-->Sacramento On The Seine

The Daily Reckoning

Paris, France

Friday, 11 July 2003

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*** Dow down...gold up...is the rally over? Does it matter?

*** Shades of '99..."inflation is returning..."
Volcker sets the odds...

*** Refi boom effect is over...alone in Paris...
and more!

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The Dow fell 120 points yesterday. Gold rose a bit. The
dollar fell.

So, now we ask ourselves - is the rally over?

No one knows the answer. But no one needs to know it.

Yes, dear reader, you can buy stocks and hope some greater
fool comes along and buys them from you at a higher price.
But what fool is not already invested in this market?
Serious investors are fleeing, not buying.

A recent newspaper column reassured investors that long-
term buy and hold is still the best way to make money. Even
including the last 40 months, it pointed out, investors
would have made 10% annual gains over the last 10 years.

Of course, those 10 years included the biggest bubble years
in all history. And the Dow began the period at only 3521.
Knock 5500 points off today's Dow and yes, maybe then
investors could expect 10% annual gains. If they were
lucky.

Or how about bonds? At least there you have a guaranteed
yield, right? Right. Except the yield on short bonds is
barely more than the inflation rate. And what do investors
think? That bonds are going to go up in price? That
Greenspan is going to cut rates even further?

But with the benchmark rate at 1%, how much cutting is
there likely to be? How much are you likely to make - even
if the economy does sink in Japan's direction, with
deflation and even lower yields? Not much, is our guess.

In a long slump, issuers of junk bonds would go bankrupt.
And the issuer of the safest bonds - the U.S. government -
would act as if it wanted to go bankrupt. It would drop
dollar bills from helicopters, Ben Bernanke has implied, if
that were what it took to avoid deflation.

We doubt that these measures would stop the slump. But we
don't doubt that they would stop bond buyers from turning a
profit.

And now Eric Fry, tanned and fit after a sojourn at the
beach, brings us the latest news:

--------------

Eric Fry in Manhattan...

- Unemployed consumers took a breather from buying tech
stocks yesterday, as the Nasdaq slipped nearly 2% to 1,716
and the Dow tumbled 120 points to 9,036. The blistering hot
Nasdaq could stand to cool off a bit...

-"Shades of 1999, the rally in technology stocks continues
to amaze - and worry - Wall Street," the Atlanta Journal-
Constitution observes."It amazes because of the 29% year-
to-date rebound in the tech-laden Nasdaq composite index,
and the 57% rise since the index's low point last Oct.
9...It worries because it looks a lot like the kind of
steep ascent that occurred in the late 1990s and culminated
in the index's all-time high of 5,048.62 on March 10,
2000."

- The amazingly rapid ascent of Nasdaq leaders like Yahoo
is also a bit worrisome...at least to those investors who
are prone to worrying about such things. Shares of the
Internet icon have more than doubled since January 1st and
have more than tripled since last October.

- Investors clipped about 8% off of Yahoo's market cap
yesterday, when it reported earnings that were merely 'in
line' with expectations. But that means that the stock
still sports a nosebleed of more than 100 times its
estimated 2003 earnings. Will Yahoo spearhead another
Nasdaq rally during the second half of the year as the
stock's valuation soars to 200 times earnings? Could
happen...but probably won't.

- Yesterday, your New York editor returned from a four-day
junket to Cape Cod. His"New York Yankees" license plate
did not endear him to the rabidly pro-Red Sox populace of
the Cape, but his cheerful New York personality triumphed
over the locals' prejudice. Remember, we always look on the
sunny side of things here at the Daily Reckoning.

- The Cape is quintessential New England-style Americana.
It hosts a timeless annual ritual that includes fried
clams, lobster rolls, ice cream and sunburns. It's true
that sunburns are not quite as common as they used to be.
But, amazingly, even with the invention of"spf 30"
sunscreen, many vacationing Bostonians haven't figured out
how to use the stuff.

- Anyway, after four days of mulling about Cape Cod and
overhearing the locals talk about having"a bowl of clam
chowdah down by the hahbah," your New York editor is a
little bit out of touch with the happenings in Lower
Manhattan. So he checked in with some of his contacts to
see what's going on in the financial markets.

-"Inflation is returning," says Andrew Kashdan of Apogee
Research,"and no matter what Greenspan says, that's not
necessarily a good thing. Rising raw material prices are
likely to squeeze already-thin profit margins.

-"For all the apparent yearning for inflation (at least in
some corners of our nation's capital), there seems to be
scant celebration of the real thing. And for good
reason...It's bad enough that some companies lack pricing
power, and a squeeze from higher raw materials prices will
only make it harder for them to profitably move the goods
piled up on their shelves. Profits, employment and
investment will all suffer.

-"As for the prospect of a significant deflation in
consumer prices, Paul Volcker has an uncommon viewpoint:
'If I were setting odds on deflation in the U.S.,' says the
former Fed chairman, 'the probability wouldn't reach 0.1%.
I see no prospect of real deflation like we had in the U.S.
and other countries in the 1930s.'

