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Ben Bernanke: “The existing approach to the Federal Reserve System focuses on maintaining medium and long term inflation stability as the primary contribution the Fed can make to maintain stability of the general economy. We’ve seen for example in the last 20 years that the economy’s become more stable, that employment growth and output growth have been stronger and more stable, and recessions have been less frequent. I attribute that to the maintenance of stable inflation and inflation expectations.” JOHN: Well, Jim, that was obviously Fed Chairman nominee Dr. Ben Bernanke, and we’re going to hear from Helicopter Commander Bernanke later. I know as we shortly move into the Thanksgiving holidays, you’re going to put a damper on the whole thing by releasing your latest installment of the Day After Tomorrow. I notice you’ve been nominated for a Pulitzer on the 40 page effort. JIM: War and Peace? JOHN: That’s right. Nobody ever makes it through War and Peace, though. You don’t want to do that. And I think you’re going to dump a few surprises on people. Because if we look out there, it is really going Looney-Tunes in Bananaland, especially in real estate. JIM: Since I started writing The Day After Tomorrow – if you’ve followed this story you know I’ve been talking about this development that’s right next door to us – we began to see prices that I’ve never seen before. They’re almost incredible in terms of what homes were selling for, and even what condominiums were selling for. And these homes are homes with very little lot line, maybe 3000 sq ft, with 2800 sq ft for the homes, some even less than that. You have some homes with zero lot lines. In fact, there’s one development where you pull into your driveway, and right next to your driveway it’s walled in by the wall of the house next door to you. You don’t even have grass separating the two homes, that’s how close it is. But as insane as this is, we are developing further West, closer to the ocean, a grand development that I’m going to call Hacienda del Sol, and we spent two days there last weekend; they had their grand opening. When you think about what this development is you realize it’s going to be for the upper end urban professional. Some of the amenities they’re going to put into this development: it’s going to be almost 6000 acres; they’re going to have a 5-star resort hotel; a public golf course; they’re going to have 18 miles of jogging, and bicycle and nature watching courses for the exercise nuts; they’re going to have an outdoor amphitheater. Because many of these homes will have very little yard around them, they’re going to have community pools for about every 140 homes. They’re even going to have a canine park for the family pet. They’re going to have tot parks, outdoor pavilions, barbecues, and then they’re also going to have in the middle of this development a strip-center of exclusive shops, and gourmet restaurants. So, this development is aimed at the upper end individual. This isn’t aimed at your average person, to get into this place you’re going to need a six figure income, and equity – meaning you’ll have to put a down payment to get in this place. I thought Big Sky had seen prices I’d never seen before, and especially for someone like myself, who moved to California in 1982 from Arizona. I can remember when I moved from Phoenix I was just shocked at the price of homes in California. This was back in 1982, because in 1982 in Phoenix Arizona you could buy a 3,000 sq ft home on an acre lot for $110,000. And I can remember when we bought our last home in Arizona, that’s exactly what we paid. It was $110,000. We put in a pool, a sport-court – I did the landscaping – and the whole thing was done for $140,000. When we moved to California, I can remember my partner at that time taking me to a development similar to what I came from in Scottsdale Arizona, and they were talking about $250,000, which was a shock to me. But John, the $250K they were talking about was the lot price. That wasn’t even the home. So, California has always been ahead of the rest of the nation, because people like living here, some of the best weather in the world is in Southern California. Take a look at what’s happening in the Midwest and the East Coast right now, and we’re having a warm spell here with temperatures in the 75-85 degrees. It’s absolutely beautiful here, but you pay a price for it. [5:31] JOHN: Let’s zoom in on what these developments are going to look like. First of all, why don’t you describe them a bit to people so they know what they look like in terms of houses, yards, access, garage, the whole schtick, if you’re looking for a house in Southern California, and then the price range, and then how quickly are these things going? JIM: What they’re trying to capture in this neighborhood is the early California look. They’re going back to the Mediterranean, the Tuscan, and the classic Spanish colonial styles. So a lot of these neighborhoods on the surface, when you look at the front of the house, there’s going to be a little bit of a yard, so you have some green grass, there’ll be a sidewalk with some grass. It’ll all be lined with trees, the street lights and it will look very homely. You’re going to see the front of the house, but in the area that’s going up first, what you’re not going to see is the garage, and that’s because in the back the lot lines are so small. What they’re going to do is behind the front of the house where you’ve got this nice, green neighborhood looking elevation in front, then behind you’ll drive down this asphalt alley where you’ll have like a two car garage at the back of your house. Some of the homes that’ll have two car garages, you’re probably talking lot lines less than 3,000 sq ft. [6:54] JOHN: That’s for the whole lot. We’re not talking about the house, right? JIM: The house will be plopped on a 3,000 sq ft lot. And you’re going to be able to hear your neighbor’s toilets flush. But they’re going to have jogging paths, they’ll have nature paths, they’re going to have community pools and parks. So, you’re going to get that feeling of openness. What the developer is essentially doing is taking from the lot line, and putting that space into public access areas, parks, soccer parks, baseball parks. Soccer Moms are going to love this, because they’re going to have grass-lined sidewalks. Lighted street lights, so it’ll be safe to go for walks