The
BIG Picture Transcript
December 8,
2007
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Part
1
Is
this a Bull or Bear Market?
Other
Voices: Chris Turner, Lombard Street Research Ltd.
Good
& Bad Credit
Part
2
Reflation
Trades
Subprime
Bailout - Consequences
Is
this a Bull or Bear Market?
JOHN: And out comes the knitting needle as we knit it all together and connect those dots that are seemingly unconnected, but in reality mean something. A meaningful picture. You know, since we reached a high in October in the stock market, so far we have seen a 10% correction in the markets and a Dow Theory sell signal. So the first question we are going to ponder deeply here on the first part of the Big Picture is whether or not a new bear market has begun here in the United States and globally. And last week, if you remember, we looked at the economy, and it looks like some sort of soft landing scenario is iffy. So I suspect, Jim, the same would hold true for equity markets if we compare them?
JIM: Sure. In fact, what we're going to try to do on this segment is go through a number of factors here both on the fundamental and the technical side. And you're right, John. Last week we looked at the economy and came to the conclusion, a recession was more likely in the US next year. We also looked at decoupling theory and discussed that this theory didn't hold water. And the decoupling theory is this idea that was developed that since the US was experiencing all of the problems in their economy with the economic slow down, the subprime crisis, that the rest of the world somehow had broken loose from the US and wouldn't be affected by that. And we showed last week the rest of the world –and especially the G7 countries – are recoupling with the US. In fact, there is evidence this is happening already in Canada, the UK, Europe and Japan. And if there is any area of the world that's probably less susceptible to problems in our economy slowing down, that would be the emerging economies, but they will be hit to some extent. I just think they will a better chance of maintaining, let's say, above average economic growth. [2:08]
JOHN: So then basically the idea that the world was sort of immune to US problems fell apart pretty quickly. It's pretty much a false assumption.
JIM: Yeah. I think we're starting to see some of that evidence almost on a daily basis. What began as sort of a US-specific shock is morphing into what we're seeing a global shock. You've seen a number of problems emerge overseas. In fact, when the crisis first emerged in August when it really began to unfold, one of the first victims was a European bank. So there have been a number of reports out lately from Bank Credit Analyst to Goldman Sachs that debunk the decoupling theory. So what we do know fundamentally is that economic growth is slowing down globally; and with an economic slow down will come a concomitant slow down in corporate earnings. And corporate earnings, John, have already peaked. [2:58]
JOHN: Well, all of this seems to be, I guess I would say, unsettling for the markets. We've seen daily fluctuations. There is obviously greater volatility in the financial markets and that's increasing tremendously over the last several months as a matter of fact.
JIM: Yeah. And I suspect you're going to see that continue. On the day you and I are talking –we are doing the Big Picture a bit earlier this week – we just had almost a 200 point rise in the Dow after seeing the precipitous drop that we saw from late October. And ever since the Fed cut (or the notion that the Fed is going to cut again) we've had a rally from that 10% correction that you talked about earlier. So I expect that volatility will continue as a result of this weak economic outlook, and also in terms of what we're seeing as a dysfunctional credit market combined with an enormous amount of leverage in the financial system.
An indicator I think that is flashing a warning sign when it comes to the market recently has been the peak in margin debt. Whenever margin debt peaks, you normally see a peak in the major indices as well. For example, when the rate of change reaches 60% on margin debt, it usually signals a peak in stock prices. And that 60% rate of change level was breached in June of this yea,r and surprisingly, that's just about the time that the markets peaked and then began selling off as we went through that late summer correction. We hit a peak in the averages in June and then the markets rolled over. We had an August crisis. The markets rallied on the Fed rate cuts, then once again they rolled over only to rally again on possible rate cuts.
But the decline in margin debt is definitely a negative omen as leverage is unwound. [4:48]
JOHN: So the unwinding of leverage could actually explain short downdrafts that we've experienced so far. But what about other indicators, any other warning signs?
JIM: There are a number of indicators. Probably one that a lot of the technicians are following is that the moving averages are sending sort of mixed signals. On the positive side, the ability of these markets to bounce off these moving averages or moving average support lines is encouraging. But failure to do so –let's say had they not been able to rally off these moving averages – that would probably have indicated that indeed a bear market had begun.
So the question now is this rally off these bottoms, are we starting to see the start of a new up leg which will be driven by a new reflationary cycle, or is what we're actually seeing right now a topping process that is starting to unfold here? I mean if you take a look at the advance/decline line bouncing off chart support. But on the negative side we're start to be see lower highs and lower lows and that's never a good sign. [5:54]
JOHN: Yeah. Like you say, it doesn't really sound encouraging all around. Why don't you explain to people advance/decline.
JIM: Well, on a daily basis, what they do is they measure all of the stocks on the exchange in terms of the stocks traded: How many stocks are advancing, how many stocks are declining. And what you really want to see in a bull market is more stocks advancing than declining. If you look at a chart pattern of that advance/decline line what we're seeing is lower highs and lower lows. So on a daily basis, there are more stocks that are declining than advancing. And even on days when the stock market rallies, the margin of the stocks advancing versus declining has been very narrow, so that's never an encouraging sign. [6:40]
JOHN: You know, it's funny when we look at what we see every single day watching the financial channels, one day everything is in euphoria, the next day they need Prozac. It's up and down. There is a British comedy team that we've run before, the Long Johns as they call themselves, and they did a skit on this which very much explains a lot of what we're seeing in the United States’ markets. So I thought we'd lift this clip from British television here. [YouTube video clip]
Presenter: John Bird and John Fortune.
[John Bird and John Fortune seated]
John: George Parr, you are an investment banker?
Banker: I am. Yes.
John: And as such have your fingers right on the pulse of the financial market.
Banker: Yes. Very much so. Yes.
John: And during the summer there has been a great deal of turbulence and...
Banker: volatility
John: ...volatility in the market.
Banker: volatility. Tremendously. Yes.
John: And what has caused that?
Banker: Well, you have to remember two things about the market. One is they are made up of very sharp and sophisticated people who, uh, these are the greatest brains in the world. And the second thing you have to remember is that the financial markets, to use the common phrase, are “driven by sentiment.”
John: What does that mean?
Banker: What does that mean? Well, the things let’s say they are just going along as normally in the market, and then suddenly out of the blue, one of these very sharp sophisticated people says “my God, something awful is going to happen! We've lost everything, my God what are we going to do! What are we we've got to do!”
John: Shall I jump out of the window?!
Banker: Shall I jump out of the window?! Let’s all jump out of the window!
John: Sell!
Banker: Sell!
All: Sell! Sell!
Banker: Yes. Precisely. And then a few days later, this same sophisticated person says, you know, I think things are going rather well. And everybody says, “actually, I agree with you. You know, I think we're rich. We're rich! We're rich!”
John: Buy, buy, buy!
Banker: Buy, buy, buy. Yes. And that is...that is what we call market sentiment.
John: But...uh. Yes. Surely we are exaggerating just a bit, aren't we?
Banker: Well, I don't know. I mean in August, the middle of August this year when the market actually plunged in London, the well known City firm State Street Global Markets issued a statement in which they said, and I quote, “market participants don’t know whether to buy on the rumor and sell on the news, do the opposite, do both or do neither depending on which way the wind is blowing,” unquote.
