-->A Damnation in Disguise

The Daily Reckoning

Albuquerque, New Mexico

Tuesday, August 03, 2004

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***"Orange alert," tear gas and homeland security...

*** Options trader: gold ready to bounce!

*** The Bonners in Albuquerque: camels, pensions and more
students!

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"I don't recognize the place," was our first comment.
We once lived in Albuquerque, nearly 40 years ago. New
Mexico was a strange place - one of the poorest states in
the nation. People lived in ramshackle hovels and drove old
pickup trucks.

But now there are houses everywhere...and new cars clogging
up the streets. One street stretches for miles, lined with
nothing but auto dealers.

How did people get so rich? We don't know. Wages have
scarcely risen, yet everyone seems to have a lot more money
to spend...

More travel notes, after the news from Eric:

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Eric Fry, from a city at risk...

- The hardy Dow Jones Industrial Average shrugged off
terrorism threats and record-high oil prices to notch its
fifth-straight winning session - the blue chip index's
longest winning streak since mid-December. Under the amber
glow of an"orange alert," the Dow advanced 39 points, to
10,179, while the Nasdaq gained 5 points, to 1,892.

- Ironically, terrorism-focused stocks logged some of the
day's largest gains. Mace Security International (MACE),
which makes pepper and tear-gas sprays, gained 6.3%, while
DHB Industries (DHB), a maker of bulletproof vests and
other body armor for our troops in Iraq, jumped 9.1%.

- Over the weekend, Homeland Security Secretary Tom Ridge
raised the terror alert level to"orange," citing
"unusually specific" evidence of possible attacks against
certain key financial buildings, including the New York
Stock Exchange. But the bulls would not be so easily cowed
into selling stocks.

- Al Qaeda be damned! The if-you-sell-stocks-the-
terrorists-win contingent was out in force yesterday,
buying stocks in the name of war. Immediately after the
opening bell, share prices charged into negative territory.
But the patriotic lumpeninvestoriat repelled the sell-off
and pushed the major averages back into the black. What's
more, the lumps maintained their buying even as crude oil
prices set new all-time highs. September crude futures
added 2 cents at $43.82 a barrel on the New York Mercantile
Exchange, after advancing within a whisker of $44 a barrel.

- Curiously, yesterday's anxieties produced precious little
buying in the precious metals pits. Gold gained a mere 40
cents, to $394.10, while most gold stocks had very little
to show for their 6½ hours of trading. Nevertheless, one
savvy investment pro believes gold stocks are now in
"bounce mode."

Jay Shartsis, professional options trader at RF Lafferty
here in New York says,"Four gold stocks had 'selling
climaxes' or bullish weekly reversals last week [They made
new 52-week lows, but closed higher on the week]. They are
ASA Limited (ASA:NYSE), Gold Fields (GFI:NYSE), Hecla
Mining (HL:NYSE) and Richmont Mines (RIC:Amex)."

- This week's Commitments of Traders report lends credence
to Shartsis' call for a bounce. The report shows that
commercial traders (known as the"smart money") have been
rapidly reducing their bearish bets against gold."The
just-released report," says Shartsis,"shows a big
shift...as the commercials decreased their shorts by a very
big 40,892 contracts, while paring their long position by
only 1,486 contracts. This is a pretty good move in the
right direction for gold bulls."

- In other words, the smart money is becoming more
favorably disposed toward the yellow metal, which should be
a good thing.

- Turning our attention back to the realm of paper assets,
what should we make of our confused little stock market?
For weeks it had been falling for no apparent reason. And
now that it finally has a good reason - or two or three -
it doesn't. It inches higher.

- Throughout the spring months, the stock market seemed
like a wax museum - lifelike, but fixed in place. As July
arrived, however, the wax museum became a House of
Horrors...the wax figures came to life and terrorized
investors. Between June 30 and July 26, the Nasdaq tumbled
more than 10%.

- But the horrors have ceased for the moment at least, as
the Nasdaq has bounced back about 3%. And the lumps are now
hoping that the House of Horrors becomes a kind of
financial Louvre - a serene location filled with countless
items of beauty and objets d'art...a place where the sights
and delights are well worth the price of admission.

