-->The Big Bad Wolf

The Daily Reckoning

Santa Fe, New Mexico

Wednesday, August 04, 2004

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*** The house Bonner built...it's still standing!

*** Oil makes new record...time to sell?

*** Hippies, marijuana, Grateful Dead T-shirts, toothless
maidens and more!

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"If I can't take it with me...I'm not going," said one sign
on the wall, next to the dollar bills that were pasted up
almost everywhere.

"We have no town drunk," said another."We all take turns."

The woman at the bar had tattoos down her arm. She was
drunk and almost ugly in the daylight. Still, she tried to
flirt with the men drinking their beer. We didn't know what
to make of her.

"She must be a local prostitute," Elizabeth guessed.

We were seated at a round table in a rectangular room in a
drifty town where nothing seemed straight. More on Madrid,
New Mexico...and other things...below...after the financial
news:

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Tom Dyson, from 808 St. Paul St....

- Flippin' Henry! Please forgive us, dear reader, if we're
beginning to sound like a broken record...but oil's march
to new heights continues. Yesterday light sweet traded up
to $44.24, a level not previously seen in 21 years of
trading on the New York Mercantile Exchange.

- OPEC's president, Purnomo Yusgiantoro, prompted the move.
He accused oil prices of being"crazy" and claimed that
OPEC was powerless to do anything about it."There is no
more supply," he said.

- We cannot contain ourselves any longer. It's time to
short oil.

- Regular readers already know about the supply-side issues
- we've been banging on about Yukos and terror threats and
instability in Saudi Arabia for months. Certainly, these
are grave concerns. But this"crazy" oil market has already
fully discounted these factors.

- On the other side of the ledger, global demand has never
been greater. Fueled by the lowest global interest rates
and loosest credit of a generation, demand for oil is
surging all around the world. The"emerging" populous
nations, like China, India and Brazil, now have to compete
with the"recovering" industrialized nations, like Japan,
the United States and Euroland for energy. This is no
secret.

- The case for high oil prices is easy, too easy.
Therefore, today, your foolhardy Baltimore-based editor
will go short by selling crude oil futures. As contrarians,
we love to defy the market that thinks it has everything
going for it. This seems to be just such a market.

- Moreover, here at Daily Reckoning HQ, we believe that,
because of the existence of a cartel, demand, not supply,
is the important dynamic in this market. And we believe
that demand for crude will gradually give way as the global
rebound falters. The recovery is a sham, we keep reminding
ourselves. A bogus illusion conjured up by those
insufferable monetary meddlers.

- Yesterday's news provided yet another straw to the poor
camel's back."Spending by U.S. consumers fell in June for
the first time in nine months," reports Bloomberg,"as auto
sales declined and incomes growth slowed." The decline in
spending was the largest since September 2001.

- Mr. Market was none too pleased with the day's news and
oil's spike. The Dow Jones Industrial Average shed 59
points to end the session at 10,120, while the S&P dropped
7 points, or 0.63%, to 2,000. The Nasdaq earns the day's
dunce cap with a 1.7% decline. Tech traders clipped off a
hearty 33 points, taking the average down to 1,859 by the
bell.

- Bond traders relished the soft data and pushed yields
down. Thirty-year and 10-year rates both declined 3 basis
points to yield 5.16% and 4.42%, respectively. Elsewhere,
December gold futures rose $2.10 to close at $394.50 an
ounce, while the dollar was off 0.2% against both the yen
and the euro. The euro currently buys $1.2048.

-"What makes [investors] more than a little antsy these
days," writes Alan Abelson in this week's Barron's,"is a
nagging doubt as to whether the recovery is the genuine
article. No secret, we suspect it isn't." With second-
quarter GDP slowing sharply, June nonfarm payrolls well
below expectations and collapsing consumer activity, it's
not hard to agree with Mr. Abelson.