at night. They’re going to have public parks, canine parks, amphitheaters. So, it’s going to have a real nice community feel to it. It reminds me of looking at the movies of Brooklyn where you had the houses – basically, town homes - right next to each other, and the kids played in the streets. It’s going to be similar to that kind of concept. There’s going to be some greenbelts because there won’t be any backyards for the kids to play in, they’ll have to go down to the park. [8:07] JOHN: You’ve sold me. I’m starry-eyed. Where do you sign up and how many other people are doing it, and what are the prices? JIM: So far, there are 5 developers that are going in there. One developer has 3 neighborhoods, and then one gated neighborhood. The gated neighborhood won’t open up until the 1st of next year. But just to give you an idea for people who live elsewhere in the country of how pricey things are, of how goofy it is. Let’s talk about the 3 neighborhoods, and these are sort of the starter home neighborhood, then the second neighborhood is a luxury upgrade duplex, and then the third has a little extra sq footage. [8:54] JOHN: So what’s the bottom line? What does a starter neighborhood look like. JIM: OK, brace yourself for this. In the starter neighborhood they have 3 models, the lowest price model is 1700 sq ft and that starts at $718,900, so let’s round that off and say roughly $720,000. Then they have a 1900 sq ft house. And remember, these are all 2-story. That starts out roughly at $749,000, and then with almost 2000 sq ft that starts out at $767,000. So your starter home, whether it’s 1700 sq ft to almost 2000 sq ft runs from about $719,000 to $767,000. Now, what they’ve also done in this second neighborhood is they have these little corners where they’ve put this duplex but if you were to look at the duplex from the street, it looks like somebody’s mansion. It looks mammoth. It’s done very cleverly. It looks like one big house, but essentially it is a duplex. And let’s take a look at some of the duplex prices. They’re going to have 3 different duplex models – a Spanish colonial, a Tuscan, and a Mediterranean look – the low end duplex has 2100 sq ft that begins at $775,000; they have another model in between at 2400 sq ft that sells for $799,000. Remember, these are without options because obviously if you want the nicer appliances, the granite counters, the LAN system, the surround sound, flooring etc, and all the goodies that go in it, [it will cost more]. Now, these are basically 3 bedroom, 2 ½ baths and a 2 car garage. Then the largest duplex goes from about 2500 sq ft to over 2600 sq ft, and that begins at $833,000. And then finally the [third neighborhood], this is for people who would like to have larger homes. In this development they have 3 models: 2400-2460 sq ft beginning at $843,000; a model 2800 sq ft beginning at $873,000; and then the third model, the largest, with about 3,000 sq ft, and this is a 4 bedroom model, with 3 ½ baths, and all [with] 2 car garage is about $875,000. So you’ve got a starter home from $719,000, you’ve got duplexes from $775,000, and then a large 2 story home that goes from $875,000. Add about 10-15% to the price of that for options because there are all kinds of upgrades from faucets to appliances to flooring to bonus room options – loft or study – you could just go on and on, and just add and add. But I would say safely, you’re going to add anywhere from 10-15% of that price goes into buying options. [12:48] JOHN: The bottom line is that’s all well and good, sounds great at least for Southern California, anyway, but are they selling? JIM: John, they sold out on the opening weekend. The thing that just astounded me is they have this gated community that they’re not going to open up until the beginning of the year – and I’m talking of homes going from 1 ¼ to 2 million dollars – and they’ve got 200 names on the waiting list. And to get on the waiting list you had to go online or fill out a form and get pre-qualified. So they’re not interested in talking to you unless you have money. They had another development in Big Sky Ranch, which was an upper end development, they had homes from 3800 sq ft up to 4200 sq ft, and they had 63 homes. They sold all but 14, before they could even get the models up. They get the models up, and they sell out in a period of six weeks, and now they’re selling the models. In this new development they’re only going to build sixty of these luxury homes, and they’ve got a waiting list of 200 people. I was talking to one of the realtors and they think the upper end gated community development, which will include a membership to an exclusive country club, is already sold out. And they probably won’t build that development for the next year or year and a half. That’s just how crazy things are.[14:19] JOHN: How are these things being financed? Are they regular, conventional loans or interest-only or what, what’s their nature? JIM: That was the other interesting thing I found. Because these homes are basically going for close to a million dollars – a starter home in this neighborhood is close to $750,000 – the lenders are getting a little bit more cautious, and they want to see some equity down, but the way they’re financing them is with interest-only loans. In other words, at these kind of prices, even if you’re making a six-figure income, you’re not going to be able to afford to pay down principal. Let me give you an example, taking a sales price of $750K, they assume you have 20% down – so at least the bank [gets] a little equity cushion there – so you’re financing 600K, and putting 150K down. They have a five year ARM – interest-only – at 5 5/8%. They have a seven year ARM at 5 ¾ %, and a ten year ARM at 5 7/8 %. So, what you have here, [even] putting 20% down, is you are not making any principal payment. To live in Southern California, to buy into these developments, you either have to have option ARMs with negative amortization, or low rate ARMs – as many people were doing between 2003 and this year – or interest-only ARMs. And now lenders in this kind of neighborhood, where you’re talking about homes going from 750K to 1.5 million, want to see a little bit more cushion. But what is interesting is nobody is paying any principal. [16:11] JOHN: OK, Jim, so far you’ve only talked about mortgage payments, but I’m assuming since you’re living in some kind of community you probably have association fees. And