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Bill Bonner, back in Albuquerque...

***"There's so much to see in New Mexico," Elizabeth
commented.

There are two factions in our family. Elizabeth and Henry
study things carefully and try to learn all they can. When
they travel, they read guidebooks, history books and travel
books - with the aim of learning every detail they can.

Elizabeth was studying an"insight Guide" to New Mexico on
the plane. By the time we landed, she knew the history of
the place - even its geological past - and was ready to
visit museums and historical sites all over the state.

The rest of the family takes a more spontaneous approach to
tourism. We get in the car and drive; we may not always end
up where we intend to go, we say to ourselves, but we
always end up where we ought to be.

"This is one of the most geologically active regions in the
world," Elizabeth continued."It has active volcanoes. Of
course, the last eruption was 3,000 years ago."

In a matter of minutes, Elizabeth was lecturing the family
on the Permian Sea...on the KT boundary...and volcanic
rocks."All igneous rocks are formed by volcanoes," she
explained."But some cool inside the earth - such as
granite - and others cool after they get to the surface,
such as...I think they're called tuffs."

We stopped in at the Natural History Museum in Albuquerque.
You walk through a display that begins with the Big Bang
and carries along until Homo sapiens appear. Particularly
impressive, and somewhat alarming, was the presentation on
the great extinction. About 65 million years ago, most
advanced forms of life on Earth were exterminated. No one
knows exactly why. But the leading theory is that a giant
burning rock, 6 miles across, smashed into the Gulf of
Mexico. It set off floods, firestorms, and all manner of
catastrophe. The big dinosaurs went down like duckpins. The
pictures in the museum show them lying on their backs with
their feet sticking up.

But the little mammals survived, flourished, and inherited
the Earth. The meek little things had been hiding in holes
to avoid the dominant, meat-eating beasts. They were saved
by their own modesty, protected by their ignoble holes.

Man is now the world's Tyrannosaurus rex...the alpha
species...the cock of the earth's walk. What meteor has our
name on it, we wondered.

***"What happened to the camels?" The question was posed
to one of the student guides at the Natural History Museum.
Elizabeth had noticed that camels disappeared from North
America about the same time as humans arrived. She assumed
they had been hunted to extinction.

"I think they just crossed the Bering Strait...at that time
it was a land bridge into Asia," was the answer she got.

There are many different reasons the camels might have
disappeared. The student seemed to have picked the least
plausible of all: that the camels all decided to move to
Siberia! What makes college graduates so dumb, we wondered
again.

Looking at the course catalogs of modern universities, we
think we have a clue. Lesbianism is a big subject in
today's universities. Lesbians in 18th Century English
Poetry is a typical course offering. Or maybe A Lesbian
Interpretation of the Class Struggle and Lesbos and the
Classical Tradition...we have not yet seen Lesbianism and
Nuclear Physics, but it is surely coming.

Forty years ago, colleges offered few courses on
lesbianism. Still, many of them must have depressed
students' intelligence. We recall a class in which the
professor tried to argue that political science was as much
a science as chemistry. The idea is absurd, but you got
credit if you were credulous enough to believe it. Another
professor used his English literature class to convince
students - especially the coeds - that they should practice
free love."Why should you treat one part of the body
different from other parts?" he would ask. And there was a
professor of philosophy who didn't believe in learning at
all. He would come to class and tell us all to be quiet and
meditate."Don't think," said he,"just be." This might
have been good advice...but not the sort you'd want to pay
for.

*** We had intended to drive across the country. We wanted
to show the children the whole place...including the vast
cornfields in the center of the country, the part between
the coasts...the part commonly called"'flyover country."
But we dallied too long on the East Coast and decided to
fly over it. Yesterday, we took a plane in Charlottesville
and few to Albuquerque.

*** We had been driving around in a Mercury minivan. But it
was too small for our family of six. Here in Albuquerque,
we switched to a Ford Expedition, a heartier vehicle with
surprisingly little space for luggage.