-"Whether or not the current Fed chairman agrees with his
predecessor (and Apogee), we can't pretend to know. And
Greenspan is in no position to give us a forthright opinion
so long as his finger is suspended over the switch on the
printing press. As the Financial Times put it, the Maestro
is 'indicating just enough worry about deflation to justify
low interest rates. The game rests, therefore, on
frightening people, but only a little.' Perhaps we're in
the minority, but we're more than a little scared...about
inflation."

- The bond market, too, seems to be a little bit scared
about inflation. Bond yields have been rising briskly for
the last few weeks. Furthermore, despite the pronounced
weakness in the stock market yesterday, bonds still could
not muster a rally. The 30-year Treasury bond fell 9/32 to
yield 4.71%.

-"Long-term interest rates have jumped over the last
several weeks," says Bridgewater Associates,"and this jump
is already starting to bite households. The average rate on
30-year mortgages has risen 31 bps in the last four weeks,
and predictably, this increase has cut significantly into
the refinancing boom that has helped to lower household
debt burdens."

- Last week, the Mortgage Bankers' Association's measure of
new applications dropped 18% from the prior week and 27%
from its peak in May. Therefore, Bridgewater concludes,
"unless rates fall to new lows, the stimulative effect of
mortgage refinancings is going away...The big question in
our mind, as far as interest rates are concerned, is
whether the US economy can survive a significant interest
rate rise. We think it probably can't. Households and the
economy as a whole are more sensitive to an interest rate
rise than ever before. Refinancing has been at record
levels and will soon collapse if rates don't resume
falling."

- If refinancings stumble, the economy will stumble close
behind.

--------------

Bill Bonner, back in Paris...

*** Gold is $344. That is more than it was yesterday, but
less than it was a few weeks ago. But how will it seem to
us in 5 or 10 years...after Ben Bernanke, Alan Greenspan
and Robert McTeer have melted down every press at the
bureau of printing and engraving in their desperation to
head off a Japan-style deflation?

At today's price, it takes 26 ounces of gold to buy the
Dow. Investors - if they think about it at all - are
inclined to think that next year, it might take 27 or 28.
We pride ourselves on the elasticity of our imaginations -
did we not think that George W. Bush would be a decent
president? - but we cannot stretch our imaginings so far as
to believe that Alan Greenspan's dollars, and the stock
market itself, will rise against gold in the years ahead.
The world's investors and central banks have favored stocks
and dollars over the last 20 years. Now, they have plenty
of them - held at basis cost far above what they are really
worth. They will almost certainly be marked down...and gold
marked up...before this decade is over. Our prediction:
sometime in the next 10 years or so, you'll be able to buy
the Dow for just one ounce of gold. Our advice: buy gold
any time the price drops below $350. Then, when it rises
above $350, buy more.

*** It is quiet in Paris. The whole family has left.
Washington, Baltimore, Miami, Bordeaux, Normandy, Milan;
they are working and vacationing in various corners of the
western world. Only your editor is still at his post -
enjoying himself in the streets of Paris...

***"You can't do this like a German machine," said the
tango teacher, turning her big smile towards your editor.
"Every step is a poem...it must be graceful, elegant."

Demonstrating, she caressed the floor with the sole of her
foot, spun around and kicked backwards.

"Oh là là...but it's meant to be fun, too. It's like
everything else in life. Tango has a structure...but
sometimes the beat almost disappears, and you have to
improvise...you have to let yourself feel the rhythm in
every cell of your body and get yourself in harmony with
it. Then, you can do what you want."

Your editor was having trouble. Not every cell was
cooperating. Some seemed unable to feel the rhythm. More
than a few didn't seem to know which foot they were located
on. Others had no idea what she was talking about.

But he stumbled on - in the Daily Reckoning tradition -
with hardly a leg to stand on.

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The Daily Reckoning PRESENTS: Bill Bonner, one foot in
France, the other in...California...


SACRAMENTO ON THE SEINE
by Bill Bonner

"California is still one of the best places in America to
build a successful small business. All you have to do is to
start with a large one."

-- Last week's Wall Street Journal


Down by the river, crews of workers are turning the banks
of the Seine into a beach. They put up palm trees - planted
in huge wooden boxes so they can be removed at the end of
the summer - set up beach chairs...even dump sand. Soon,
people will be sunning themselves in the center of town.

It could be Southern California.

France is the world's 5th largest economy. California, if
it were a nation, would be ranked just ahead of it.

France has a little more land...and more than 20 million
more people, but each Frenchman produces a little less than
the average Californian.

Both have palmy trees and sunny places in the south; both
have balmy people and shady characters in the north.
Californians and French each think they are exceptional.
Both have huge holes in public finances. And neither France
nor California has a reserve currency of its own with which
to fill them.