then, what are property taxes running in that part of the country? JIM: It’s close to 1.8-1.9%, and let me give you an idea of what that pencils out to be. Let’s take a 5 year interest-only ARM, at 5 5/8 %. The mortgage payment is going to be $2,813 a month, and remember you’re paying no principal. Property taxes are going to be $1,235 a month, hazard insurance $70/month, then homeowner’s association dues $175. By the time you wrap it all up, you’re out the door at roughly $4300/month. Now, with some of the 7 year ARM, and 10 year ARM it gets a little bit more expensive, but figure between $4300 to $4500 per month, and you’re not putting down one dime of principal. In other words, you’re not paying down your mortgage other than 20% that you put down initially. This is what is going on here. So, even with people making six figure incomes, you can no longer afford to make principal payments. [17:34] JOHN: If we just run real quick numbers in our heads, with interest-only loans it’s obvious you’re never going to own the property, all you’re doing is paying interest. And if the bank gets 20% down, as equity, basically they’re expecting at some point or other you’re going to walk away from it, and they can sell the property. JIM: Yeah, with an interest-only loan you’re essentially renting the property, because all you’re doing is paying the bank interest every month. You’ve probably seen those figures where, let’s say, you had bought a home with a 30 year mortgage, but you bought the home for $100K. Over the life of the mortgage, with interest, you would probably pay a couple of hundred thousand in interest, and so you’d pay the bank $300K. Think of where we’re going with this now, when you never pay off your principal. You could own this home for 10 to 15 years, and you would never have any principal paid down, other than the fact that you hope with inflation the property appreciates, because that’s the only way you’re going to build up any equity: through inflation. There is no equity pay down. [18:43] JOHN: So, why do people do this, just to be in a home? JIM: Well, that’s the only way they can get into this. Let’s put it this way, to get into this new neighborhood you’re going to have to have a six figure income, have 20% money down because you can’t get in on 5% down. The banks are getting a little bit tighter which is telling us we’re close to the end of the cycle on this one. Who has 20% down? Either you had to work for a company that had stock options, and you’re cashing out, or you’d been a previous home owner and made some money, and you’re just rolling over your profit from your previous home into this. But you’re talking about starter homes, John. You’re talking about 1700 sq ft here, for ¾ million dollars. [19:30] JOHN: But if you proceed along this path, say I were a home owner, I’m going to pay interest on this no matter how long I own the home but I have no [equity] in it whatsoever. That’s the first thing. The second thing is, how would that compare, say if I bought on a conventional loan, what would the difference be? JIM: This is the only way these homes are selling, and the only way people are qualifying is because, take for example a 5 year interest-only loan where the payment was $4,293 with property taxes and interest-only payments, that IO payment of $2,813 would jump to $3,454, so you’re talking about a difference of almost $640 if you had to pay the traditional type principal pay down each month. And so with that extra $640, you’re talking about 5K a month to get into a starter home. The only way this stuff is flying is because of no principal pay down. Back when Big Sky Ranch started people went with neg. am. loans, or people rolled over property profits and they put those profits in what I call option upgrades. And because the lenders know when you’re making interest-only payments you’re not building any equity for yourself, nor is the bank building any cushion for itself in cases where you lose your job or you default, or the real estate market rolls over, the way they are protecting themselves is they are requiring 20% down. [21:16] JOHN: So basically the bank is going to walk away from it regardless of what happens? JIM: Yes, they’ve got the 20% down. They’re saying at this point, “well, if things roll over, maybe we can afford to take a 20% hit and we’ll be protected.” But what if we get a roll over in the real estate market like we did in 90 and 91 where prices in California dropped 30 and 40%. You’ve got to understand the implications of this. The difference between an equity bubble and a real estate bubble is that in an equity bubble not as many of the public is involved in the stock market in comparison to the real estate market. Moreover, in a real estate bubble it’s not just the public that’s involved here, it is also the financial institutions who have made these loans, so think of these institutions that have made loans to buyers that have only put 5% down or no money down, or if they put 5 or 10% down within 6 months or a year, they’ve taken all that equity out with a home equity loan. Because remember, up and till about 6 months ago banks here were loaning up to 100% of the value of the property, banking on the fact that homes would continue to appreciate and then through that appreciation the homeowner would build equity and the bank would have a collateral cushion as a result of inflation. So, you’ve got a lot of banks here. And one lender in particular, who’s been very big on these projects that almost 80% of their book of business is variable rate loans, either option ARMS, or fixed rate, short term ARMs, or it’s interest-only loans. So, what cushion does the bank have. In fact I was doing research on this lender, and it was amazing. I looked at their most recent 8-K filing, and the percentage of non-performing loans has been going up every single month, not by much, it started out at 1/10th of 1% of total assets, it’s now 2/10th of 1% of total assets, so non-performing loans have doubled in the last 12 months. And as we go forward into the future and these fixed rate ARMs come due, and they’re due to reset – and that’s what’s happening right now beginning in October, November, a lot of these loans that were taken out say 3 years ago in 2003 or 2004 are going to be resetting every single month – and what happens when these people have no equity in the property. They’ve borrowed it out with either no money down, neg. am loans, IO loans, and home equity loans. What protects the bank in case of this downturn? But I’ve never seen anything like this. When I was in the homeowner’s pavilion, and they had the builders’ trailers right out in back because the models aren’t even built yet, and John, I couldn’t believe the traffic that was there. All the sales offices were busy, and in fact, I had a hard time having someone pay attention to me, and then I just said, “well, we’re trying to buy two homes for our kids.” and that perked them up, and I got them to talk to me. It was just absolutely astounding. I’ve thought things were ridiculous at Big Sky, but this has all of the makings of a top of the market if I’ve ever seen one. What do you think of a starter home for $750,000? [24:58]
