-->Increasingly Wicked Inflation

The Daily Reckoning

Rancho Santana, Nicaragua

Thursday, 19 February 2004

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*** The Question... when? If only we knew the answer...

*** The Great Slump continues... enjoy the pause...

*** The value of a good hosing... is this progress - or
what? And more...

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"I enjoy the Daily Reckoning..." begins a friendly reader
from Britain,"... However I must pose the Question, when is
the big drop going to take place?

"Any regular reader would, several years ago on reading the
'reckoning' forecasts, have put up his umbrella, canceled
all trading, withdrawn into a defensive shell, and taken up
residence in a cave situated on K9.

"And in the meantime missed out on a great bull rally.

"Thank you for the Daily Reckoning regular 'The end is
nigh' messages. We for countless years have had chaps
strolling up and down Oxford St. daily giving the same
message by sandwich boards. Anyone in their right mind
knows that this crazy economical dreamland cannot carry on
for ever, and that one day the piper will call for
repayment.

"In the meantime, we have to trade to live. So in the
meantime, I trade what is happening, not that which I think
should happen. And it might be a good idea for Bill Bonner
& Co. to encourage such action in his otherwise excellent
messages."

Of course, fish gotta swim, birds gotta fly... and traders
gotta trade what is happening NOW.

But, here at the Daily Reckoning, we have neither gills nor
wings. We have no sure answer to the Question. And if we
thought we could help readers trade successfully... well,
we'd be tempted to charge for it.

No, our beat here is merely trying to figure out what is
happening. We want to know, partly because we are curious,
partly because we greedy, and partly because we are just
looking for entertainment.

What is really going on, we ask ourselves? What does it
mean? Why is it happening? What OUGHT we to do about it?

We step back to get a better view... or climb a pile
corpses. Either way, you could hardly expect us to be able
to spot a decent trade at this distance!

It has been four years since the 3rd millennium and the
Great Slump began. Stocks, generally, began to fall in
January of 2000....10 years after Japan's slump began. In
Japan, it took the next 14 years to squeeze out the spirit
of optimism and wring out the inflation that had puffed out
asset prices. Stock and real estate investors lost
70%... 80%... 90% of their money.

In America, Nasdaq investors took similar losses. But they
were largely"paper losses." Many investors saw their
'profits' wiped out... but their stocks and options were
right back where they started. And they were still pretty
sure that stocks were the place to be 'for the long run.'

And then the Feds came to the rescue with truckloads of
cash. They spread it around Manhattan as though it were
bales of cotton on a bayou dock. A desperate investor,
jumping out of a high window, would fall right into it and
not feel a thing. He just got up, dusted himself, and went
back to ruining himself with more confidence than ever.
Now, he was not merely a genius, he told himself, but a
survivor.

When the bull market on Wall Street began, you could buy
the entire list of Dow stocks for the price of a single
ounce of gold. By the time the bull market had hit its
bubble peak, it took more than 30 ounces of gold to buy the
Dow. In the last 4 years, that number has come down... but
only slightly... to 25.

As we sit here under the starry skies of Latin America... we
wonder. If the ratio of 20 years ago were ever to be seen
again... either gold must go up 25 times, or stocks must go
down 96%. We don't know, but we guess that it will take a
little of both... and that some gloomy day, sometime in the
future, maybe the Dow will be around 2,500... and maybe an
ounce of gold will sell for the same price.

Something big began 4 years ago. The U.S. had climbed a
mountain of credit in the preceding 25 years; now, it is
headed down. Somehow, sometime, someway... it will work its
way down to the valley of despair that lies ahead. Several
times in the past, investors were sour enough to think that
a dollar's worth of stock market earnings was worth only $5
or $6 of share price. Why wouldn't they think that way
again? They once thought, too, that America's leading
stocks - all 30 of them - were worth no more than a single
ounce of the yellow metal. Why wouldn't they think so
again?

The work of the Great Slump is far from over, we conclude.
Yes, you can trade the rally. But don't forget to step back
and have a look around occasionally. Otherwise, you might
forget who you are... and what you are doing.

Why should stocks be 25 times more valuable - in terms of
gold - than they were in 1980, you might ask yourself?
Neither stocks nor gold are intrinsically more valuable. No
important new use has been found for that which glitters.
Nor has any new advantage been discovered from owning
stocks. Stockholders do not necessarily live longer or
weigh less. People do not admire the cut of their suits or
their skill at Parcheesi any more than they did before. Nor
is a buyer of gold any dorkier than he was in the final
years of the Carter Administration. We are all the same
race... the same people... with the same hearts and the same
fears. We still live on the same planet... and under the
same stars...