John: Yes. And this is the kind of rigorous analysis that companies will pay huge salaries for.
Banker: Huge. Yes. Exactly. And a few days later when the markets had gone up a little bit, the senior equities advisor on ABN AMBRO Morgans said, and I quote, “we're back to happy days again.”
John: Well, no price is too high for that kind of mature wisdom. Banker: Certainly not. These sort of people are paid millions of pounds in bonuses.
John: Yes. Of course. [9:41]
JOHN: I was just going to jump out the window. Hold on a second. Let me come back over here. So I guess that's why people are confused. It's almost like bipolar disorder.
JIM: Yeah. It's funny, and we'll get to some of the reasons that are behind this, but we've been in a bull market. Despite the Fed raising interest rates beginning in 2004, the stock market went up each year. Despite the signs that the housing market was rolling over and corporate profits were peaking, the markets still continued. But now the difference between, I think, the last downturn, John, in real estate, real estate rolls over slowly. It's not like you wake up one day and the value of your house drops 40%, so it takes longer to play its way through the economy and I think now a lot of that is starting to catch up with this.
JOHN: Yeah. So to reiterate sort of what I said before we heard from the Two Johns, the evidence that's coming in really doesn't look too good.
JIM: Well, the one thing that the market had going for it up until, let's say, in the last half of this year is the momentum in the market is starting to lose steam, so that doesn't bode well for stocks. The RSI on weekly and monthly charts is starting to exhibit a pattern of lower highs coupled with the fact that this is probably the most serious downturn in RSI in five years. That's once again like the advance/decline line is another warning sign that the staying power of any year end rally is in doubt. [11:03]
JOHN: Okay. So giving this scenario that we're outlining here, would you be buying or selling?
JIM: Well, let's put this into perspective. Why don't we talk about some of the positives. I've been talking about the negatives: The moving averages being tested; we’ve talked about momentum falling. But there are a few positives and there are four of them. Right now we're moving into what I call a number of seasonal factors that are coming into play here. Normally late fall and winter all of the way until about May are the strongest periods in terms of the stock market gains. The old rumors, “sell in May, go away, come back after Labor Day” – the old cliché. We also have the presidential cycle that's going to kick into full gear next year; and which, if we go back probably half a century, back into the 60s, the fourth year of the presidential cycle has –and I stress this – has always been positive with average gains in the market around 20%. Let's face it, if you're the political party in office or you're trying to take control of the White House or Congress or even hold onto your position, you're going to try to do as much as you can to create some kind of stimulus and better economic conditions. No politician, whether you're running for the presidency or you're running for Congress, wants to face the voters when the economy is in a full-fledged recession. That’s because if you're a Democrat, you can be blamed for it; if you're Republican, you can be blamed for it, if you're an incumbent.
So this is a very strong season that we have, so we have the presidential cycle and we have the strong seasonals that come in around the end of the year; and finally we always have what the market’s doing in response to Federal Reserve rate cuts. And if we look back historically, after the Fed has cut interest rates twice, which is where we are today, then I expect the third time beginning next week, the market has been very positive 6 to 12 months from that second rate cut. So if you're looking at, let's say, markets in late spring or early December, you could see the markets being a lot more positive light. So what I expect that we're going to see, not only this month, but also in the first part of next year, are additional rate cuts. It's just going to be a question of how aggressive the Fed gets. And it's my belief they can't get aggressive until they get the cooperation of other central banks. In other words, it's got to be global reflation to make this thing work, much in the same way that you had global reflation going back to the last recession and bear market which took place in 2001. [13:43]
JOHN: Okay. Well, theoretically that should provide some kind of relief, some sort of nose dive into the pit. But if you remember, last week you were talking about that Transports telegraphing problems for the economy in the markets, so that hasn't gone away, though. That's still there.
JIM: No. In fact, the Transports are definitely telling us a story. If you look at the Cass Index, if you look at rail shippings, if you look at truck loadings, they are all consistent with what all of them are telling us which is that the economy is slowing down rapidly. That means, if we were to sum it up, that the boxes aren't moving out of the warehouse. We're starting to see additional signs that inventories are starting to build. So there is definitely trouble ahead for the economy and especially as the credit crisis gets bigger next year and especially in the first half of the year.
You know, we spent one day this week, we just took off and we decided, all right, we're going to get done with all of our Christmas shopping and I went down to probably one of the more exclusive malls that we have here in San Diego. You have department stores, the specialty stores, the luxury stores. And one message that I found repeatedly when talking to clerks and people in the stores was unlike last year, when the closer you got to Christmas and stuff wasn't moving, you would start slashing prices the last week or so before Christmas, but this year right from the day after Thanksgiving, every single weekend, you've got to put things on sale to get people into the stores.
And I talked to one gentleman at a major department store. He was saying his department had expanded this year. But even despite more merchandise, a larger department, he said he just wasn't seeing the traffic that they had seen last year.
So it didn't matter whether I went into a luxury store, a department store, a specialty store, they were pretty much all telling a – I can remember one gal telling me about, “boy,” she said, “you keep hearing about all of these foreclosures and people losing their homes.” This gal was fortunate enough that her husband was in the Navy, he's on a ship right now, and so she felt secure about his job. But she's talking about her friends and her neighbors. So that was something that I'm hearing today, John, that I didn't hear at the malls in August and September. So there has been a noticeable change and I think that's what the Transportation Index is telling us. [16:09]
JOHN: You know, with all of these variables –whether we're talking about the economy or the markets – it's really no wonder with everybody getting jittery because when you have this kind of variability everybody gets a little nervous. You're not sure which way things are going to go. It’s no wonder we've become so bipolar or psychotic.
JIM: Yeah. You definitely look at it, the sentiment has almost become schizophrenic. And I attribute that a lot to the behavior of the central banks here and abroad. They have been talking out of both sides of their mouths. One day, let's say that you experience a week where the markets really start falling –pretty much as we did in October – and all of a sudden they are out there talking like in a chorus line and saying “oh my goodness, we're concerned about growth.” And so on October 31st, the Fed cuts interest rates a quarter of a point and we get this rally in the market and then immediately the markets start going down again because what did the Fed governors do? They came out immediately after the meeting and said, “we're not sure we should have done that, we may have to take it back. We're now concerned about inflation.” So one day they are talking tough on inflation. The next day they are worried about economic growth. And sometimes they are talking and saying something different at the same time.
So given the fact that money supply growth is exploding along with credit, they are trying to talk down inflationary expectations –which is, by the way, a direct result of their monetary policies. So they can't have it both ways, which is one reason why the markets have become so destabilized is that central banks have become a destabilizing force as they inject this ocean of money into the financial system. And at the same time, they are trying to talk down inflationary expectations, “boy, we're going to hang tough in there” and then depending on what happens to the market or some economic reports, then they are reversing their roles. A lot of that is destabilizing. Why don't they just come up with a single message and say, “look, we're more concerned about inflation.” Stick with that message. Or, “we're more concerned about economic growth.” I think they are more concerned about economic growth because they know where the economy is heading. But at the same time, unlike 2001, when they were aggressively cutting interest rates, they are not dealing with $20 oil or 250 gold or 60 cent copper, they are dealing with inflation in the system. [18:32]
JOHN: Yeah. And basically they are trying to talk down inflation, but despite what our reservations might be about where things are, that's where they are and what is it investors are going to have to do then?