JOHN: Obviously, Jim, things are going to be changing in very short order as we go over the next 12, 24, and 36 months, and if we’re looking at trying to make money in the next 12 months what should we be looking for? JIM: A number of things, John. I think the first thing you have to take a look at is the markets are just barely in positive territory. But what has been driving this has been every single quarter, profits have been pretty robust in terms of what we’ve seen: there’s been double-digit profit growth by quarter, year over year, and that’s helped to sustain the market to some extent. What I find right now, and I believe this is where we are right now, is I think the profit cycle has peaked. What does that translate into? Well, once a profit cycle peaks, then it starts to begin to roll over, and then you start to see profits decline, so that when we get into next year when we’re going to be comparing quarters to the previous year I think you’re going to see a downward trend in profits. And lower profits are going to translate in to a corrective cycle in the market, and once that corrective cycle happens I think you’re going to see a shift in terms of where investors are putting their money in the market. [26:32] JOHN: So far, though, if you look at it, Jim, it’s looking like profits are pretty good, so if you’re picking indicators to tell us that perhaps these things have peaked, what are you looking at? JIM: If you take a look over the last 30 or 40 years, we’ve had 5 cycles where profits have peaked. They peaked in 1974 and everybody remembers the big bear market that year, we also got a recession. We got another profit peak in 1981, and then that was followed by a recession. We got sort of a mini peak in 1984, and then of course in 1989 profits peaked, and in 1990-91 we got a recession. More recently, in 2000 profits peaked for companies and that was followed by a bear market, and also by a recession. So, we’ve had 5 of these cycles over the last 3 or 4 decades, and there are a number of indicators that have been sort of a warning that we were heading to a profit peak. One thing that you’re going to see that is common to all these cycles is everyone of them was preceded by a sharp spike in oil prices. 1974, you remember the oil embargo when OPEC embargoed oil to the United States and oil prices doubled and tripled. In 1981 we got another spike in oil prices, oil hit $40/barrel with the Iranian revolution and the taking of American hostages. We had another peak in 1984, of course [then] the Fed was raising interest rates. 1989, going into the Gulf War we had another increase in energy, and of course the year 2000 everyone remembers natural gas prices going to $10/cu.ft here in California, and the brownouts we had. And of course, look at where we are today, and if we just look at the price of energy in the last 12 months, last year at this time we were looking at around $40 oil, and today we’re looking at $57 oil, and we’ve got as high as $70. I think we’re going to see another peak here in oil as we head into the Winter months, and especially with natural gas. But one indicator is a 50% year over year increase in the price of energy. We’ve seen that this year. The other thing that you see is very favorable conditions on the corporate balance sheet, return on equity (ROE), costs are down, profits are up, and so return on equity flattens out. And if you take a look quarter by quarter, the ROE is now flattening out. Another factor that you see that’s common to these periods is headline inflation rates are rising, inflation rates are up almost 4.7% y-o-y, and of course you hear the Fed talking about core rate of inflation but nonetheless the real rate of inflation that you and I have to pay, let’s say as homeowners – the cost of living, food, energy, fuel, utilities, trips to the doctor, medical premiums –is rising. And remember with rising energy prices and rising health care costs that is also a cost factor to corporations. In other words, one of the problems of GM right now is healthcare, and they’re negotiating with the unions on healthcare because it’s just ravaging GMs profit margin. They can’t make profits on selling cars in North America. A fourth factor that you see in these periods is a rising Federal Funds rate. We’ve had 12 increases in the last 12 months, we’ll probably see the 13th increase in December and possibly the 14th increase in January of next year. The other thing that you’re starting to see is unit labor costs are starting to grow. There are calls now in Congress for increasing the minimum wage. If you start increasing the minimum wage labor contracts start going up. That is a cost factor. So if you look at this overall we’ve got rising energy costs, rising headline inflation, and rising interest rates which means it’s going to be more expensive to borrow. All of these things are taking place right now. And then another factor is the ISM new orders book has to be lower y-o-y, and we take a look at the last 3 or 4 quarters that is a trend. New orders are up, but not up as a percentage, so that percentage increase in new orders is starting to fall off which tells us we could be getting close to a recession, especially if we start looking at the yield curve which has been flattening recently. [31:17] JOHN: If you look at it overall though you’re going to have costs and inflation pressures putting pressure on profits for obvious reasons, and so the warning lights should be coming on about now. JIM: The warning lights should be coming on right about now, and you’re going to have a change in portfolio leadership I believe in the next 3 to 4 months. In other words, if the economy starts to slow down, if the