***"The pension crisis of the world's richest nations is
like prostate cancer - evolving so slowly that it's likely
to be ignored until it approaches an excruciatingly painful
climax," writes old friend, Martin Spring."Victims ignore
early signs of the problem, frightened by the prospect of
the unpleasantness of the treatments required. Yet the
longer they delay, the more painful and dangerous the
condition will become.

"Future pensions are going to be much less attractive than
the current generation of retirees enjoy and the next
generations expect. Funding them is going to become a major
burden on taxpayers, businesses, employees and investors.
And along the way there are going to be some painful
accidents."

The black hole in U.K. public-sector schemes alone has been
estimated at the equivalent of more than $850 billion, and
the cost of additional contributions to close the gap at
$57 billion a year. Generating that sort of money would
require massive tax rises and savage cuts in public
services. The politicians prefer to ignore the problem
(although they've made sure that their own pension scheme
is both lavish and secure).

The evolving pensions crisis is not limited to Britain:

In the United States, corporate pension funds have
seriously underprovided for their liabilities - airline
funds alone are $280 billion in deficit. To try to make up
the shortfalls, employers are having to contribute more -
the"legacy costs" of past retirement promises (pensions
and medical care insurance) have become a major burden for
industries such as steel, airlines and automobiles. For
example, they account for $1,900 of the costs of every car
sold by General Motors.

The federal bailout fund is already in the red, yet there's
worse to come as companies seek to dump their pension
obligations on the fund. Retirees suffer, too. When the
fund took over U.S. Airways' liabilities recently, its
pensioners faced cuts of up to 50 per cent in benefits.

In Europe, where retirees depend on state pensions rather
than company funds, experts warn that benefits may have to
be cut by up to a third to keep the system solvent.

In Japan, pension fund assets of the 100 largest companies
cover less than half the amount of their promises to
retirees. In the year to March 2003, pensions-related
write-offs were equivalent to a massive 72% of their pre-
tax corporate profits."

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The Daily Reckoning PRESENTS: This expert's principal
concern - regarding the U.S. financial and real estate
markets - is precisely that the economy is as strong as
everyone predicts. How can that possibly be? Read on...


A DAMNATION IN DISGUISE
by Marc Faber

If the Fed continues to print money at the rate they have
done in the last couple of weeks, there is a chance - given
that the global economy is, while unbalanced, nevertheless
in a strong synchronized growth mode - that inflationary
pressures could accelerate far more than is currently
expected.

In this instance, inflationary symptoms would show up in
sharply rising wholesale and consumer prices and not
necessarily in rising asset prices, such as real estate. In
other words, inflation would migrate from the asset markets
to consumer prices and lead to far higher interest rates
and, possibly, to a rout in the bond market, as has already
happened in Japan, where JGB bond yields have risen by more
than 300% since June 2003, knocking off bond prices!

Now, in the case of Japan, the more-than-tripling in bond
yields coincided with a strong recovery in the stock market
(up from less than 8,000 in April to around 11,500
recently); therefore, one could argue that, in the United
States, further weakness in bonds, or even a collapsing
bond market, may not derail a bull market in equities.

But there are numerous important differences between Japan
and the United States. For one, I suppose that a rise in
Japanese bond yields from less than 0.5% to 1.9% has hardly
had an impact on the Japanese property market, since
properties have rental yields of 6% or more.

In the United States, however, where rental yields are
frequently below mortgage rates, I suppose that a rise in
mortgage rates from 6% to 18% would have a devastating
impact. (Such a rise in bond yields is, for now,
inconceivable.) Also, when Japanese stocks and interest
rates bottomed out a year ago, expectations in Japan about
future economic growth were extremely depressed, bearish
sentiment was at an extreme, and Japanese institutional
investors and individuals were very underweighted in
equities compared to bonds. Otherwise, how could one
explain that, at the time, the Japanese stock market had a
dividend yield of more than 1.5%, while bonds were yielding
less than 0.5%?