.. and suffer the same slumps... just as in Japan.

Over to you, Dan...

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Dan Denning under the cold, gray skies of Paris...

- Pause. That's what stocks seemed to do yesterday. The Dow
closed at 10,672. April gold was down a few bucks to close
at $412. You can't blame stocks for being tired... they've
come a long way, baby. And when they stopped yesterday, in
the rarefied air of one of the strongest rallies in the
post-WWII era, they couldn't have liked the lay of the
macro-economic land.

- First, the Commerce Department reported that January
housing starts were down nearly 8% from December's
record... but perhaps that's simply a seasonal phenomenon.
The Mortgage Bankers Association reported that its purchase
index, a measure of new loan requests, was up 2.9%. Still,
the National Homebuilders Association reported that its
Housing Index, a measure of sentiment in homebuilders, fell
from 69 to 65.

- Is the home-building boom ending? Is the mortgage
financing bubble fixing to pop? One month does not a trend
make, but at the very least, housing activity - both
building and buying - is coming off record levels. We're
starting to see signs that interest-rate-sensitive demand
might be slowing, even while home building supply keeps
increasing. As Scott Winningham, an economist at Stone and
McCarthy Research Associates, said in a Reuters article,
"There's a growing divergence between new home sales, and
homes being started and those still on the market."

- Of course, as interest rates go, so goes mortgage
activity. And on the interest rate front, stocks will have
to digest the news last night that for the first time in
the history of the Republic, the government debt is over $7
trillion.

- Bond prices haven't reacted to the news yet. But the
obvious question is: will rising government debt force the
Fed to finally"defend the dollar" and raise rates before
it wants to? After all, seven trillion is a pretty big
number... though one Treasury Department official claimed,
"there's nothing special about [it]." But according to
Congressman Baron Hill of Indiana,"It is simply immoral to
run a national debt exceeding $7 trillion, every penny of
which our children and grandchildren will be responsible
for paying back."

- Naturally, since we live in bizarro investment world, the
dollar rallied on the news that America's government is
fiscally and monetarily incontinent. After trading at a
record level of $1.29 to the euro, the greenback recovered,
presumably as euro traders took some profits.

- The fireworks, however, are just beginning, and a big
move down in the dollar may be in the offing shortly. Otmar
Issing, the chief economist at the European Central Bank,
delivered a monetary slap to Alan Greenspan yesterday in
the Wall Street Journal."... We have repeatedly experienced
situations," writes Issing,"in which market participants
found it more rewarding to follow a trend than to bet
against it despite their own view that the development was
not sustainable. It is worth noting that with hindsight,
i.e. after the collapse, almost everybody seems to agree
that a 'bubble' has burst. Is it not difficult, then, to
accept the argument that it should be totally impossible to
make any judgment ex ante? Should it not be the role of
central banks to communicate concerns in an appropriate
form and thereby to try to contribute to a more sober
assessment of asset price developments?"

- Translation:"Hey Mr. Greenspan, sober up, you've got an
asset bubble on your hands, you big lush." It appears a
strong currency makes central bankers rhetorically cocky.
But Issing is right. He has essentially rebuked his
colleagues in the U.S. with this sentence -"... It should
not be overlooked that most exceptional increases in prices
for stocks and real estate in history were accompanied by
strong expansions of money and/or credit. Just as consumer-
price inflation is often described as a situation of 'too
much money chasing too few goods,' asset-price inflation
could similarly be characterized as 'too much money chasing
too few assets.'"

- The Fed is beginning to reap what it has sown in the
monetary whirlwind. And the dollar will be the chief
(although not the only) victim. The chief beneficiaries
will be currency speculators... and, of course, gold. As
Thomas Donlan said in this week's Barron's,"You don't have
to wish for gold coins clinking in your pocket to realize
that gold is still a relevant measure of wealth, no matter
how many economists denounce it as a barbarous relic.
Without some attachment to harder values, the half-life of
paper money is Hobbesian - 'nasty, brutish and short.'

- Donlan continues,"Every day, millions of traders,
speculators and investors pass judgment on the dollar and
its stewards as much as on the supply and demand for
whatever they happen to be buying or selling that's priced
in dollars, euros, yen, yuan, rupees or wastepaper. When
the dollar goes down, that's a sign we're going wrong. As
any Argentine must know by now, the markets, like the mills
of the gods of old, grind slow, but they grind exceedingly
fine. At the moment, the markets threaten to grind the
dollar to powder."

- Enjoy the pause... while it lasts.

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And back in sunny Nicaragua...