headline inflation numbers slow down in the next 4 or 5 months you’re going to see a change of leadership in the market. People will start talking about disinflation or deflation, very much in the same way they did between 2002 and 2003, even though real inflation was not coming down. Because of the slowdown in the economy, people were talking about maybe retail sales weren’t as high but through this all – and we’ll get into this during the next topic – the money supply is going to be expanded like you’ve never seen it before, but I don’t want to take away from the next topic. So, you’re going to see a brief transitionary period of talk of disinflation, or deflation, because home prices will start to come down, and you may see some retail price weakness. You’ll see some economic weakness, and so you’ll start seeing the headlines change from talk of inflation to talk of deflation, and what that’s going to do is it’s going to change leadership in the market and you’re going to see a rotation. [32:55] JOHN: OK, Jim, obviously we’ve been talking about the next 12 months which will be a transitional phase. There are certain things that are going to do well during this period and certain things that are not, so what are those going to be? JIM: What happens is the economy starts to slow down, people start getting out of speculative type of investments, and start looking more for safer types of investments. Remember, most equity fund managers – mutual fund managers – they’re going to have to be invested in stocks. In other words, nobody’s going to pay a mutual fund manager one or two percent a year to be invested in money market funds. They may increase their cash position, but they’re going to start investing defensively. In the previous 5 cycles I’ve talked about, sectors that did well were electric utilities – people have got to have energy – nice dividends, low PE ratios, a nice, stable type of investment, household consumer product companies – personal care, people that sell toothpaste, bleach, detergent, razor blades – these are the things that people have to have in a slowing economy. I mean you’re not going to say, “hey, we’ve stopped going to the grocery store, or I’m going to stop buying razor blades.” Food manufacturing, healthcare, tobacco – if you’re a smoker you’re going to continue to smoke – if you drink beer you’re going to continue to drink. Heck, in economic weakness you may be drinking a little more beer. So, what I call consumer staples, defensive type issues, and things that I call basic necessities: water, electric utilities, natural gas utilities, grocery store chains, or food processing companies. And pharmaceuticals, which are one of the stand out sectors in our opinion right now. Maybe just a little bit early, but I think you can see a turnaround in this sector because we’re starting to see very, very strong money flows in this sector. [34:53] JOHN: So, the other half of what we were talking about, if those are the things that do well, there’s a downside, what are the things that do not do well? JIM: Steel, metals, heavy industrial type companies, forestry, paper, chemistry, chemicals, software, technology companies. Remember, technology is really a cyclical industry, and that was really one thing that took a lot of investors by surprise in the recession of 2001. Everybody remembers the new era cycle, technology stocks, the Internet, and everybody thought these were immune to any kind of downturn in the economy. And as we found out later technology is a cyclical industry just like everything else. And more importantly now, most of the product upgrade cycle people have replaced their PCs, corporations have replaced their file servers so we’re almost coming to the end of a product upgrade cycle, and so you could see a downturn, not only in IT spending, but a lot of technology spending, software or hardware type. So these companies do not do very well during this period of time. So the message here is we’re going to go to a more defensive market. [36:06] JOHN: If you are right that profits have peaked, and we begin to see a cooling in the economy and it starts to slow down, then switching over to the bond market, what’s going to happen over there? JIM: I think what’s going to happen is people are going to start getting defensive. At some point in the next 3 months, you’re going to want to go into Treasuries, and Treasuries are the only area you’re going to want to get, because eventually the US will have peaked in its interest rate raising cycle. By the same token, you’re hearing talk of Europe and Japan may start increasing interest rates and begin an interest rate raising cycle over in Europe and Japan, which is obviously going to harm their stock markets if you look at year to date, the European stock market and the Asian stock markets have outperformed the US stock market by a wide margin. Forgetting currencies for a moment, the Dow is down for the year, the NASDAQ is only up 2% and the S&P is up about 3%. By comparison, the Dow Jones 50 stock index in Europe is up 18%. Most of the European indexes are up high double digits, some of them as high as – the Swiss market – up 30% for the year. If we look at the Japanese Nikkei it’s up 27% for the year. Now, Europe is going to start raising interest rates because if you take a look at the money supply in Europe it is absolutely going bonkers, it’s up almost 13% year to date. So, they’re flooding the banking with money in Europe, and they’re going to have to start tightening, putting on the brakes. Headline inflation is running around 2 ½ - 3%, which is above European inflation target rates of about 2%. Budget deficits are getting bigger in Europe, and so you’re going to see a rate raising cycle there. And so Treasuries may become a very attractive proposition. Not yet. I think we’ve got probably another 4-8 weeks yet, before this transition period happens. [38:11] JOHN: If interest rates are peaking in the US, and they’re going up in Europe, which makes our bonds attractive over there, what about corporates? JIM: That’s the one area, John, that I would be avoiding because this goes back to the first topic we talked about that corporate profits are peaking. Remember, as long as profits are going up that means a company’s earning enough money to cover its interest payments. Now, as the cycle peaks, we’re going in the opposite direction. You’re going to see lower profits, lower growth. Less profits means there’s