- And should the recovery wither, it follows that demand
for oil must also wilt. Not that falling demand guarantees
a fall in price - supply must also cooperate. But
realistically, how much tighter can oil supply be? More
strikes in Venezuela, more taxes in Siberia or more bombs
in Saudi Arabia would all certainly do the trick. But the
one thing markets react to more than anything else is
uncertainty. We must now be close to the point of maximum
uncertainty.

- Furthermore, an attack on the United States would
probably cause oil prices to FALL.

-"After 9/11 people stopped consuming because of
uncertainty," explains Tony Nunan at Mitsubishi Corporation
in Tokyo."If the target is a consuming nation, you would
expect an attack to affect the market to the downside."

- Buy the rumor, sell the news? We shall see...

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Bill Bonner, back in Albuquerque...

*** We had giant breakfasts at Manny's on Central Ave. in
Albuquerque, and then, after a visit downtown - to the
Museum of Natural History - we headed east.

Our first stop was Cedar Crest, on the eastern slope of
Sandia Crest Mountain. As a very young man, your editor had
lived here. Not knowing what to do with himself, after
trying his hand at journalism as the European correspondent
for a magazine that went bust without ever paying him a
dime, he decided to go into the building trade. So he
designed and built - by hand - a house.

He realized, gradually, that he knew as little then about
homebuilding as he does now about economics. Then, as now,
he nevertheless persevered and ended up with a house that
was vaguely interesting and habitable. He had invested
about $7,000 - this was the early '70s - and was later able
to sell the house for what seemed like a fortune, $25,000.
He should have held on. Today, houses in the area go for
$250,000 to $500,000.

But at the time, he felt lucky to get away from it. His
lack of building skills haunted him like a crime; he
worried that he had made mistakes that would be difficult
and expensive to fix. And he was happy to take up a new
profession...if he could find one.

"Let's go up to the door and introduce ourselves. We will
get a better look around. And they'll probably be
interested to meet the guy who built the house," Elizabeth
suggested.

"Uh...no, I don't think that's such a good idea," we
replied. The house looked good. It looked solid. At least,
it was still standing, which was almost a surprise. The
second floor balcony looked out over a vast expanse of
forestland; the view must have been a joy for the last 4
decades. But we wondered what misery and expense it had
taken the owners to get it in this condition. We wondered
how many times they had wished they had the builder in
front of them so they could give him a piece of their
minds. We wondered what a fool thing it would be to present
ourselves now...and risk a barrage of 40 years' worth of
complaints.

"Nah...let's get out of here," we suggested.

We got back in the car and drove up the back of Sandia
Crest.

"Wow..."

Even the blasé, jaded teenagers in the car -Jules and Henry
- were impressed. We had been trying to get them to look up
from their books and take a peek out the window.

"This may be the first and last time you ever seen anything
like this," we told them.

"Like what?" was their response."There's nothing to see
but trees. We've seen trees before. Big deal."

But once at the top, the views, and the altitude, took
their breath away.

"It says here," Elizabeth began imparting knowledge to us,
"that you can see 100 miles on a clear day. Also - this is
interesting - we are so high up that the climate here is
nothing like the climate down in Albuquerque. It is more
like the climate you'd find in Hudson Bay, Canada."

Elizabeth is an improver. She improves us every chance she
gets by herding us to museums, points of interest and
monuments and lecturing us; for our part, we act like a
gang of seventh graders, hoping the schoolhouse will burn
down.

"Do you know," she went on, sure that none of her listeners
could answer in the affirmative,"that the Spanish were
driven out of New Mexico not long after they got here? The
Pueblo Indians revolted. They had been made into something
like serfs by the Spanish. But what set them off was when
the Spanish forbid them to practice their religion. The
Indian priests were accused of sorcery. Several of them
were executed. Others were whipped. One of those who had
been whipped led the uprising. They massacred hundreds of
Spanish settlers and burnt their missions. They besieged
Santa Fe...the settlers were lucky to get out with their
lives."

Elizabeth was right about Sandia Crest. It was so cold at
the top we couldn't stay long. We took a footpath that ran
along the top of the ridge, but we were soon too cold to
continue. So we got back in our car and continued on the
Turquoise Trail toward Santa Fe.