JIM: Well, one of the most important things I've learned from following central banks, it's not important to watch what they say. It's more important to watch what they do. So watch the growth in money supply. Look at government fiscal imbalances which are getting worse. That should tell you what they are going to do in the end because massive inflation is coming next year. And if they don't inflate massively, then the credit turmoil implodes, the banking system implodes, and instead of talking about that a recession we’d in reality be talking about a depression. I just don't see that outcome, so I'm not that negative. [19:20]
JOHN: You're positive or negative? Which one?
JIM: I'm going to go back to a theme that we had talked about last year and I believe it's going to be the “pain, then gain” scenario. If we get a rally into the end of the year following a bout of monetary reflation, which I expect –I do expect the Fed to cut and take some extraordinary measures beginning next week – but I also think that in January and February, the bad news starts to hit hard on the economy and the earnings front. So I expect to see that another major downdraft in the market in the first quarter following a rally into the end of the year; and then I expect wide spread monetary coordination to come from central banks. We've seen already this week Canada eased interest rates. I expect the UK to follow next; and then finally to be followed by Europe in late spring. So when this monetary inflation finally kicks in, I expect the market indexes to hit new record levels with the possibility of 15 to 20% gains in stocks by the end of next year. [20:23]
JOHN: Oh, boy. So there you go. You're out on a limb again. I hope you're wearing a safety belt or something. You seem to like it out there, though.
Well, obviously we're coming up on next year, so you're going to be formulating our January forecast for next year to see where it goes. Any hints as to where this might be going?
JIM: It's just starting to take shape, but it's looking more like “first the pain, then the gain” as it will take time for coordinated monetary reflation to take place. Just because the Fed cuts interest rates... remember, when they raise interest rates there's a lag effect between the time they raise rates. I mean they began raising rates in April of 2004 and they raised rates over a two year period of time. And look now, John, we're just now starting to see the lag effect of those 17 rate hikes. So just as when they move in the opposite direction and they start cutting interest rates, there is always a lag effect there. So it does take time to take place, so what comes first, I think, are going to be the problems which will weigh heavily on the markets in the first quarter of next year. [21:25]
JOHN: So if I were to summarize: You don't expect that this is the end. We never quite get to there. The sky is obviously not falling. We're even hearing some new reports that are starting to surface about the deflationists that maybe a deflationary depression is about to unfold. What do you think about that?
JIM: I just don't buy that assumption. I mean if you take a look at the fiat world that we live in with nothing inhibiting –and I mean nothing inhibiting – governments from debasing their currencies and printing unlimited amounts of money, I just don't think that's possible. Deflation, if you look at its true definition is a contracting money supply –A negative rate of growth in the supply of money. And quite honestly, I simply don't see it. If anywhere at all, all of the world's largest economies are experiencing double-digit money growth. I mean if you take a look at the top 20 central banks around the globe, 18 of the 20 have double-digit money supply growth. So by definition, you can't have deflation. We'll eventually get deflation, I think, but that is only after a hyperinflation runs its course. So right now, the financial markets, John, are begging the Fed to lower interest rates. I mean I can't turn on my Bloomberg on a daily basis without reading stories about, “oh, we need to inflate, we need to inflate, we're worried about this, we're worried about that, cut interest rates.” So right now the financial markets are begging the Fed to cut; and I'm talking about equity managers, bond managers, all of them want to see reflation.
And quite honestly, I mean we've talked about this in our Dying of Money series, this is no different today than it was in Germany during the 1920s when investors and citizens cried out for the Reichsbank to create more currency to make up for what was being lost by inflation. And translated, what that means, the US dollar and other major currencies are handled in the same way as the Reichsmark. Falling demand is eroding –and this is important to understand – the purchasing power of the currency. And the central bank – the Fed, ECB, Canadian central bank –responds to it by creating more currency units or what we call printing paper or printing money. What we call adding liquidity, as central banks do today, is no different from what the Reichsbank was doing in the 20s. [23:49]
JOHN: So in conclusion, if we were to try to summarize our prediction for next year –and this is, say, an early release, this is prediction 1.0 before the next revision comes up – number one, we're probably looking at a year end stock rally which will follow on the heels of the Fed's rate cuts. Okay. But in the first quarter of 2008, there will be trouble emerging, to be followed by what will probably be coordinated intervention by the central banks, which is then really going to lead to higher record stock prices next year. So we're going to hit these higher Dows. And we're going to hear all of the crowing about how the economy is doing great because look at the high Dow scores that were hit, failing of course, to take account, the inflated dollar, the devalued dollar. [24:31]
JIM: That pretty much sums up the way I see things unfolding: First the pain, then the gain. But here is something I think is going to be more important. The real issue investors should be focusing on here is: What is going to be the object of obsession for the next reflation? In other words, where is all of this money going to gravitate to? It was stocks in the 1990s, then in this decade it was real estate. And I believe it's going to be commodities and emerging markets –a topic we'll cover later on in the show. [25:09]
JOHN: And you're listening to the Financial Sense Newshour at www.financialsense.com. Please remember that radio show content you hear on the show is for informational and educational purposes only and should not be considered as a solicitation or offer to purchase or sell any securities and we're not liable to any person for their financial losses or other things that result from investing in areas that we profile on the program. Please consult a responsible party who knows what they are doing before you invest.
JIM: Are you implying that we don't know what we're doing?
JOHN: I've been trying to avoid admitting that publicly, but you know, we might as well come clean on the whole thing here, so --
Other
Voices: Chris Turner, Lombard Street Research Ltd.
JIM: Well, there is not a day that goes by that you read the headlines, more subprime problems; the Treasury Secretary of the United States is trying to work with lenders to solve the crisis. Are we heading for a recession? Has a new bear market begun? Joining us in Other Voices this week is Chris Turner. He's head of strategy at Lombard Street Research.
And Chris, why don't we start out with the Big Picture and give us your view of the macro picture right now.
CHRIS TURNER: Well, I think in big picture terms is we have a global economy which is still quite strong in terms of its historical growth rates, but it's definitely slowing, led obviously by the US. But in recent months we've seen Japan on the verge of recession. In the last couple of months I’d say that Europe has slowed down from what might be called trend growth to something below trend growth, with the UK in particular showing signs of a sharper slow down. And really the only areas of the world growing reasonably strong right now are Asia, ex-Japan. And even there, there are signs of exports are slowing in a number of economies as the rest of the world slow down.
So the global economy is definitely past the peak: We’re seeing industrial metal prices weakening, oil prices probably at or near the peak. Central banks, surprisingly enough in the last three months since August there have been more central banks tightening policy than easing policy which is still kind of hard to believe. But nonetheless because the pass-through from earlier rises in commodity prices up until I'd say the last couple of weeks, the general central bank view across the world (excluding the US and one or two other economies) has been that there are upside inflation risks and they need to be on top of those. I think the last two weeks we have seen a big change of emphasis with previously hawkish central banks, at least stopping in their tracks or in the case of Canada beginning to ease policy. And I think that's going to be the trend over December and then the first part of next year. And that's what's really, I think, giving some support to the equity markets as we go towards the end of the year. [28:14]
JIM: Chris, what about this decoupling theory that was bandied around the financial markets for pretty much this year: Even though the US economy was slowing down, there was the thought, well, perhaps the rest of the world was immune to anything happening here to the United States. But on the day you and I talking, Goldman Sachs has come out with a report saying that perhaps the Western economies are more linked to the US than once thought.
