-->Signs Of A Hurricane

The Daily Reckoning

Managua, Nicaragua

Wednesday 18 February 2004


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*** Will we ever see gold at $400 again? 7 Small Steps to
Crisis...

*** Stocks up... bonds up... commodities up... gold up... Why?
Why ask why - step up and buy!

*** Liquidity finds its way into the market... Americans get
rich on borrowed money... stars... and more...

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Oh là là, we're glad we bought gold last week rather than
this week. Last week, you could get it for around $400. We
worried that it might be the last time we would see the
price so low in our lifetimes. Today, we wonder if ever, in
anyone's lifetime, gold sellers will ever again accept 400
paper dollars in exchange for an ounce.

The dollar went down hard again yesterday... It had to
resist a hot upswing in practically everything else.
Commodities went up. Copper hit an 8-year high. Stocks went
into even more delusional territory. But the dollar kept a
cool head... with both feet on the ground. And then the
ground gave way beneath it.

Bill Fleckenstein has identified what he calls the"7 small
steps to crisis":

* Step 1. Nobody notices or pays attention to the fact that
the dollar is falling.
* Step 2. Folks wake up, but they either don't care or they
rationalize dollar weakness as a good thing.
* Step 3. The central banks now know they have a problem,
but the bankers think the market will obey them. It will,
for a while. (This is the step we have now reached and what
emerged at the G7 meeting.)
* Step 4. The dollar now tests everyone's resolve by
resuming its decline. The currency markets will not respond
to jawboning by finance ministers.
* Step 5. In this step, the finance ministers are forced to
take action. (Think about it. Even if they'd stated that
they wanted the dollar to go up, nothing either explicit or
implied indicates they'll do anything about what's
happening. That will come next.) When they do take action,
the market will do what they want - but only for a while.
* Step 6. The ministers take some additional action, but it
won't be enough, and the currency markets won't do what the
ministers want.
* Step 7. Finally, we'll have a full-blown crisis, and that
will be the end game.

Americans have come to expect stability from their dollar.
Not that it held its value... but that it lost value at a
reasonably predictable rate. They didn't sweat the dollar's
decline; they welcomed it. A steady rate of inflation and
full employment made it easier for them to live beyond
their means; they could borrow... confident that inflation
would make the loans a little easier to carry.

But now the dollar is losing value in a new and different
way - while prices at Wal-Mart are going down, too. They
don't know what to make of it. They continue to bet that
they won't really have to pay their debts... while, as in
Japan 10 years ago, consumer prices sink and well-paying
jobs become scarce.

We don't know what will happen... but, before it is over, we
wager that the poor lumps will wish they had bought gold
below $400.

Addison is vacationing in the French countryside, we hear.
But here is Dan Denning, our other Paris-based analyst,
with more news...

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

Dan Denning in the City of Light...

-"Why are the lumps buying?" your New York and Nicaraguan
editors ask."Why ask why," your Paris-based pinch-hitting
editor replies,"step up and buy!" The market was open for
business again yesterday, and fresh from a three-day
weekend, investors couldn't resist the urge to buy.

- I'm only joking about buying, of course. But all the
signs are pointing to a new high on the Dow, whether it
makes any sense or not. The Dow was up 87 points at 10,714
by yesterday's close. It's now within spitting distance of
its all-time closing high of 11,287, set way back on May
12, 2000. To put that in perspective, the Dow need only
rise 5% to make a new all-time high, or about one month's
solid effort (the Dow was up 5.6% in December).

- How is this possible? Isn't the financial economy
terribly overvalued? Well, yes. The S&P 500 trades at about
30 times earnings. And yet the Fed reported yesterday that
foreigners bought another $75.7 billion in U.S. financial
assets in December. That was down about 13% from November's
$87.5 billion level. But it still represented net buying.

- In fact, while no one was watching, a handful of
financial indexes started trading at new all-time highs.
The Philly Banking Index (BKX) is up 50% since March of
last year - at 1,008, it's higher than it was in 2001. The
Amex Broker/Dealer Index (XBD) is up 114% over the same
period and is also trading at an all-time high.