*** Gold fell $3.70 yesterday. It is still at $412... and
still a bargain. But we are alarmed by the number of people
who think the dollar is on course for steady decline. Even
the major media - TIME and BusinessWeek - are talking about
a continued drop of the greenback. This can only mean two
things. Either the dollar is ready for an important
rally... or it is ready to collapse.

*** Ah paradise...! We discovered this place, what, 5 years
ago... or more. We lay in a hammock... with no phone... no
TV... no Internet... What a pleasure it was to walk on the
lonely beach... and then read a book....and let 'Rome in the
Tiber melt"...

But then we became accidental, reluctant developers -
building a clubhouse... roads... houses... tennis
courts... pools... riding stables. All very well to have a
beautiful setting... but we needed things to do!
And so, on this vacation, your editor spends his days in
meetings - discussing all the things that need to be done
in order to make sure there are things to do. There are
phones... TV... and Internet. And the latest... a WIFI
connection... so that your editor can work on his laptop
computer no matter where he is - even on the beach itself.
Now, nowhere - in this corner of God's green earth anyway -
can a man get away.

Your editor has barely seen his family... he has barely felt
the sand beneath his feet or the sun on his back... but he
has gotten a lot of work done. Is this progress... or what!

*** Following his comments on China last week... our friend,
Karim Rahemtulla, writes about his mother country...

"Prior to 1997, I had never visited India nor paid much
attention to the region. After all, the Indians that I knew
were all fleeing the country for better opportunities
abroad. But, Asia was in vogue in the early to mid-
nineties, and I felt the need to make a trip over there and
to other parts of Asia to check it out in person...

"... After a late night arrival in Delhi, I woke up the next
day for a walk around. I wore new white sneakers, a pair of
walkers bought just for the trip. I got my first take on
Indian capitalism very soon after leaving the hotel. A
street urchin approached me and told me my sneakers needed
cleaning. I was wearing shorts and a polo shirt - I guess I
stood out as a tourist from a mile. I didn't have to look
down - after all, the sneaks were new. I said no and began
walking away. He persisted and so I finally looked down,
and lo and behold... something gross was smeared all over
one of my sneakers. There were few cows walking around on
the streets, so I know I did not step in a cow patty. To
this day I know the little guy had intentionally pitched
something on my sneakers just to make a sale.

"'Ok. Go ahead, clean it up.' It took him about 20 seconds
of mixing some concoction from his little box to come up
with a cleanser to miraculously make my shoes look like new
again ( I wonder if Proctor and Gamble gets its formulas
from some backstreet chemist in Delhi.) His price - $3
dollars. I gave him a dime and told him to take a hike. He
did while firing off expletives in Hindi in my direction.
Hey, I may be a tourist, but I do know the value of a good
hosing. I guess in a country where 80% of the population
(at least 1 billion out of 1.3 billion) are poor, the art
of making something out of nothing has been perfected!

"Let me digress for a minute. I am not opposed to investing
in India, China or Asia in general. I am opposed to
investing without a darn good guide who knows what is
happening on the ground. There are too many 'me too'
investments that pop up from these countries with nothing
more than a trumped-up story of gold in them thar' hills.
So, please, invest away, but do so with eyes wide open and
ears to the ground."

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The Daily Reckoning PRESENTS: As the dollar continues its
stately decline... or, as your Paris editor notes above,
possibly approaches its rout... certain"reflatables" are
poised to profit. But be careful how you choose them!


INCREASINGLY WICKED INFLATION
By Christopher Mayer

Inflation proper - an expansion of the money supply - has
been going on for quite a while. It was the fuel for the
late nineties boom. But a different sort of inflation is
now beginning to emerge, a growing menace to indebted
consumers.

What we are talking about here might be more accurately
described as price inflation - a general and widespread
increase in prices, or stated differently, a general and
widespread decline in the purchasing power of money. In the
dollar's decline, we have started to see this... but it is
only the beginning.

Bill Gross of PIMCO, the Warren Buffett of the bond world,
has long been an astute observer of the bond market, and
financial markets generally. His December 2003 Investment
Outlook contained a nice summation of an investment thesis
for 2004. In short, Gross is in the inflation camp... as am
I.

Gross seems to take Fed officials at their word when they
talk about"printing presses." Wisely, in my estimation.
There are few things government cudgels do with much skill,
but one of them is certainly destroying the value of their
own currencies. History gives us plenty of examples, most
famously the great German hyperinflation of the early 1920s
or France in the 1790s. But there are recent examples, too,
especially in Latin America and the old Soviet bloc
countries. All paper monetary systems tend toward the
valueless and crisis-ridden, as history proves.