CHRIS: Yeah. I think they’re right. I think the frustrating thing, in a way, there has been the potential for some of these other economies, particularly in Asia to decouple in the sense that they've got these high savings, they could have really gone down a different economic policy path whereby they put an emphasis on domestic demand, but they’ve stuck to very much an export-led program. And that ultimately is going to undermine their current strength. In a sense, you know, we’re just seeing the end of that process now whereby China and India are still growing quite strongly, but they have inflation pressures of their own, so they are tightening policy. The Chinese today came out and said they were doing a switch from the kind of neutral monetary policy this year to a tight monetary policy next year. So it's hard to see where that decoupling is going to come from going into 2008.
And I think it might be the Goldman's report or at least I've seen other figures suggesting that the portion of exports to GDP is actually higher now in many of these economies than it was five or 10 years ago. So they've had the chance to shift the emphasis of their growth towards domestic demand and they haven't really taken that opportunity. [29:52]
JIM: So do you expect for example as the US economy weakens and it spills over into other Western G7 economies that maybe one of the themes that we're going to see in the first quarter of next year is what we've seen recently from the Bank of Canada where central banks will be cutting interest rates and following the Fed?
CHRIS: Yep. I think we'll see it in the UK possibly tomorrow –certainly early in the New Year. Canada is slightly a special case in the sense, because the currency was so strong in the last two or three months, that actually bore down on those inflation pressures and inflation has been undershooting their targets whereas everywhere else pretty much, inflation has been surprising on the upside. So the Canadians are slightly a special case. The UK, if they do cut tomorrow will be in some ways more significant because in the UK, the headline inflation is still at a level which would not normally allow the Bank of England to cut rates. But they are more aware now, I think, of the slow burn effects really of the credit crunch and the likelihood that these distortions in the money market between interbank rates and policy rates are not going to go away without some unusual policy measures. And an interest rate cut at a time when inflation is still quite high is an unusual policy measure. That's the first stage towards the more kind of overtly reflationary policy. [31:16]
JIM: What about the ECB? They've sort of been hanging tough or at least talking tough. As I look at some of the economic statistics for Europe –whether it's the PMI Service Index, business sentiment, consumer sentiment – it seems to be slowing. Do you think they reverse course?
CHRIS: I think they do eventually. Traditionally, the Bundesbank was always quite slow to change course and the ECB seems to have taken over that role. They do, I think, pay more emphasis on current inflation rates and current money growth rates than other central banks, which means that they are likely to be a bit behind other central banks in changing course. But you're right: The PMI indices have come down, you know, below long term averages or to long term averages over the past two-or-three months, and the long awaited boost from the consumer hasn't really materialized this year. And again, they are, to some extent, very much export-led. So I think the ECB will be changing policy but probably not in the early part of next year. Probably more towards mid year, I would guess. [32:27]
JIM: Given this macro environment when we're seeing central banks beginning to cut interest rates and we expect more of that in the New Year and a slowing economy, from an investment perspective, how would you play this?
CHRIS: What's interesting from the equity market perspective is that valuations are quite low in terms of actually risk premiums or forward PEs – measures like that. So to some extent they are already discounting a weak outlook for 2008, so we're not actually that negative on equity markets. We think that there is some scope for equity markets to kind of recover in the second half of next year even if they kind of maintain a bearish outlook in the first half of the year.
We don't have a huge directional view on equity markets overall. What we would have more conviction on really is the sector and style positions. So we’d very much favor the large cap stocks over the small caps which I know has been kind of a consensus theme this year, but I think it still makes a lot of sense. Large caps do tend to do best relative to small caps when the credit cycle is tightening. And we think that large caps look quite cheap relative to the small caps. And we’d also favor growth over value, which again has kind of done well this year after a miserable four or five years before that. So those are two things which tend to run for several years at a time once they get doing. I think that's a good investment case for those.
So in terms of sectors, one or two sectors in the US have obviously been beaten up heavily this year, things like retail and financials, of course. And the retail one interests us at the moment because on a range of measures, the retail sector now looks as cheap relative to the rest of the market as it did at a couple of points in the past 15 years from which it rallied quite strongly. And so if you're looking for, you know, a kind of recovery story, we'd certainly favor retail before financials when we think there is still a lot of bad news to dribble out over the next few quarters. [34:27]
JIM: Do you think the US can avoid a recession?
CHRIS: We think probably it can and probably will. If you look at the consumer, obviously the housing sector is a big drag on confidence but for the moment at least, the personal income growth is reasonably strong, the employment growth is holding in. The corporate sector is in very good shape going into a slow down in terms of its overall cash flow and balance sheet. So that's quite a big difference from the slow down in the early part of the century when the corporate sector was in very poor shape going into that slow down and that's why you had big cutbacks in employment and quite a sharp slowdown. This time the corporate sector shouldn't need to retrench in quite the same way. Obviously, the concern is that the housing slowdown continues for even longer than people think and at some point that leads to a big rise in the personal savings ratio, which remarkably enough we haven't seen so far. And so I’d say that's the main downside risk. [35:31]
JIM: All right. Well, Chris, I want to thank you for joining us from London on this week's show. If our listeners would like to find out more about Lombard Street Research, why don't you give out your website and tell them how they could do so.
CHRIS: Yes. Thank you. It's www.lombardstreetresearch.com. Plenty of details on there.
JIM: All right. Well, Chris, listen, all of the best to you and good evening to you in London, and once again, thanks for joining us on the program.
CHRIS: Thank you very much.
JOHN: You know, if we go back to the early days of the 20th Century in the dark mists of history and we remember the Federal Reserve Act which created the Federal Reserve, remember one of the selling points that it was sold to the public on. It was going to prevent bank panics and the boom-bust cycles of what were alleged to be, even at the time, the capitalist system. And they said that if we had a central bank, we could avoid these boom-bust cycles. But in reality, you don't buy into that. You would say the boom-bust cycle is a product of centralized and fiat money banking.
JIM: Oh, absolutely. In fact, if anything, we had a Great Depression and these boom-bust cycles have always become more pronounced throughout the 20th Century. You know, if you take a look at just in the last couple of decades, we seem to be moving from one crisis period to another. There was a period in the 80s under Paul Volcker where the money supply was constrained. In fact, he actually tightened the money supply and raised interest rates and created back-to-back recessions in 79 and 81. But that began to change, John, with the Greenspan Fed, with Greenspan responding to the 87 stock market crash by flooding the market with liquidity. And then we had the S&L crisis in 1991 and a recession and the Gulf War, he did the same thing: Slashed interest rates, flooded the markets with liquidity. And then we had the same thing happen in 94 with the Peso crisis. Once again in 97 with the Asian crisis; once again in 98 with Long Term Capital Management and Russia; once again in 99 with Y2K; once again in 2001 with the recession and 9/11. And here you are again.