Albuquerque is a bright, shining, growing, spreading,
lively, empty, tasteless, efficient, convenient, grid-based
metropolis...green lawns and gravelly lots...parking
lots......aluminum, plastic, vinyl...new cars, new people,
new houses...new shopping malls. It is the present...and
maybe the future.

There are many words that could be used to describe it.

But when we got to the little town of Madrid, New Mexico,
only one word seemed to work: funky. Without it, the town
couldn't exist.

Madrid is an old mining town that had become a ghost town
by the mid-1900s. It was rediscovered by hippies in the
1960s. The hippies were attracted by the remoteness and
desolation of the place. They could do what they wanted
here; nobody seemed to care. They lived in old school
buses, teepees and abandoned mining shacks. They planted
marijuana in the hills, sold tie-dyed Grateful Dead T-
shirts to the tourists, collected junk...and enjoyed
watching tumbleweeds blow through town.

Nothing is quite straight in Madrid. The houses lean. The
floors sink. The people drift.

The houses and retail shops deserve description. They are
encyclopedic in their illustration of dereliction,
degradation, abject desolation, disrepair, trashy
disintegration and makeshift decrepitude. One of them
fascinated us. It was a"company house," no doubt, built
for the miners who once inhabited the place. But it had not
been touched by a paintbrush since the Coolidge
administration. Windows were broken out; in their place
were pieces of cardboard or plywood. And the porch roof had
been entirely ruined, so that rain fell directly onto the
floor, which was fast settling into a kind of rot. Some of
the houses in Madrid seemed to be suffering from dry rot.
Others from wet rot. And still others from kinds of rot
that have not yet been cataloged.

The Madrilenos seemed to be a bit rotten too. The old
hippies still hate corporate capitalism, but now their hair
has grown gray...their beards are white... and their
principles, whatever they once were, have given way to the
general desuetude of the surroundings. They sell whatever
the tourists will buy...though their main product is the
counterculture itself. A T-shirt, for example, proclaims:
"Homeland Security...fighting terror since 1492." The
picture on it is of Geronimo with a group of armed Apaches.

The Mine Shaft Saloon is a local hangout. It is a friendly
place with a broad bar and dollar bills pasted up on the
wall...each one with someone's name on it. Country music
plays loudly...

Several cowboys sat on bar stools drinking their beer, when
we came in. The barmaid seemed as busy as a firefighter -
trying to keep up with the demand for beer. Cowboys and
tourists sat at the tables. One man in a Stetson hat leaned
on a walker as he made his way to the bathroom.

One of the men at the bar was a typical and unmemorable
fellow in jeans and T-shirt. Another was a strange, big-
bellied character with black muttonchop whiskers and eyes
that hadn't seen straight in years. But what caught our
attention was the woman who moved between them. Flirting
with the first man...and then, when he ignored her...she
moved onto the second. If it was a paramour she was
seeking, she seemed to be in the wrong place. Then again,
she seemed to be the wrong woman, too. She had tattoos up
and down her arm...and wore a dress that took all the form
out of her. This left the viewer's eye with nothing to
focus upon but the hideous tattoos...and the face.

The poor woman was no beauty. She was no young filly
either. Not that she was old; she simply looked as though
she had been ridden too hard. She had long dark
hair...which framed a bad complexion and a missing tooth.

After a few minutes, she was joined by another woman of
about the same age. This one had just come in from outside,
where a thunderstorm had caught her. She was wearing a pair
of overalls with the legs cut off...and a pair of hiking
boots. Her hair was plastered down from the rain...her
clothes were soaked...and water glistened from her bare
legs. The slippery, wet legs were pretty and well shaped.
In fact, the woman might have been attractive, but she too
looked as though she needed a vacation, and a tooth.

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The Daily Reckoning PRESENTS: Porter Stansberry smells
inflation, and last month, Porter glimpsed two items that
bolster this conclusion.