May I remind our readers that in the 1940s, the Dow Jones
Industrial Average had, at times, a dividend yield of 7%,
while government bond yields fell to below 2%, indicating
that growth expectations were then as low as they were last
year in Japan. And in the same way that the 1940s
represented the best short opportunity in one's lifetime
for U.S. bonds, I suppose that investors will never again
see Japanese bond yields of less than 0.5%, and that from
here on, interrupted by trading rallies, Japanese bonds
will continue to decline for the next 10 years or so.

Over the last 12 months, as the bearish sentiment about the
Japanese economy and its stocks began to dissipate, a
massive shift from bonds into equities got under way.
Admittedly, foreign investors largely drove this shift. In
short, because Japan suffered from a severe asset deflation
and a poor economic environment throughout the 1990s and
until just recently, when its bond market bubble was
deflated over the last 12 months, it did not cause any
serious pain in the asset markets as the economy improved
and deflationary forces dissipated. (Still, if interest
rates rise much further in the immediate future, some pain
may be felt - particularly in the banking sector, which
still holds huge bond positions.)

In any event, I hope that the reader will understand the
current fundamentally different conditions between Japan
(which also enjoys a high savings rate and a huge current
account surplus) and the United States, where asset prices
didn't deflate over the past 15 years, as was the case in
Japan, but were instead inflated as a result of
expansionary monetary policies.

Moreover, U.S. stocks have a far lower dividend yield than
long-term bonds (high growth expectations) and households
and financial institutions hold a far higher percentage of
their financial assets in equities than in Japan.

To put it in very simplistic terms, whereas rising global
inflation and interest rates are likely to be beneficial
for the Japanese economy, whose problem was asset
deflation, this is unlikely to be the case for the United
States, where excessive debt growth fuelled asset inflation
and led to a highly leveraged consumer. In fact, my
principal concern regarding the U.S. financial and real
estate markets would be precisely that the economy is as
strong as everyone is predicting.

In this scenario, I wouldn't be surprised to see a
repetition not of 1994, as is popularly supposed, but of
1973/1974, when corporate earnings expanded but stocks fell
out of bed because of rising inflation and interest rates.
(Watergate certainly didn't help, but today's geopolitical
tensions are, in my opinion, far more serious.)

In this respect, it is important to understand the
following.

The Fed can largely control to what extent it wants to
expand the money supply (print money), but it doesn't
control its consequences - that is, where the money flows
to and which sectors of the economy inflate. (Admittedly,
Mr. Greenspan has been able to inflate just about
everything around the world.) Still, one sector that has
not been inflating much, given the global competition for
labor, is wages and salaries of the U.S. labor force.

Therefore, if expansionary monetary policies lead to a rise
in the cost of living (not the CPI, published by the Bureau
of Labor Statistics, which understates for political
reasons the true rate of inflation), then real wages will
continue to decline since cost-of-living increases are more
likely to run at 5-7% per annum while wages are rising at
most by 2-3% per annum. If this were to occur, the
consequence would be that affordability will become a
problem and households will have to reduce the rate at
which they are spending, unless they choose to increase
their borrowing.

But here comes the problem. In this scenario of declining
real earnings but accelerating inflation (read
stagflation), it is likely that the market - not the Fed -
would force interest rates up considerably and that,
therefore, the asset markets (notably real estate) may - if
not decline - at least cease to appreciate at the rate at
which they have done so over the last few years. As a
result, the rate at which the consumer takes on additional
debt will slow down or even decline (should consumers, for
a change, decide to boost their saving rate).

The Federal Reserve Board is caught in a very difficult
position. Continuous excessive money printing may not lead
to a stronger economy but to declining real incomes and
rising interest rates as inflation picks up. Conversely,
resolute tightening moves could easily upset already
overleveraged consumers and lead to a severe adjustment in
the real estate market, whose appreciation has fuelled
consumption since 2000. In fact, it would seem to me that,
regardless of future monetary policies, the economy will
disappoint, as the market mechanism has begun to take away
the Fed's job by tightening monetary conditions.

I might add that the Fed should never have had the
authority to distort the free market for interest rates
through monetary policies. Hopefully, the market mechanism
is now powerful enough to render the Fed's monetary
manipulations irrelevant.

Regards,


Marc Faber,
for The Daily Reckoning