The problem is these boom and bust cycles, the credit expansion, always evokes this up swing that's always followed by a down swing. And there is always the business stagnation or the recession that follows. There is a cry coming from the financial markets and economy and politicians is that business stagnation must be overcome by easy money. So there is always a tendency within the economy coming from both Washington and Wall Street for easy money. [38:45]
JOHN: You know, it does work in the early part of the cycle. Remember you always talked about the gain and the pain. And when you do loosen the money, it does give the desired result. But the illusion is that it's always going to do that.
JIM: Yeah. And you can see this coming every time the trouble spots start to emerge. People who sought cheap credit and clamored for the establishment of banks and bank to reduce interest rates, every measure is seized upon to avoid raising the discount rate. And look at the last rate raising cycle where the Fed basically had to take it in baby steps raising it at a quarter point at a time over a two year period because of the leverage in the system. So every time you get into these problems, the markets want easy money. The fact that reducing interest rates through credit expansion, the end result is this led to price increases. That is often ignored. You know, we don't even talk about money supply growth anymore or what money aggregates are doing. All you hear when you're watching the cable channels or talking to politicians: “We want easy money. We want the Fed to lower interest rates. We want the government to do something.” And so once again, instead of taking our medicine and trying to heal the patient, the cry is give us more stimulants, give us more drugs. [40:14]
JOHN: But ultimately there is a time when this is going to fail too.
JIM: Yeah. And if you take a look at some of the measures that are being taken right now –whether it's the government trying to extend mortgage or freeze mortgage rates for five years – we're talking about once more, government intervention, more regulation, the interference with contract law. And one of the characteristics in this age that we live in is a general attack launched by governments and pressure groups against the rights of creditors. And here is the problem: If the public does not think of themselves as creditors and sympathize with these non-creditor policies, you know, it comes back to bite them in the end. That’s because however that ignorance [arises] on the real causes of loose money, it doesn't alter the fact that the immense majority of the nation are to be classified as creditors and that these people in approving of easy money policies unwittingly hurt their own material interest. [41:20]
JOHN: It's also cyclical too because the people out there who get hurt ultimately cry to the people who cause the problem to solve the problem, thinking that the cause and solution are two different sources.
JIM: Yeah. And this all gets down to what I call a sound money policy and a sound credit policy. And we're going to digress a little bit here and talk about the root causes of all of this. I mean, John, there is basically two kinds of credit out there. There is what we call commodity credit and circulation credit. [41:53]
JOHN: And before you go any further, you need to define those so people know what we're talking about.
JIM: Okay. Commodity credit is the transfer of savings from the hands of the original saver into those of entrepreneurs who plan to use these funds in, let's say, increasing production, expanding of business. On the other hand, commodity credit is strictly limited. Where commodity credit is limited by the amount of savings, the other type of credit, circulation credit, there is no limit to it. Circulation credit is credit that is granted out of funds especially created by banks. In other words, creating money out of thin air which is what we can do under a fiat system.
So I mean if we take, for example, let's say, John, if you started the business and as a result of the business, I don't know, you're making some kind of widgets and so out of your business you have a million dollars of revenue and let's say your expenses are half a million, so you have, let's say, half a million dollars profit. Now, as a business man, you can take that half a million, you can spend it, you can reinvest it, you can expand your business. But let's say, for example, that you decide that okay, your business is doing well, you don't need this money in the business, so you have this half a million that is savings. You don't need it to spend. And we're going to ignore taxes for the moment. So you deposit this half a million dollars in the bank which is called savings. That savings allows a bank to loan that money out to, let's say, another entrepreneur like yourself for business expansion.
And in a society that has sound money, the real rate of interest is determined by the amount of savings in the marketplace and a free capitalistic market. So the more savings and more people save, the more money there is available to lend. The more money that's available to lending the lower the interest rate.
On the other hand, if, let's say, the following year your business doesn't do so well and let's say your profits are only 2- or 300,000, you have less to, let's say, save or invest, then when savings or the amount of savings that's available contracts or there is less of it, what happen is interest rates start go to up and that's a natural force in the market. The higher the rate of interest, that signals to investors or business men, “wait a minute, interest rates are rising, savings aren't as plentiful. At a higher interest rate it doesn't make a lot of sense for me to borrow and build a new plant or a new factory because the numbers don't pencil out at these kind of interest rates.” So these are the kind of natural mechanisms that are available in what I call a sound money economy. In other words, savings support lending. [44:55]
JOHN: Okay. Well, obviously if we compare between commodity credit and circulation credit, commodity credit really represents real wealth going into the system to be invested. Circulation credit is credit out of thin air and so that's the primary difference. A sound economy, where you're using real wealth invested into the economy to make more wealth back would be the ideal. That's what, you know, free market economists would argue for, but we don't have that today. We've got all sorts of, well, we call it funny money floating around out there and yeah, on the short term a lot of people can become rich off of that, but sooner or later if they don't convert that funny money back into some sort of asset, if the funny money goes fluey, then their wealth goes fluey with it.
JIM: Yeah. And see, that's one of the problems. Like when we gave the example of your business, and let's say you had that million dollars of revenue, your expenses were half a million, you saved half a million dollars. Well, when you save that half a million, it went into a bank, a bank made a loan to somebody that maybe invested in plant and equipment and that created more jobs, more wealth in the economy and you're creating real wealth.
However, when a bank creates money out of thin air, there was no wealth, there was no new factories, there was no increase in production that was behind that fiat money. So while the quantity of what we call commodity credit is originally fixed by the amount of capital accumulated by previous savings, the quantity of circulation credit or printing money out of thin air depends on the conduct of bank business. Commodity credit cannot be expanded but circulation credit can because there is no limitation to it. When there is no circulation credit, a bank can only increase its lending –and this is key – to the extent that savers have entrusted the bank with more deposits.
On the other hand when you have what is called circulation credit, a bank can expand its lending by what is curiously called “being more liberal.” In other words, credit expansion not only brings about inextricable tendency for commodity price and wage rates to rise because, John, there was no real wealth increase in production, no savings that are behind it. So what happens is when you create money out of thin air, the typical signals that businesses would use in terms of a free market, in other words higher interest rates would discourage a business from borrowing because they are saying, you know what, with these high interest rates I can't make this project or this investment fly. It doesn't pencil out. But when you create a whole bunch of money out of thin air, what you do is you artificially lower the rate of interest and that signals all kinds of false signals to entrepreneurs and businesses.
I mean take a look at what we did when Greenspan slashed interest rates from 6% down to 1% between 2001 and 2003. Interest rates got down to the lowest level that we had seen in half a century. And all of a sudden everyone just went bonkers and started borrowing money. Businesses borrowed money to expand. They borrowed money to make acquisitions. They borrowed money to take over other companies. Homeowners went out and voters went out and started buying homes because they were saying, “my goodness, these are the lowest mortgage rates that we've seen in half a century.” So it stimulated all of this malinvestment, and all of this real estate product came onto the market to people that normally couldn’t even afford to buy this. In other words, the economy and the financial markets were sending out false signals to consumers to go out and spend, go out and borrow, go out and buy because interest rates were artificially low. And look what happened. We over built on real estate and we are now suffering the consequences of that. [49:06]
JOHN: Yeah. So basically, we created this real estate boom. It was an artificial creation. Everyone rushed into it but then it goes bust and everybody is left, you know, it's like something that goes [puff] right in front of you, it wasn't there in the first place.