The French believe their centralized"model" is unique,
exceptional...and better than any other.

Americans have recently become even more conceited; they
think their system of democratic capitalism is superior to
that of other nations - and especially superior to the
French, whom they see as hopelessly socialized.

Not only do Americans think their system is superior, they
believe it is destined to prevail over French social
welfarism...in the same way that Marxism was once thought
to be destined to triumph over the West...by immutable,
historical determinism.

And yet we, who live and work under both systems, find the
sting of the one lash little different from the sting of
the next. It is the ways they are alike that irritate us;
it is the ways they are different that please. Neither in
Sacramento, Baltimore nor Paris can a man go about his
business as he pleases. Even in family matters, the state
thinks it knows best. In France, a woman who gives birth to
her third child is required to stay away from work for 6
months to take care of it. In California, a new law
provides state payments to an employee who stays away from
work for the purpose of"bonding with a child new to the
family."

An entrepreneur may find it easier to start a business in
California and pay slightly lower taxes...

..on the other hand, he will not eat as well, the women he
ogles will not be as slim...he will not be permitted to
drive as fast...nor to smoke in restaurants...and the
building he works in will probably be uglier.

Americans delude themselves that their system of free
enterprise was what beat the collectivists in Russia and
now races ahead of the rigid social welfare model in
France. They think they see victory signs in every pair of
golden arches and Schwarzenegger movie they spot overseas.

They practically broke out into applause when Jean-Marie
Messier consciously Americanized his French water company,
turning it into a aggressive, debt-soaked entertainment
conglomerate.

And then, of course, Vivendi did what leveraged American
companies did following the blow-out of the early 2000s; it
almost went under. And then, it was the French turn to
applaud. The American system of cutthroat capitalism didn't
work, they said.

Colbert was one of the first great centralizers in France.
He, too, created the first public pension system. In 1673,
he put into place a system that would pay sailors to do
nothing after they reached a certain age. The plan was
intended to combat piracy, because the old sailors often
took to that devilry after they could no longer get honest
work; it was the only way they could feed their families.

Later, Otto von Bismarck took up the idea and created the
first modern social welfare state in Germany in the late
19th century.

"We'll take care of you," said the central planners in
Paris, Berlin...and later, Moscow.

"This was the exact opposite of the idea [which came,
notably, out of the Scottish Enlightenment] that a man
should take care of himself," explained Michel at lunch the
other day.

"America was founded on the idea that the individual knows
what is best for him and should be free to seek happiness
in his own way."

These two ideas - central planning on the one hand...and
individual planning on the other - were what separated
America from the rest of the world. Americans think their
model triumphed over the central planning model of the
Soviet Union...and is now beating the pants off Europe's
lighter, softer versions. But it is just the opposite. Even
in America, no one really argues against central planning
anymore. That's why there is a Federal Reserve System...a
progressive income tax...social security...the
SEC...OSHA...EEOC...FDA...and all the rest of the expensive
impedimenta of a modern welfare state. Colbert, Bismarck
and Marx have won, in other words, not Adam Smith.

Returning to California, we find in the land of the free
the very problem that now preoccupies the French. And if
you were planning to attend the Avignon Festival, the
world's largest theatre hullabaloo, this year - forget it.
It is closed because France's entertainment industry
workers are on strike. They don't care much for their
government's pension reform suggestions, and have let it be
known in the traditional way.

Lacking a reserve currency, France must ultimately find an
honest way to pay for the social welfare promises it has
made. Or it must cut back on the promises. Those promises
will cost $7 trillion, says Gerard Maudrux. Finding less
than that under the seat cushions, the prime minister has
proposed a longer period of work and set off a period of
social unrest.

Meanwhile, the Golden State has the same problem. When the
going was good - in the late '90s - public pension benefits
were increased 50%. Typically, no money was set aside to
pay for them. Instead, California operates a miniature
version of the U.S. Social Security system. It is pay-as-
you-go, without a printing press in the basement to help
out when the going gets tough.

The state receives about $65 billion in taxes. It is
scheduled to pay out about $20 billion more than that next
year. Over the next 2 years, the total shortfall is
expected to be nearly $40 billion. Balancing the budget
would require either a 47% tax increase...or a 35% tax cut.
(We know which we would choose...but nobody asked us.) Most
likely, Californians will get a little of each...and more
public debt...and a new governor, too.

California readers know the story better than we do.

We write only to offer sympathy; they are not alone. Their
state...their nation...and their situation is not so
different, after all. Even a private company, General
Motors, is in a not-so-different predicament. Unable to pay
its pension promises, GM borrows...just like France and
California.

Somehow, the same bad brew was taken up all over the world.
Whether called French dirigisme...the quest for shareholder
value...or dynamic American capitalism, they all have the
same bitter aftertaste: neither voters, retirees, nor
shareholders are likely to get what they were promised.


Bill Bonner