up his Midwestern ethanol assessment tour, and had this to report:

“Reduced return on investment, increased supplies of ethanol and, ultimately, falling prices will bury this industry sooner than most people think. In Minnesota alone, ethanol production is projected to top 620 million gallons this year, or about 10% of the overall national production. As the national production number goes beyond 7-8 billion gallons, it’s likely that margins will drop as prices fall. Fourteen billion gallons of production is likely by 2008, and at that point, I think we will see the peak.

“Ethanol from corn is not going to last. I estimate that the ethanol revolution will dwindle by the end of 2008.” Place your bets accordingly…

Everyone’s favorite ex-Fed chief is going to appear on 60 minutes this Sunday, defending his decision to keep interest rates low from 2001 to 2004…oh, and his book is being released the next day.

In his first major interview, Ol’ Bubbles will be talking about subprime lending tactics and their effect on the economy – explaining why he thinks the low interest rates aren’t to blame for the recent market crises.

“It was our job to unfreeze the American banking system if we wanted to function. This required to keep rates modestly low,” Greenspan told interviewer Lesley Stahl on the CBS show.

And while many analysts are criticizing Bernanke for not moving quicker to cut interest rates, Big Al thinks his successor is doing an “excellent job” and he’s “not certain [he] would have done anything different.”

Interestingly, the folks at have paired up Bill’s latest tome (written with co-author Lila Rajiva), Mobs, Markets and Messiahs with Greenspan’s memoir The Age of Turbulence.

Do you remember what practically everyone said after the Japanese stock market began falling apart in January 1990?

“Don’t worry,” they said. “Japan has the most dynamic economy in the world…it’s just a temporary pull-back.”

Well, that was 17 years ago. Japanese stocks pulled back…and kept pulling back for more than a decade. Only recently have they begun to move forward again…and they’re still far cheaper than they were at the end of the Reagan years.

And do you remember how American economists and pundits criticized the Japanese? They refused to let their big banks fail, said the critics…and thus stretched out the pain of a correction.

“We wouldn’t do something that stupid,” they seemed to say.

And do you remember how here at The Daily Reckoning we predicted that the United States would follow Japan into a long, deflationary slump? You do? Well, forget it…we were obviously wrong. Or, at least seven years too early…because we made that prediction back in 1999!

Still, we were right in predicting that when the water started coming over the gunwales, English-speaking financial authorities would race to the pumps at least as fast as their Japanese counterparts.

Today comes word that the feds are bailing out the big banks as fast as their buckets allow. It is the biggest bailout in five years, say the reports…with big banks averaging about $2.7 billion per day in loans from the Fed. These injections of cash are said to be ‘forced’ by the Fed itself…rather that the result of desperation on the part of member banks. Still, recent estimates put the increase in U.S. money at nearly 50%, annualized.

The Bank of Britain took the high road on these bailouts – until yesterday.

Mark Gilbert explains:

“The Bank of England, by contrast, has been adamant that it won’t rescue the money markets by accepting low-grade collateral, or by offering three-month cash. Indeed, the Fed and the ECB were rebuked yesterday, albeit obliquely, by U.K. central bank Governor Mervyn King for bailing out commercial banks.

“‘The provision of such liquidity support undermines the efficient pricing of risk by providing ex post insurance for risky behavior,’ King said in a copy of testimony he plans to deliver to the U.K. Parliament’s Treasury Committee on Sept. 20. ‘That encourages excessive risk-taking, and sows the seeds of a future financial crisis.’

“Victoria Mortgage Funding Ltd., a U.K. company that lent about 300 million pounds ($609 million) in subprime mortgages to British borrowers, was placed into administration earlier this week, the U.K. equivalent of Chapter 11. Victoria couldn’t secure enough funding to stay in business.”

But then came the news that house prices in Britain fell in August – for the first time in two years. Practically in the same flurry of news reports we found the BOE offering to prop up Northern Rock, a major source of funds for UK property speculators. (More below…)

But at least there are still a few voices of rectitude and probity. Out comes that sly fox, Alan Greenspan, announcing that he doesn’t approve of such rescue efforts and opposes an emergency rate cut!

Could this be the same Alan “Bubbles” Greenspan who allowed, encouraged and facilitated history’s largest credit bubble ever? We haven’t checked the fingerprints, but we believe it is.