JIM: Yeah. And what's the first thing that we're starting to see as a result of that is this bust that we're seeing is invoking from the business community, the financial community and politicians to do what? Reinflate. We can't withstand the pain. All of this malinvestment instead of allowing it to clear, what are we doing? Paulson is trying to extend mortgage resets and freeze these teaser rates at five years. The Fed is lowering interest rates and the central bank is going to reinflate again. In fact, John, I wonder if we can go to that quote when Bernanke was on Capitol Hill, the Ron Paul quote.
RON PAUL: So my question boils down to this. How in the world can we expect to solve the problems of inflation, that is the increase in supply money, with more inflation?
BERNANKE: Congressman, first just a small technical point. On the growth in money, money growth has been pretty moderate over the last few years. The increase of MZM is probably related to the financial turmoil. People have be taking their savings out of risky assets, putting them in the bank and that makes the money data show faster growth. So I'm not sure that's indicative of policy necessarily. What we're trying to do is follow the mandate that Congress gave us. And the mandate that Congress gave us is to look at employment and inflation as measured by domestic price growth. And as I talked about today, and I think you would agree that we do see risk to inflation, and we are taking those into account, and we want to make sure that -- that prices remain as stable as possible in the United States. [51:03]
RON PAUL: How can you do this and pursue this, the policy you have without further weakening the dollar? There is a dollar crisis out there and people's money is being stolen. People who have saved, they are being robbed. I mean if you have a devaluation of the dollar of 10%, people have been robbed of 10%. But how can you pursue this policy without addressing the subject that somebody is losing their wealth because of a weaker dollar. And it's going to lead to higher interest rates and a weaker economy.
BERNANKE: If somebody has their wealth in dollars and they are going to buy consumer goods in dollars, a typical American, then the decline in the dollar, the only effect it has on their buying power is it makes imported goods more expensive.
RON PAUL: Yeah. But not if you're retired and elderly and you have CDs and they are -- their cost of living is going up no matter what your CPI says, their cost of living is going up and they are hurting and that's why people in this country are very upset. [51:56]
JOHN: Okay. So you start with a boom. Everybody is thrilled. Then you have a bust. Everybody feels the pain and that doesn't fly politically or economically. And so they scream out “do something” and the same process starts all over again. It's just cyclical, but in reality, they don't have any other options; do they?
JIM: If you had true leadership and you had a public that was more educated in terms of monetary affairs because, you know, what are you seeing from voters? Voters are the public. “Hey, lower interest rates make my life easy. I don't want to go through pain. I'm in debt to my eyeballs. I'm over-extended.” But one of the reasons that people are in debt to their eyeballs, John, are two factors that we've been fighting as a result of an unsound money system which are taxes and inflation. In an inflationary environment, you get more inflation, prices become more expensive, it's harder for couples to make ends meet, that's why you've got husband and wife working today plus husband and wife working plus taking on more debt to pay their bills and pay their taxes. The cost of goods are going to go up. And that's why you've had a little bit of this hesitation by central banks and this talking out of both sides of their mouth where they realize that they are facing an economic crisis, but at the same time they know the amount of money printing and the money supply growth is so large that they also know that inflation is baked in the system right now. [53:26]
JOHN: Yeah. That's what I meant. They don't really have any other option. You're stuck with this and you're sort of condemned to this trail. It takes -- seems to take on its own life until it ends badly.
JIM: Sure. It's like being on an upward track on a treadmill. You have to keep running faster and faster and faster to remain in place. And that's one of the cycles that this takes. In the end is these cycles of credit creation, it takes larger and larger amounts of debt, larger and higher percentages of credit creation to keep this thing extended. And eventually, I think what we're doing now as we head towards the end of this decade is that we're entering the final era or end game of this whole process where it eventually becomes unwound. I think they are going to be able to reinflate one more time, but not without consequences this time. [54:17]
JOHN: Well, whenever we talk about creating an inflationary bubble though, the money has to go somewhere in some market to have it's impact. Last time it was housing. It's got to have a new object. Well, it can conceivably good back to housing, but is there a different object or target for the inflation bubble this time?
JIM: Sure. You go to rotating asset classes and I think that that should be the number one focus for investors. That's a topic that we're going to cover in the next hour is the object of reflation. That’s because money, once it's created, the central banks cannot control where that money goes. And one thing that we know as a result of last year it took five dollars of debt to create one dollar of GDP. [55:02]
JOHN: Okay there is a mathematical issue there. Five dollars of debt to create one of GDP. What happened to the other four?
JIM: Well, if you take a look at all of that debt, part of it will go into imports and money going into imports doesn't drive our GDP. It drives the GDP of other countries. And then the balance of that money goes into financial speculation. That's why markets or what you get asset bubbles as a result of all of this liquidity that they are talking about. So the next object and it's never the same thing. I think what you're going to see going forward and it's beginning to dawn on people all around the globe, smart money is moving and has been moving for the last six years into hard assets, especially gold. And I think you're going to see that trend continue. And especially next year when you start seeing coordinated intervention and monetary reflation by all of the central banks. And you're already seeing this, John, with the sovereign funds that are being developed or launched by many of these central banks that are accumulating all of these excess reserves. They know that the interest rates –whether you're looking at the US or Europe – are nowhere close to the real underlying inflation rates. So you're starting to see the sovereign funds. You saw Dubai invest and buy nearly 5% of Citigroup. They bought 5% of Sony. And I think they are going to start buying real assets, whether it's commodities, real companies, real businesses. And I think that's where this money is going to go next because people are going to start wanting to own something that's real rather than something that is paper, which is losing its purchasing power and is constantly being devalued and depreciated. [56:46]
JOHN: Online with the Financial Sense Newshour, www.financialsense.com. We'll be right back after this.
MR. PAULSON: In the final days of the congressional session, there was much that Congress can do to help American homeowners. As we are all aware, the housing and mortgage markets are working through a period of turmoil as are other credit markets, as risk is being reassessed and repriced. We expect that this turbulence will take some time to work through, and we expect some penalty on our short term economic growth. The positive news is that we are confronting and managing these challenges against the back drop of a strong global economy and the US economy remains fundamentally sound, core inflation is contained, continued job gains are providing a good foundation for household spending, corporate balance sheets remain healthy overall and strong growth abroad is supporting US exports. Our economy will continue to grow, but it is facing a number of challenges. And as I've said before, the housing market downturn is the biggest challenge to our economy. When home foreclosures spike, the damage is not limited only to those who lose their homes. Homes in foreclosures can pose costs for whole neighborhoods as crime goes up and property values decline.
JOHN: That was the voice of Treasury Secretary Henry Paulson this week talking about the very same subject we were discussing in the last hour, Jim. And strangely enough, he's echoing those things which we were discussing. Number one, he seems to anticipate that we're going to have some kind of pain in the first quarter coming up very shortly here and that what they are anticipating to try to deal with that is another kind of reinflationary fiscal stimulus to stop the pain. Like you said, one more time around the loop before maybe the pain pill isn't going to work anymore, but at least he's already telegraphed the intentions to do that.