less profits to cover interest expense, and you’ve got a lot of corporations that have issued junk bonds. A couple of years ago when the economy was beginning to expand and take off, now you’re going to see a contraction of profits which means that the bond investors have less of a cushion for the company to be making enough money to meet their interest payments. I expect you’re going to start seeing here shortly, and I’m starting to see it in the last six weeks, the credit spreads – meaning the difference let’s say between a 10-year Treasury note and say a junk bond – is now starting to widen, because that reflects investor anxiety that some of these bonds may default, as we saw for example in Delphi. So, you’re going to start seeing a lot more credit defaults. You’re going to start seeing a lot more companies just basically throwing the towel in, especially the weaker companies – the ‘C’ rated bonds, C-, D bonds – you’re going to see a lot more downgrades by the credit rating agencies. Remember the 5 or 6 factors we talked about: rising energy costs, rising labor costs, rising headline inflation. As costs go up companies have more difficulty passing all those costs on even though they are raising prices. Profit margins are squeezed and as a result as profits come down many marginal companies may not make it because there were a lot of junk bonds that were issued roughly from 2002 to the beginning of this year because interest rates were coming down, and made it very favorable for companies to finance. The other thing that happens too, with these junk bonds, is let’s say a company needs to raise $100 million, they may go out and raise $130 million, even though they only need 100 million, and they’ll bank that 30 million – put it in a bank – and they’ll use it to pay the interest on the bonds each year for the first couple of years. So, normally, after a junk bond is issued, you’ll see the first couple of years a company makes its payments because they have this reserve that they have in order to make these payments. But once that reserve is eaten up, because they’ve paid out that interest, then the company is left in a very weakened position. Normally, 2 or 3 years after these junks bonds have been issued you start to see the default rate go up, which is what I think you’re going to see in 2006. So, we’ve got a real, nasty period for the markets that are coming ahead, probably in the next 4 to 6 months, and once this trouble starts to surface then what’s going to happen is the Fed is going to go on hold, and then eventually they’re going to be cutting interest rates. So we’ve probably got a 6 to 9 month cycle that we’re going to be going through here. This cycle that we’re in now is going to peak – almost go parabolic – as it peaks, and I’m talking about energy, gold, cycle, silver, precious metals, and I think we’re going to go out with a bang here, but then it’s going to be time to be defensive, and then I predict, by the time we get to this time next year, instead of talking about rate hikes, we’re going to be talking about, “well, the next FOMC meeting, that’s where they expect the Fed will raise interest rates again.” And that’s how the cycle is, so if I had to play this John, I would ride this parabolic top we’re going to see in metals, I think we’re going to see in the energy sector, especially when we get into December and January as the Midwest and East Coast are buried in snow, and as these big draw downs in natural gas begin to occur, you’re going to see a spike in energy prices, and we’re right on track for that, the Commercials are increasing their position in energy, so I think that’s going to play out. We’ve got gold prices only $10 away from hitting $500/oz, and you’ve got a lot of money flowing into the gold stocks, and alternative energy plays, but somewhere in these next 3 to 4 months there’s going to be a transition time where you’re going to want to be defensive for maybe 2 or 3 months and then they’re going to start a great reflation exercise beginning with the United States. [43:33] JOHN: And we’ll come back talking about helicopter money in just a moment. [43:35] [music: promo for the new Bernanke Babble dictionary] JOHN: Well, it’s time on the Big Picture, Jim, to talk about helicopter money. Hurry up, I’m running out of fuel here in these choppers. Helicopter money, where do you think good 'ole Dr. Ben is going to go? JIM: We’ve gotten a lot of emails about the Fed dropping M3 beginning in March which will be, by the way, Bernanke’s first month on the job. And what is rather interesting about this is almost 34% of what goes in the money supply they’re no longer going to report on, and what else I found was rather interesting is if you take the components – the individual components by themselves – it’s no wonder they’re not going to be talking about it. For example, Money Funds are up 4% y-o-y, and then large denomination time deposits – these are $100,000 or what we call jumbo CDs – are up a whopping 28%, Repos are up 8%, Eurodollar deposits are up 16 ½ %. So if you take total non-M2, M3 is growing at 14.3%, and essentially what they’re going to do is they’re going to say, “you know what, the fastest growing part of the money supply we’re going to throw out of the window and not cover anymore.” And for good reason, if you had money growth growing at that rate. And it’s interesting, I’m looking at a graph of M3 in the last 3 months. M3 is roughly going at 10% if we take a look at the last 6 months, it’s growing at over 8%, and at the last 12 months it’s growing at 6.7%. So, the other money supply figures like M1 and M2 aren’t growing as much which is why I think they’re still going to cover it. If you look at M2 it’s only growing at 4% over the last year, 3 ½ % over the last 6 months, and roughly 5% over the last 3 months. Those components are growing at a slower rate from what we’re seeing in M3. So, isn’t it interesting that the first month on the job they’re throwing out the fastest growing components of the money supply, so people won’t be able to track them. Senator Robert Bennett, (R) Utah “I talked to him about one of my favorite issues which again I’ve raised with Greenspan, which is the measure of inflation, and I got out of him the answer that I wanted which is the CPI overstates it, and we really ought to be looking at a different kind of measure and that has all kinds of implications down the road.” JOHN: That was Republican Senator