THE BIG BAD WOLF
by Porter Stansberry

The title of this essay comes from one of my favorite
Warren Buffett quotes. This one is taken from his 1988
annual report. It was written just after the great
leveraged buyout and junk bond boom. Said Buffett, about
volatile markets and people doing foolish things with OPM
(other people's money),"But we do know that the less the
prudence with which others conduct their affairs, the
greater the prudence with which we should conduct our own
affairs."

What would Buffett say about the Federal Reserve today as
they do foolish things with everyone's money? I'll show you
what I mean. But before we get to the facts about the Fed's
currency debasing, consider that Warren Buffett is now
holding $34 billion in cash - with most of it in foreign
currencies. In his previous 50 years as an investor, he'd
never bought foreign stocks or currencies. Now he owns
billions of both.

He didn't suddenly see the advantages of global asset
allocation. He's just doing his best to protect his assets
from the confiscatory policies of the Fed.

Other notable money managers - the best in the business -
have allocated heavily into cash and foreign securities
too. Mason Hawkins of Longleaf Partners is the best mutual
fund manager in the United States. He's holding 25% of his
fund's assets in cash now, and his largest equity holding
is Vivendi, a French media conglomerate.

Bill Gross, the"bond king," who manages $400 billion in
bonds for PIMCO, says he'd own more foreign bonds if he
could, but his funds' charter prevents him. Meanwhile, he
personally sold his own flagship bond fund and is buying
commodities and, more recently, tax-free municipal bonds,
another way of holding a cash-like asset.

Ironically, as the world's best investors get out of
stocks, move out of U.S. bonds, and move heavily into cash
and foreign securities, Mr. and Mrs. Mutual Fund are still
piling in. But that's par for the course. Mutual fund
buyers tend to have all their money in stocks and bonds at
the market top and all their money in cash at the market
bottom.
They're right on track once again.

In 1981, after a 15-year grinding bear market, Mr. and Mrs.
Mutual Fund held 77.1% of their investable assets in money
market funds (cash). Said another way, at the bottom of the
market, Mr. and Mrs. Mutual Fund only held 22.9% of their
investable assets in stocks and bonds.

Today the average mutual fund buyer holds 72.3% of his
investable assets in stocks and bonds. Only 27.7% of his
mutual fund assets are in cash.

This bullish level of asset allocation was only slightly
exceeded at the last market top, in 1999, when money market
fund assets, as a percentage of all mutual fund holdings,
hit a cycle low of 23.7% (76.3% in stocks and bonds).

In their own ways, the world's best investors and the
world's patsies are telling us it's time to be cautious in
stocks and bonds. Why?

I began this year with a warning about the stock market and
I've returned to the theme frequently over the last several
months. I think it's very important: Expensive stocks and
inflation don't mix.

And last month, I saw two things that make me think
inflation is going to continue to grow and be a much bigger
factor this year and next than most people realize.

The first thing I saw was research by Ed Yardeni on
something he calls"Super Money." Super Money is a measure
of global money supply. It's the sum of the U.S. monetary
base plus dollars held by foreign central banks. You can
think of this as a good measure of the world's supply of
dollars.

It's important to measure foreign dollar holdings as well
as the U.S. monetary base because many of those foreign
dollars are invested here, influencing our economy and our
bond market. Specifically, foreigners now own 40% of all
U.S. Treasury debt. Over the last 12 months, foreign
central banks bought $198 billion of U.S. Treasury
securities, financing 49% of the U.S. deficit last year
(the largest annual deficit on record). Additionally,
foreigners bought enormous amounts of U.S. agency debt
(Fannie Mae and Freddie Mac) - a total of $170 billion in
agency purchases in the last 12 months.

Federal credit creation (deficit spending) and foreign
investment increases the money supply in the United States,
which leads to faster rates of economic growth and
inflation.

What's worrisome to me is that"Super Money" is now growing
at a faster rate than at anytime in the last 30 years.

It's hard for me to believe that foreign central banks will
continue to be such large holders of U.S. currency,
especially considering that China is now the world's
largest buyer of U.S. government paper (debts).