JIM: Yeah. And given the fact that I do expect some kind of fiscal stimulus, some kind of legislation passed by Congress, also monetary stimulus and it's going to take not only coordinated monetary stimulus, but it's also going to take fiscal stimulus and you already just heard Mr. Paulson talk about that. And there is growing support on it, both in Washington and Wall Street – and especially next year, John. I've been reading some of the public opinion polls that the economy is now starting to move to the top of the heap in terms of the things that voters are most concerned about, and for very good reason, by some of the things that we were talking about that not only in the last hour but also last week on the economy. [2:48]
JOHN: So given the fact that we assume that this reflationary effort is going to be there basically because of the pain that we're going to feel in the first quarter, remember we're right around 300 days by then toward the next election, and there will be a fiscal stimulus which results in a monetary stimulus. What is going to be the target? It's got to go somewhere just like it did in the housing bubble the last time around.
JIM: Sure. Because we're still seeing credit expansion both here in the US. We're seeing it also in Europe and elsewhere in the globe. And John, usually when you go through these boom and bust cycles, when the next boom starts, it's never the same asset class. It's usually something different, so that, for example, when the technology boom came to an end with the bear market of 2000 to 2002, the next object of reinflation was real estate. So that's probably the most single most important investment question that investors need to be asking. Where is the object of the next reflation going to be? [3:52]
JOHN: Typically when this happens, you've always got some kind of a for-public-consumption story that goes behind it. It was new economy for stocks. That was what we saw in the 90s and then it was this great housing boom that we were seeing around the country. What is the sell point going to be this time around?
JIM: I think there is already a good story, and you're right. You need a story and then that story gets developed, it gets expanded, you get analysts getting behind it, you've got politicians getting behind it. And I think the next story, and we've already got it, is the booming emerging markets. And what a booming emerging markets. As their economies develop, there is greater demand for housing. In China, you have more people moving in from the countryside to the city, so you have infrastructure expansion. And what does that result in? It results in greater demand for commodities. People's diets improve, so they eat more beef or chicken and protein is added to the diet, so more demand for agricultural products. Agricultural products are going to take fertilizer. It's going to require water. It's going to require infrastructure. And of course behind all of that is energy. So you already have the basis there of the story for it. So I think that you are going to see the next object of that reinflation is going to be into commodities, hard assets and business franchises that have an enduring moat or franchise that is going to be very attractive to a lot of sovereign funds that are developed all over these massive amounts of currency reserves. [5:35]
JOHN: Okay. So as we begin this new reinflationary cycle, looking at energy prices and precious metals, this should just impel them higher.
JIM: Yeah. One of the things that I can see happening next year is I can see a rally in the dollar coming about as a result of everybody's recognition that, “hey, wait a minute, the Euro has problems, other countries have problems.” And the Euro isn't tested in terms of a crisis. So you could have money coming back from a contrarian point of view or the fact that they've got problems too, back into the dollar. But I think like what we saw in 2005, you could see a rising dollar and rising gold prices. So I definitely believe that we're going to see rising metal prices next year. I also believe that we will see higher energy prices next year as supply constraints are even tighter; although we may have a down draft in the first quarter as a result to markets reacting to slower economic growth. It was the same thing, John, remember after Katrina and Rita, everybody was telling us that we had demand destruction when in reality we didn't. But we did see oil pull back from the mid-70s all of the way down to the $60-level and below as a result of that initial reaction. But over the course of the year, I do expect higher energy prices, especially higher precious metal prices reacting to that because it will dawn on everybody as central banks globally begin to reinflate. And then also I expect one of the objects or the story behind the next reinflationary bubble is I also expect higher markets in the emerging markets, the BRIC countries especially. [7:21]
JOHN: You know, if we compare that to what we've seen already this year, gold has gone from somewhere in the 600s to around 850 an ounce. But at the same time, a lot of the gold indexes are really, really struggling. So although the metals are reflecting the changes already, it seems like investing in gold securities really hasn't caught on.
JIM: No. In fact, it's really surprising and you can see this on the charts. If you take a look at the price of bullion since the beginning of the year and then also look at the influx of assets into for example, the Rydex Precious Metals Fund. John, there is almost a complete divergence. Hardly any money is grown into the gold sector. People are chasing Google or they are chasing anything else but the gold story. And I really don't expect that to change much until, I would suspect by the time gold crosses $1000 an ounce, silver is in the mid-20s, you know, about that time, when those kind of events take place, you know, maybe then it starts capturing the imagination of the public. But if you look at John Q, he's not invested in gold. It's nowhere on anybody's radar screen in terms of the investment public. The institutions have gone into the gold sector, but they are mainly trading it. They'll trade bullion, they will trade the major stocks. That's why the major large cap stocks like the Barricks, the Newmonts, the Agnico-Eagles, the Goldcorps have done much better than, let’s say, some of the juniors. But I think in terms of the public catching on to the gold market, I mean what would you get, John, if you were talking to your neighbors and they are saying, “hey, John, where are you putting your money?” “Hey, I'm buying gold and silver.” They'd probably look at you rather strangely. [9:05]
JOHN: They've been doing that for...I mean they were doing this especially at the beginning of the millennium when we turned it around. You kept hearing over and over again gold was such a risky investment. It came right off brokers mouths like a reflex reaction.
JIM: Yeah. And the unfortunate thing is being a small market, the rise in gold stocks and bullion and the drop, conversely, is always very sharp. It's a very small-cap market when you compare other asset classes such as stocks and bonds in general. I mean the HUI, which is 15 stocks, the largest producers, you know, John, that market cap is somewhere in the neighborhood of 120, 130 billion. That doesn't even come close to, you know, stocks like General Electric, Exxon or even a Microsoft. So money moving in can move these stocks sharply, money moving out will move these things down in the same direction. [10:02]
JOHN: But that would seem to be why investors shy away from it, and as a result of that, it really doesn't come up on the radar screen for the general public.
JIM: You know, on the surface that may sound true, but if you look at this year's stock market, we took off the beginning of the year, everybody had high hopes for the stock market and then we had that rapid plunge in stock prices that occurred in February as the subprime market problems first surfaced. And then all of a sudden we were told it was contained and the markets took off from February all of the way up to reaching their first initial high in the June period and we hit new records on the Dow. Then all of a sudden in August, the problem surfaces again. We get almost a 10% correction. The central banks start lowering interest rates. We get another take off to a new high in October, and then from October, we get a 10% pull back. So even if you look at the regular stock market this year, we've had three sizable corrections. And if you look at the VIX, or the volatility in the stock market, it is certainly on the up swing. So I don't think you can [attribute] it to that. But one of the problems is what brokers are telling their client to invest in gold? They are probably telling them to buy Google or take a look at some of the stocks that investors are chasing. I just don't think it's anywhere near on the radar screen. And if you want to say that gold stocks are volatile, then you'd also have to say that the stock market has been volatile, which it's proven itself to be this year. [11:33]
JOHN: Yeah. The real oddity of the whole thing, although I guess it's part of human psychology, is that the only time gold investors seem to suddenly go “gee, what's going on over there” is when gold is going over the top. But when it pulls back the optimum buying opportunity is just when it just attracts no attention whatsoever. “It's not doing anything” is what you'll hear. So they are actually doing 180 degrees out of phase what they should be doing.