And it makes sense. The man is a scoundrel but not a fool. He sees trouble coming…and he’s getting as far away from it as possible. Since a real rescue is probably impossible at this stage, he will begin criticizing the rescuers…laying the blame squarely where it does not belong – on his successors.

Of course, the rescuers are bound to make the situation worse – just as they did in Japan…and just as they always do. Capitalism functions best without bailouts. Leaky, overloaded, lost vessels sink; the sea-lanes and ports are opened to new ships and better captains.

But tomorrow’s captains don’t vote, make campaign contributions, work in the big banks, or have lunch with Fed governors. It’s today’s captains who get the favors…and money – whether they speak Japanese…or English.

We’ve been reading Richard Russell, one of the greatest stock market observers in the country, for at least 10 years. Now in his mid-80s, Russell has seen it all. And he thinks we’re in a bull market.

Though we’ve been reading for a long time, we have never figured out how Dow Theory (his system) works. There are a lot of indicators and technical enhancements involved, but it appears to us to come down to this:

When prices are moving up, we are in a bull market. When prices are going down, we are in a bear market. When we are in a bull market – as Russell believes we are now – how long will it continue? Until prices go down!

After the epic high of 2000, Russell maintained that the Dow would probably remain in a bear market until an epic low was reached. This made sense to us. At least in broad outline. We buy when prices are low. So, we’ll wait for another epic low. What the heck…we know it is coming sooner or later. In the meantime, taking the long view, everything is going downhill.

But now, Russell says stocks are in a bull market…with another big burst of gains coming. How long will it last? Until it comes to an end, says Russell. How high will it go? Until it reaches its peak, he explains.

The Dow only went down only about 20%, after January 2000, so it never got to an epic low; it never even reverted to the mean. Instead, stocks have been expensive since the mid-’90s. From here, maybe they’ll go higher. Maybe they won’t.

We don’t know what to make of Russell’s system, but we have a deep respect for the man’s experience and intuition. When he says stocks are headed higher…we pay attention.

Why would stocks go up from here? Could it be just the final stage of a credit bubble…could it be the bailout cash will float them up…

…or, could it be that stocks’ earnings will rise?

Colleague Chris Mayer ruminates:

“You know the big debate about profit margins. They are near all-time highs. The mean-reversion guys (Granthan, et al) say they will come back to trend. Others (GaveKal) believe the economy is fundamentally different now.

“But what if the high profit margins (and high return on assets) are due to understated book values (because of the cost accounting assumptions) and that the actual cost to replace these assets – because of inflation – is actually much much higher?

“Then, what happens is that as companies replace plant and equipment or expand, capex expenses should rise. This won’t show up in earnings right away, because of the delay between capex and when they start hitting the P&L in the form of depreciation charges.

“But is becomes a stiff headwind against earnings after a while. Earnings fall as they reflect more truly the cost of the assets used, and profit margins fall, book values rise, returns on equity fall…stuff starts to move back to trend…

“Obviously, this doesn’t affect all industries equally…but it could be a contributing factor to a potential decline in earnings…

“And, of course, it would mean the market price has to come down some. Bad for stocks generally.”

We suspect Chris is right. American companies have borrowed heavily. But much of the money has gone into bonuses, fees, buybacks and other non-capital investments. When they actually have to replace plant and equipment, to keep up with foreign competitors, they’re going to find themselves a little short.

“What’s the matter?” we asked.

We have been working with a group from Ireland. Last night, late, after a good meal, well lavaged with liquor, a few of them had tears in their eyes.

“Liam has been telling us about his dead pets…” one young woman explained.

A tall young man, his dark hair swept back, making him look a little like Yeats himself, continued:

“Yes, I remember Fluffy…and Hammy…they were such good dogs. Followed me around. They slept on my bed…though Hammy moved around so much at night I had to keep him out of the bedroom. He would follow me to school when I was about 6 or 7. I had to take him back to the house and lock him inside, and then go back to school.

“All seven of my pets…4 dogs…and 3 cats…all dead now…

“…it’s overwhelming really…even now, I can barely stand to talk about them.”

“Liam is a poet, you know. And like all the Irish, he gets very sentimental when he drinks.”

Have a nice weekend,

Bill Bonner
The Daily Reckoning

The Daily Reckoning