China buys tons of U.S. paper in order to maintain its
currency peg to the dollar. Eventually, the Chinese
government will have to stop buying so many dollars and let
the yuan rise in value in order to afford the raw materials
China needs - oil in particular. When this happens, foreign
central banks could begin selling their Treasurys. The
result would be a financial catastrophe for the United
States - a run on the dollar. That would cause drastically
higher interest rates for U.S. consumers and businesses.

I'm not predicting this will happen tomorrow... but it
should be clear to anyone with a brain that foreigners will
not continue to subsidize our economy's massive deficits
forever. The most likely trigger for a reversal in foreign
investment is the falling purchasing power of the dollar,
especially in the market for oil.

These facts, combined with the skyrocketing, over 20%
annual growth in"Super Money," mean investors must be on
the lookout for rising commodity prices and higher interest
rates.

We've already seen examples of both. Oil soared to over $44
yesterday. And U.S. Treasury bonds have just experienced
their worst quarterly performance since 1980.

Looking at these facts, you might expect the Federal
Reserve to make cautionary statements regarding money
supply. It's not. And that leads to the second scary thing
I saw last month...

A report issued in June by the St. Louis Federal Reserve
proclaims the supply of money is irrelevant to monetary
policy. We found these views on the cover of the St. Louis
Fed's monthly publication Monetary Trends.

"Most central banks that were targeting money growth have
stopped doing so," writes William Gavin from the Fed."We
no longer ask which measure of money is the 'correct'
indicator for monetary policy. Instead, we directly examine
measures of inflation and output for guidance about setting
the stance of monetary policy."

"Since 1982, however, measures of the quantity of money
have provided little useful information about the near-term
outlook for spending or inflation," continues Gavin."Our
models and our discussions focus not on the quantity of
money but on the purchasing power of the dollar."

Gavin concludes,"We do not have to pay attention to the
quantity of money today because policymakers are paying
attention to its price, by focusing on inflation and
inflation expectations."

This is especially frightening because the Fed's measures
of inflation (primarily CPI) ignore many of inflation's
most important effects - such as asset price inflation.

The Fed took its overnight borrowing rate to a level unseen
in the last 40 years (1%). And, thanks to the war on
terrorism and Congress' pork-barrel politics, deficit
spending has soared. Meanwhile, Greenspan continues to
insist that there's little to no inflation in our economy.
Apparently, he doesn't consider soaring housing prices, a
wildly expensive stock market and rocketing raw materials
prices to represent inflation. And now the Fed is
attempting to argue that the supply of money isn't even a
factor in the creation of inflation. They're nuts.

I can't imagine a worse outlook for the future value of our
dollar. Read the last paragraph of William Gavin's report
one more time:"We do not have to pay attention to the
quantity of money today because policymakers are paying
attention to its price, by focusing on inflation and
inflation expectations."

Inflation, even measured by the Fed's cross-eyed CPI
measure, is running at about 3.5% right now. The Fed's
overnight interest rate is 1.25% annualized - nowhere near
the rate of inflation. How can the Fed argue it is paying
attention to inflation?

Gavin's other comments are even more bizarre. How could
anyone with more than a 10th-grade understanding of
economics argue that the supply of money is irrelevant as
an indicator of future inflation?

I'm not bearish by nature or philosophy. I'm sure things
will be better in 10 years than they are now. Stocks could
even be higher. But I can't imagine a worse scenario for
investors than the one I see developing right now.

Inflation is moving higher. But interest rates are still at
near record lows. Prices for financial assets, real estate,
stocks, and now commodities are at record levels. Yields on
fixed income investments are not attractive, given the rate
of inflation and the likelihood of it increasing. There's
almost nothing safe to do with your money... or anything to
buy that's likely to garner a good return.

There will be a time to speculate in stocks again - but it
hasn't arrived yet. Please, be cautious with your equity
portfolio and don't try to buy the dips...

We could still be a long way from the bottom.

Regards,


Porter Stansberry
for The Daily Reckoning