Robert Bennett from Utah, and basically that really surprised me to hear the CPI overstates inflation. And of course, what the Senator was pushing for, if you listen to the whole hearings, was that maybe we need to reindex the income taxes because they’re supposed to have adjustments for inflation. But maybe, in essence, we’re not taxing people enough. JIM: They’re talking about inflation as being actually overstated because they keep making reference to this core rate which is absolutely meaningless to anybody. In other words, the core rate is for people that don’t eat, heat, cool, or drive cars, or businesses that don’t use any energy to make anything that they do, they don’t turn on the lights, they don’t have electricity, basically they’re shoe cobblers or something. Politicians including government, not only this Senator, but also Federal Reserve officials and then guys on Wall Street are all always talking about this core rate. So, what it does is it deflects the individual over from looking at the cost of living, whereby everything I need or like to do is going up, over to this core rate. It’s interesting if we take a look at the actual inflation and given the fact that they actually overstate this. Just take a look at the trends year over year beginning in January starting with the Producer Price Index which was up y-o-y in January up 4.2% over the previous year. As of October producer prices are up 5.9%. If we take a look at the last 3 months, and remember the money supply has just been bulging, the last 3 months, producer prices are up between 13 and 14%. If we take that and follow it over to consumer prices they are up 4.3% over the last 12 months – between 4.3 and 4.7% - if we take the last 3 months consumer prices are going up at an annual rate of 8-9%. If we take import prices y-o-y they’re up between 8-10% y-o-y, and if we take a look at the last 3 months they’re up between 15 and almost 22%. So all these numbers are going up, and if we take the statistical average of all the most recent 12 months we’ve got wholesale prices up at 4 ½ %, Consumer Prices up at 3.2%, and we have import prices up at 10%. So, all these numbers are going up at the time they’re talking about price stability. Ben Bernanke: “Central bankers in the United States and around the world have come to understand that ensuring long run price stability is essential for achieving maximum employment, and overall economic stability.” There you have it, John, He’s talking about price stability but can anyone really say we have price stability when a starter home here in California is going for three quarters of a million dollars. That 1700 sq ft home, when I moved here in 1982, you could’ve got that home for $110,000. So where’s the price stability? Look what you’re having to pay for gasoline. Look what a midsize car costs you today, take a look at a 1 year tuition at a public university costs. God forbid if you have a genius in the family, and you send him to a private school. Take a look at what your medical premiums are, at your deductible, Take a look at what your car insurance costs. Take a look at what you’re shelling out for food or what you’re paying for utilities today. In the example we gave in the first segment it’s going to cost between $4300 and $4500 just to buy into these homes. Talking about price stability where is it? And the fact they’re saying inflation is overstated it’s just absolutely ridiculous. But you know what, we’ve got inflation numbers that are hedonically adjusted, we have GDP numbers that are overstated, we have an unemployment rate that is understated, and now we’re going to [lose] a gauge that was used to monitor how much money is going into the system – is the Fed really printing a lot of money, is the money supply expanding? These are the kinds of things you would look at if you were a bond fund manager or if you were taking a look at what is going to be the underlying trend in the economy. And you can see this for example in 2002 where the money supply year over year grew by almost 1 trillion dollars. So, that money was going to show up somewhere. It was going to go into the stock market, or the real estate market – a lot of it did – or financial speculation and then eventually into the economy. And so now, one of the measuring gauges we have of tracking this is going to be taken away. [53:25] JOHN: But it’s obvious that the purpose of doing something like this is to cover up their tracks. There’s not a rational reason for doing it other than for concealing what’s happening here. JIM: Yeah, because I think what we’re doing is we’re going back to the 1970s Federal Reserve policies of interest rate targeting, and if you hear inflation rate targeting what you’re talking about is interest rate targeting which is what Arthur Burns did, and it ignored the increase in the supply of money. The only difference between 1970 and where we are today is the inflation gauges are going to be jerry-rigged so there will be no reflection – the best example I can give you was in 2003 when the CPI rate dropped from 3.2% down to 1 ½ % and everyone was saying deflation, deflation. Meanwhile, the money supply is literally going bonkers, it’s growing by almost a trillion dollars a year. The housing market is getting reinflated, the bond market is getting reinflated, and the mortgage bubble is inflating during all of this, and the only reason we got the drop in the CPI rate, dropping by almost 50% was because statistically they tinkered with it and instead of measuring home prices which were going up double digits each year. They were measuring owner’s equivalent rent, and rents were going down because a lot more people were buying homes, and likewise with incentive plans for buying new cars, new car prices were going up, used car prices were going down. They were measuring used car prices. So, we’re going back to inflation rate targeting, an Arthur Burns type Fed, which means we’re going to have a staginflationary type economy, with asset bubbles that reemerge, and I think what you’re going to see is the asset bubble in this next cycle is going to be the same asset bubble that was in the first cycle, which is hard assets. What we’re going to have is a bridge between the first phase of this cycle coming to an end, and the second phase of this cycle really taking off with the expansion of money, and as you see globally I think you will see all the central banks, the US, Europe and