- As Steve Barrow, a currency trader at Bear Stearns in
London, remarks:"Too much liquidity has been created. It
has to find a home. And with global growth still sluggish,
it will find a home in financial assets."

- All this is happening in spite of the dollar... that
miserable excuse for purchasing power. In London this
morning, it will cost you $1.91 to buy a pound. And here in
Paris, it now costs $1.29 to buy a euro, leaving me with an
average nightly bar tab of $13 for two beers at the
Australian bar on rue St. Denis. Just think what the euro
will get you over in the States now, though. In fact, I'm
encouraging other American immigrants in Europe like myself
to mail euros to our currency-cursed relatives back home.

- Oddly - in this age of financial oddities - even while
the world sells the dollar, it turns around and buys U.S.
bonds. The rest of the world bought another $29.8 billion
in U.S. government bonds in December. This total is down
from $33.5 billion the month before, but not enough of a
reduction to worry about a panic selling in the Treasury
market (yet).

- This is good news if you own bond calls (as I've
recommended to readers of my options service.) But it's not
entirely good news. Here's a curious fact I gleaned from
Treasury department data: between 2002 and 2003, Caribbean
banking centers added to their ownership of U.S. bonds by
almost 40% - from $49.5 billion in 2002 to $69.5 billion in
2003. They are now the fourth-largest owner of U.S. bonds,
behind Japan, China, and the U.K.

- There may be an obvious reason for this. Offshore hedge
fund buying, for example. But we don't really know who is
now the fourth-largest owner of U.S. bonds. It could be a
hodge-podge of wealthy individuals. Then again, it could be
narco traffickers... political terrorists like Osama bin
Laden... or George Soros (who was once called a financial
terrorist), building up a huge position in Treasuries to
spring an October surprise on George Bush and crash the
dollar by selling.

- As Stephen Jin, a currency economist, said in a recent
Wall Street Journal article, it probably isn't desirable
for the U.S. that"a small number of countries control its
Treasury market." Then again, that's what you get when you
spend more than you earn (or tax away). It's probably not
desirable that the U.S. has twin current account and fiscal
deficits of half a trillion dollars a piece. But it's a
fact anyway.

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Bill Bonner, back in Nicaragua...

*** Japan's economy is growing at a 7% rate - faster than
at any time since its slump began in 1990. Is its recovery
for real? Maybe.

*** The financial economy is"terribly overvalued," Dan
Denning notes above.

Dan Ferris agrees:"After 11 months of a rallying market,
bargains are scarce."

Even Warren Buffett, the king of value investing, can't
find anything worth investing in inside the U.S. stock
market. On only one other occasion did he reach a similar
conclusion:

"In 1968," writes Dan Ferris,"Buffett's partnership gained
$40 million, or 59%. Assets ballooned to $104 million.
After a year like that, a modern-day mutual fund manager
would take out a full-page ad in the Wall Street Journal.
He'd brag about his one-year, five-year, and ten-year track
records, trying to garner more capital... and more fees.

"Not Buffett. He let it be known that such a performance
'should be treated as a freak [event],' akin to a 100-year
flood.

"That's the difference between value investors and
everybody else. Everybody else loves it when stocks go up.
They buy more and suddenly feel like financial geniuses.
Value investors just collect their profits and wait for
stocks to get cheap again.

"That's exactly what the great value investors of our time
are doing right now."

*** Surprise, surprise. We all know, of course, that
Americans are getting rich by borrowing money. Now, USA
Today tells us the average car buyer puts down only a third
as much as he did 10 years ago... and stretches out his
payments over 63 months rather than the 48 that were common
in the 1990s. What's more, he typically finances 101% of
the purchase price.

*** What a treat. After months in cold, gray Northern
Europe... we lay beside the pool last night and admired the
stars.

"I didn't know there were so many stars," said Henry. There
were blue stars and red ones. Small, faint little twinkles
and great shining stars that looked like parking lot
lights. We didn't even need our reading glasses to see
them.

But why are we telling you, dear reader? You have seen the
stars yourself. Still, as we looked up the heavens last
night, we felt as if we had forgotten them. They must have
been there all along... but we hadn't noticed. Instead, we
filled our days and our heads with Dow price points,
deadlines, homework, and trips to the bakery. We forgot
that we lived among stars.