In Gross's view, the reflationary effort is only in its
infancy and is not likely to immediately jump up and bite
investors. [Note: reflation is the somewhat contrived term
often used to describe an attempt to revive a previous
inflationary boom by increasing or stepping up inflation.]
Nonetheless, the stance for investors today should be one
of preparing for increasingly wicked inflation.

Gross presents the following asset categories, which he
ranks by his own personal preference. These include
commodities and tangible assets, foreign currencies, real
estate, TIPS, and global bonds and equities denominated in
non-dollar currencies. Gross calls these
"reflatables"... and if you are shopping for places to put
your money, this list would be a good place to start.

Reflecting on his choices, in particular global bonds,
Gross notes the likelihood that foreign currency gains will
dominate returns, even if yields should move higher.
Foreign credit markets present slightly higher yields to
begin with, though one has to wrestle (sometimes) with
estimating the additional political risk. Similarly, global
equities offer cheaper valuations than U.S. equities. Gross
notes that the UK's FTSE yields 3.7% compared to 1.6% for
the S&P, as well as selling for lower P/E multiples.

There is no doubt the dollar is weakening. Long held as the
international currency of choice, it has been weakening for
at least a year, and there are suggestions that it may be
the beginning of a significant revaluation.

First, there is the simple raw evidence of market data. The
dollar seems to make new lows against the euro every day;
the dollar declined 20% against the euro in 2003. It also
reached an eleven-year low against the pound and a ten-year
low against the Canadian dollar. These are not isolated
examples, but recurring strands of a larger fabric of soft
comparisons against foreign currencies. From its peak in
2001, the U.S. dollar index, which charts the currency
against a basket of six major foreign currencies, has
declined more than 25%.

Another clue is found in the gold market. The yellow metal
had a tremendous year in 2003 and now trades north of $410
per ounce - a level not seen in more than eight years - and
is up more than 25% from one year ago. Gold is up 60% from
its low of $255 per ounce in 1999.

In addition to cold numbers, there is anecdotal evidence of
interest. Warren Buffett, for one, is selling the dollar.
In his article for Fortune ("Why I'm not buying the U.S.
dollar") Buffett writes,"Through the spring of 2002, I had
lived nearly 72 years without purchasing a foreign
currency. Since then Berkshire has made significant
investments in - and today holds - several currencies. I
won't give you the particulars; in fact, it is largely
irrelevant which currencies they are. What does matter is
the underlying point: To hold other currencies is to
believe that the dollar will decline."

When the Oracle of Omaha does something he has never done
before, that is worth noting.

Buffett cites primarily the unprecedented size of the U.S.
balance of payments deficit. Foreigners hold $9 trillion
worth of U.S. dollar-denominated assets. Much of that is in
U.S. bonds. The accumulation of this debt has surpassed all
previous records. Foreigners are not likely to continue
buying dollars at record-setting levels and any shifting in
this trend will result in a further weakening of the
dollar.

Buffett is not alone - Soros, Templeton, Jim Rogers and
other investment luminaries are betting on a dollar
decline. That is not a crowd one is going to make a lot of
money betting against.

With continued weakening of the dollar playing a
significant part of the investment backdrop, investors find
themselves in a tough spot. During the boom of 1995-1999,
it was easy enough to refrain from buying tech stocks, for
example. The risks today seem more nebulous and far-
reaching, and hedging seems more difficult. It is easy to
understand the bullish case for reflatables - but it is
more difficult finding concrete investment ideas that
represent good values in these areas.

Looking at commodities, for example, many gold companies
seem expensive and lack Ben Graham's margin of safety. They
have become speculations on the price of gold - a good
speculation, perhaps, but a speculation nonetheless. Better
to own the metal itself, at this point, but that is not
easy to do.

Investors can widen their search and explore other tangible
assets. But again, in most of these instances, the readily
available and liquid investments are going to be in
commodity-oriented companies that have their attendant
risks and are not pure plays on the underlying commodities
themselves. Real estate is similar, except that most people
have real estate exposure with their investment in their
own homes.

A weakening dollar naturally implies that several (many?)
foreign currencies will do better relative to the dollar.
Hence, investments in non-dollar-denominated foreign
securities should do well relative to the dollar, all else
being equal. The problem is that international investing
(especially the emerging market variety) has its own risks,
often overlooked.

In summary, Bill Gross's"reflatables" have a great deal of
investment appeal at the theoretical level. Finding
concrete ideas and opportunities that meet a rigorous test
for a margin of safety is more difficult. That is always
the more difficult task.


Regards,

Christopher Mayer,
for The Daily Reckoning