Japan, reinflate. [55:58] JOHN: Basically, Jim they’re going to inflate the Bejeebers out of the money supply, but officially we aren’t going to have any inflation. JIM: That’s it. Ben Bernanke: “I believe inflationary expectations remain well anchored. I believe it’s important to ensure that they remain well anchored, but as long as they remain well tied down, and low and stable, I imagine the economy will be much better able to absorb any further increases in energy prices, than they were 30 years ago.” [56:26] [music: promo for Bernanke Babble dictionary] JOHN: Here we need to talk about what is hot and what is not hot, and I’m not referring to Southern California versus the Northeast. And basically I’m putting this in a philosophical bed here. We started last month looking at which sectors are doing well, and which sectors are not. And actually it ties into the segment we did on making money in the next 12 months. JIM: If we take a look at what has done well, and what are some of the best performing sectors this gets back to what I think are really going to be top performing sectors for the end of the year, and probably for the first month or two into 2006. That’s going to be metals; gold and silver are the number one performing sector according to IBD, internet content; metal ores, and what I’m referring to here is look at the price of platinum, the price of platinum is what, 1000 bucks, you’ve got to take a look at the price of copper. Transportation equipment manufacturing, and then everything else is energy, oil and gas machinery and equipment, oil and gas field services, computer manufactures, oil and gas exploration and production, and heavy construction which goes along with mining. And we get all the way down to oil and gas drilling. It’s surprising, financial services which have gotten a nice pop, especially the brokerage firms. In terms of putting this into perspective by industry:
If you take a look at the common theme between them: energy, base metals and precious metals. These are the top performing sectors, and this is what I think is going to take us, as we get close to a market top here, towards the end of the year, because remember as you get close to a market top you see fewer and fewer companies that will be driving the index to higher levels. So, there are less and less companies participating, and I think what you may have driving all of this are going to be some new highs for the energy sector, the large cap stocks, the mid cap stocks, the natural gas companies. You’re going to see the precious metal stocks, although it may have one or two short corrective cycles that may last 2 or 3 days, but I think you’ll see gold hit close to $500, maybe go beyond that, and then there’ll be a fierce battle for it. But this is what we see unfolding here in the next five, six, maybe eight weeks, depending on how bad and how cold the Winter actually gets. If we really get some severe snow storms and nor’easters that you typically get right around the Winter months you could see some real big drawdowns. You get a storm or a cold spell that lasts a week or ten days, you could see some big drawdowns in heating oil and also natural gas. And what that will do is spike up the cost of energy, that’s going to spike up the inflation indexes, and that’s going to carry us over into 1Q next year. What you’re having is like a game of musical chairs. More and more of the chairs are being taken away as the music gets close to stopping, and the market peaks so you only have a couple of chairs left and those chairs are going to be base metals, precious metals, and the energy complex, which I think is going to be the top performing sector. The other thing you may also have is what we call the seasonal play on retailing because you could, depending on refinancing, see Christmas come in a little better than expected, in other words, everybody has such a low expectation for Christmas right now that we may surprise on the upside. I don’t know what it’s like in other parts of the country, but here in what we call Bananaland, if you go to the malls, they are packed. If you go to the movie houses they’re packed. If you go to restaurants on Friday or Saturday night they’re busy, there’s a waiting-list, you have to have reservations, or plan on waiting 45 or 50 minutes to get a table. [1:03:09] JOHN: Well, it’s been a busy Big Picture today, Jim. We first of all looked at Looney Tunes in Bananaland and we seem to have come full circle on this whole thing, talking about the restaurants and other activities. But I think if you go to a lot of major cities you still find that going on at that point. Obviously, watching those things that are hot and not hot, which involves making money over the next 12 months, and plotting the future course of Helicopter Commander in terms of what the Fed is going to be doing when Ben Bernanke gets on the bridge and assumes control, that pretty well exhausts our topics for today. What are we going to be doing in the next couple of weeks here? Obviously, next weekend is Thanksgiving week again, so special show. JIM: Yes, we’re going to have a special show next weekend. It’s going to be a shortened version, we won’t have our guest experts but John and I will be back with the Big Picture. My guest next week will be Deborah Weir. She’s written a book called Timing the Market: How to Profit in the Stock Market Using the Yield Curve, Technical Analysis and Cultural Indicators, and then I’m off to the San Francisco Gold Show. We’re going to have a special edition coming up the week after Thanksgiving in the San Francisco Gold Show. You don’t want to miss that. I’ll be interviewing one of the top CEOs of the gold companies Ian Telfer will be my guest, James Turk, a lot of mining companies, and also speakers from the conference. So a lot of stuff coming up, and we’re also going to have a great debate in the month of December. Two different views of where we’re heading one view which is more on the gloom and doom side – a new book by Addison Wiggin and Bill Bonner called Empire of Debt – and then another book called Our Brave New World by Charles Gave et al., which takes the opposite approach. We’re going to have those back to back in December. We’re going to have interviews on foreign currency trading, lots of great stuff to end out the year, so we hope you’ll be there to join us for that. © 2005 James J. Puplava, Financial Sense Newshour |
Looney
Tunes in Bananaland: Cycle Peak