"Is that Orion's Belt? Is that the Big Dipper? I think that
must be Mars... or is it Venus?" The boys had questions your
editor couldn't answer. So he changed the subject:

"Look, that big dusty cluster that stretches across the
sky... that's the Milky Way," he said confidently."And some
of these stars are dead. The stars are so far away it can
take millions of years for the light to reach us. So, what
we see is the way the star looked millions of years ago."

"That was before I was even born," said Edward, 10.

"Wait a minute, Dad," said Henry, spotting the flaw."If
you had looked out millions of years ago, you wouldn't have
seen what you see now. You would have seen what the star
looked like millions of years before that... maybe you would
have seen nothing, because it hadn't been born yet. You can
only see what you see now right here and right now. So what
we see is what the star looks like right here and right
now... not the way it looked millions of years ago. Right?"

"Henry, don't you have a book to read?"

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The Daily Reckoning PRESENTS: The U.S. 'recovery'
continues... but tensions are billowing beneath its surface.
How long before they unleash the winds of fury - causing
the consumer to retrench, inflation and interest rates to
surge, and the dollar to fall precipitously?


SIGNS OF A HURRICANE
by Marc Faber

The present"strong" recovery phase in the U.S. economy
won't last for long, as it is totally artificial. There are
simply too many imbalances in the system - as reflected by
a record low national saving rate, record household debts,
and record trade and current account deficits - for this
recovery to lead to sustainable strong growth that would
justify the present stock valuations.

According to economic theorist Joseph Schumpeter, economic
recoveries that are purely a consequence of fiscal and
monetary stimulus must ultimately fail. Schumpeter writes:
"Our analysis leads us to believe that recovery is sound
only if it does come from itself. For any revival which is
merely due to artificial stimulus leaves part of the work
of depression undone and adds, to an undigested remnant of
maladjustments, new maladjustments of its own."

My colleague Peter Bernstein correctly points out the
complexity of the issues involved:"Private sector saving,
private sector investment, household consumption,
government spending, government revenues, capital flows,
and trade balance all react upon one another - often in
surprising fashion. We live in a complex system: each piece
tends to function as both symptom and cause." And while I
cannot discuss here Bernstein's entire analysis of economic
data, which he himself admits is"confusing," I would like
to point out that he also is"certain" that"current trends
are not sustainable."

Bernstein writes:"The imbalances are now enormous, far
more glaring than at any point in the past. Furthermore,
the linkage of the parts are so tightly knit into the whole
that reducing any one imbalance to zero, or even
compressing them all to a more manageable level, appears to
be impossible without a major upheaval. A hitch here or a
tuck there has little chance of success. When it hits, and
whichever sector takes the first blows, the restoration of
balance will be a compelling force roaring through the
entire economy - globally in all likelihood. The breeze
will not be gentle. Hurricane may be the more appropriate
metaphor."

Part of the problem the United States is facing is the
long-term decline in the U.S. national saving rate
(including household saving, corporate cash flows, and the
government's budget surplus or deficit). As a percentage of
GDP, there was an improvement in the national saving rate
between 1993 and 2000 due to higher taxes and a swing in
the federal budget toward surplus... but thereafter, the
national saving rate plunged. Over the same time period,
real personal consumption expenditures as a percentage of
GDP declined modestly between 1988 and 1998, but soared
between 2000 and 2003 to a record.

Now, in past recessionary periods (1973-74, 1981-82, and
1990), the tendency has been for real personal consumption
expenditures as a percentage of GDP to decline modestly
and, in the process, create"pent-up" demand - which then
leads to sustainable growth. But at present, given the low
national saving rate and record real personal consumption
expenditures as a percentage of real GDP, there seems
little room for consumers to boost their expenditures
significantly... unless households increase their
indebtedness much more, or households' net worth or income
rises substantially. U.S. consumers have increased their
spending for an unprecedented 47 quarters in a row. (The
last downturn was in the fourth quarter of 1991.)

More recently, consumer spending rose largely as a result
of higher borrowings. U.S. household sector debt to net
worth is at an all-time high, having expanded very rapidly
since 2000, when the economic expansion started to stall.
And while it is true that the cost of servicing the debt
isn't excessive, this is only due to the sharp decline in
interest rates we have had since the early 1980s and
especially after 2001.

Meanwhile, household income has declined significantly.
Hourly earnings increases have been declining sharply since
late 2002 - most likely because of the accelerating trend
to manufacture in low-cost countries and outsource services
to countries such as India. In fact, real wages have
actually been in decline since 2001; in the 12 months ended
September 2003, they fell 0.2%. Some recovery in real wages
is possible... but given the low level of hourly earnings
increases, the fading impact of the tax cuts after January
2004, and lower refinancing activity, consumption is
unlikely to receive much of a boost from the households'
income.

Then again, actual figures for real wages and salaries are
far lower than those reported, as the U.S. government has
been purposely understating inflation figures by a wide
margin. Moreover, overseas competition for manufacturing
and services is here to stay, and inflation may actually
pick up. These factors lead me to believe that real wages
could actually decline further.

So where does all that leave us? Consumption could
theoretically be increased, if not through income growth,
then through a further decline in the national saving rate
and additional consumer borrowings. But for households'
borrowings to keep on expanding, asset prices - including
housing and equities - must continue to appreciate, or
interest rates will have to decline much further!

In other words, rising asset prices, which supported
additional borrowings, have largely been driving the U.S.
recovery (though the government also made a small
contribution by boosting spending). This is particularly
true of the housing sector, where rising home prices
allowed households to increase their mortgages and provided
them with additional spending power.

I hope you appreciate the precarious nature of this state
of affairs. The entire U.S. economy is depending on high
"asset inflation" in order to stay afloat! Only if asset
prices continue to rise at high rates can consumers
maintain their borrowing binge.

But trouble seems to be brewing in the American wonderland.
First of all, it would appear that the housing sector is
slowing down. The Merrill Lynch Housing Index has declined
sharply since August, and the growth rate in real estate
loans has slowed to an 11.5% year-over-year growth rate,
down from this summer's 18% growth rate. Refinancing
activity is down by 70% from its summer peak, and real
estate loans at banks have begun to contract. But why
worry? Most recently, the tireless and imaginative American
consumer offset slower real estate loan growth with a sharp
jump in consumer loans carrying a higher interest rate!

The question that arises is, of course, how sustainable is
an economic recovery that is driven by a declining saving
rate and strongly rising additional borrowings - which in
turn depend on rising home and equity prices, especially
since the combination of these factors has led to a sharp
deterioration in the U.S. trade and current account deficit
and hence to a weakening dollar? Please also note the
doubling of the trade deficit with developing countries
(especially due to U.S. imports from China).

This highly artificial recovery is, in our opinion, not
sustainable for very much longer. Even so, we should all
realize that the Fed is fully aware that asset prices must,
under no circumstances, be allowed to decline. In fact, the
Fed will try to make them appreciate even further through
highly expansionary monetary policies, as stagnating home
prices alone would endanger the recovery, while declining
prices would be altogether unbearable for the highly
leveraged household sector, whose debt to net worth would
soar in an environment of declining asset prices.

So, we are in a situation where the imbalances are likely
to worsen further until something gives. At some point, the
American consumer will retrench voluntarily, which might
slow down the expansion (but probably not much) of the
trade and current account deficit. Or, it is possible that
the consumer will be forced to retrench through a rapid
loss of the U.S. dollar's purchasing power. Rising
inflation rates would then inevitably lead to higher
interest rates, and most likely also to falling real
household income, as wage increases would be unlikely to
match the rate of inflation.

Therefore, a voluntary or involuntary consumer retrenchment
could badly derail the Fed's inflationary monetary
policies. I am not sure exactly how the present imbalances
will play themselves out, since, as Mark Twain remarked,"A
thing long expected takes the form of the unexpected when
at last it comes." But I am certain that Peter Bernstein
will be proved right when he writes, above, that the breeze
accompanying the restoration of balance will not be
"gentle"... but will likely take the form of a financial and
economic hurricane.


Regards,

Marc Faber
for The Daily Reckoning