JIM: When you take a look at the gold market, you know, one of the better ways to buy gold is when it's going through a correction rather than when it's going through the roof and that's one of the problems that we see. You know, when gold is correcting, nobody wants to buy it. It's only when, you know, as we saw in August when the HUI index got down to 284, which was its low point for the year and then all of a sudden it goes from 284 all of the way to 463. So, you know, it's funny, John, it's only after the gold index rises 63%, which was the gain in gold stocks from August until reaching a peak in the first week in February, it's only around that time when the HUI is around 450, 460 when people become interested. We talked throughout the summer months that we talked about, for example, the juniors during the summer that they were being trashed, they were literally being given away, thrown away as valued as almost being worthless, nobody wanted to own these stocks then. It was only after we had that huge 60% run up in the HUI that it was only at that point that it got people's attention. So in terms of buying bullion or buying gold stocks, you always want to buy them when they are going down. You want to buy them when they are cheap, not when everybody and their mother is chasing them which is so often the case. [13:26]
JOHN: So I guess the conclusion we can draw out of the whole thing is given the turmoil in the stock market and given the fiscal policy of where we think the Fed is going to go, gold and other metals would seem to be again another option because if we're headed for another cycle of inflation, ultimately the metals are going to reflect increase in value because of that.
JIM: Absolutely. I mean I would want to buy them while they are consolidating or going down versus when they are going through the roof as we saw, let's say, mid August all of the way into the first part of November.
You know, it always amazes me, John, when I see, for example, two weeks ago we saw oil at $99 a barrel. Today on the day you and I speaking oil prices are roughly around 87 and $88 a barrel. So we've had prices come back, let's say, 10 bucks in the last two weeks. We're continuing to see inventories drawn down and it's amazing. You know at $88 a barrel, do you realize the amount of money that oil companies and natural gas companies are making at these kind of prices? And if oil prices pull back 10, 12, $15 a barrel, I don't care, even if they pull back to $80 a barrel, what always amazes me is investors are selling off oil stocks that are trailing, selling at eight or nine times earning, some selling at seven times earnings. I mean why would you do that? And more importantly, if oil prices are heading higher, let's say that if we were talking to each other this time next year oil prices are above $100 a barrel, what do you care if oil prices pull back? [15:05]
JOHN: You can see some of that hysteria that we were talking about that in the markets. Remember this year when we hit a warm spell and Goldman Sachs lowered its energy index and suddenly everybody is dumping. And less than three weeks later they are shoveling snow like crazy in the Northeast. Everybody is yelling buy, buy, buy. That's the insanity of the whole thing on the short term.
JIM: Yeah. It goes back to that almost like the Two Johns that we discussed in the first hour. All of a sudden sentiment changes on a dime. And that's what you see happen too often. People sell because they look at price, and price doesn't tell you everything about what's going on fundamentally. So people are saying, “oh, my God, my oil stock is down $5, sell, sell, sell, jump out the window,” you know. They don't react rationally to this. That's why I think it's much easier if you're a long term investor to say you know what, ignore these little blips when people get crazy or act insane or irrational. If you think oil prices are going to be higher a year from now, two years from now or three years from now, supply is struggling as it is to keep up with demand and what are the chances the economies, the emerging economies of Latin America, India and China where most of the world's population resides, what is the fact that they are going to contract and go and stop consuming energy? What happens if China sells – I'm looking at figures that they may sell 10 million cars in the next couple of years surpassing even some of the larger markets around the globe? You know, once you own a car, you become an energy consumer. And these are the questions people don't ask. They are always looking at the moment. [16:41]
JOHN: So this gets us back to something you wrote way back in 2003. It sounds strange when we say “way back in 2003.”
JIM: The way back machine.
JOHN: You're talking about the next big thing, remember that, way back then, and we were talking about long term trends and real investing demands that you, other than day traders, that you basically identified those things that are going to be really serious long term trends and then you stick with them regardless of whether or not you have the little upsy doodles that you hit from time to time in the markets.
JIM: Yeah. I think that's probably the most important lesson that you can learn as an investor. The things that have always worked out for me personally and the things that we have done have all been long term investments. Whether it was investing in real estate during the S&L crisis or buying energy and precious metals back at the turn of this decade. You know, John, I think an investor, if you really look at the markets over the last half century, there were very few moves that investors needed to make. In other words, these long trending cycles, whether it was a bull market in stocks that began after World War I and lasted all of the way into the mid to late 60s. Then there was another cycle that took over in the mid 60s lasting to the, let's say, the 1981, 82 period, which was an 18 year cycle of commodity bull market; and then from 1982 to 2000, we had an 18 year bull market run in equities.
Well, now, I think this next trend for basic supply and demand reasons, remember, bull markets always start out on fundamentals. We are not seeing large amounts of new oil discoveries. We're not seeing large, huge discoveries made in gold, silver, copper. So where is all of this new supply that's going to keep up with this demand? That's why these bull markets tend to be long trending in nature. And if you just look at a chart –whether you look at a chart of the HUI, gold, bullion, energy –just take a look at the last five or six years. And you're right. It's been a bull market, those charts are going up at 45 degree angles. But along the way you are going to have these pull backs and you will in the future as well. But it's very clear if you look at a chart of energy, you look at a chart of silver, you look at a chart of gold, copper, and even now more recently the ags or the agricultural commodities, it's very clear that we're in a very clear long trending cycle up trend. [19:13]
Subprime
Bailout - Consequences
PRESIDENT BUSH: I’m pleased to announce that our efforts have yielded a promising, new source of relief for American homeowners. Representatives of HOPE NOW just briefed me on their plan to help homeowners who will not be able to make the higher payments on the subprime loan once the interest rates go up, but who can at least afford the current starter rate. HOPE NOW members have agreed on a set of industry-wide standards to provide relief to these borrowers in one of three ways: By refinancing the existing loan into a new private mortgage; by moving them into a FHA secure loan; or by freezing their current interest rates for five years.
JOHN: Well, with only 332 days to go until the election, it's important to frame the next subject in that 332 days. That was the voice of President Bush speaking on Thursday unveiling his subprime mortgage bail out plan for people who had been involved in taking out mortgages under the subprime scenario. And we need to examine a whole series of different things that are related to this, which we'll do right here in the section of the Big Picture. It's really important, Jim, to frame this in terms of election because some of the proponents have really even more expansive bailouts. This is all framed in this 300 days here as well, not to mention the fact that the situation is probably going to get a lot worse in the next, what, first quarter of the next year?
JIM: Yeah. Probably the first two quarters of next year where I think it's by the end of the second quarter the peak in mortgage resets will have reached, so there is a flood of resets on adjustable rate mortgages, not just on sub prime, but also on prime adjustable rate mortgages which are coming due. And that's going to create this problem and make it even bigger. So this is an attempt to head part of this off at the pass and we're going to examine whether this is an effective means of doing so. But you're right, John, we're heading into an election year and this is the economy slowing down, mortgage resets due to peak in the first six months of a presidential election year. You know, politicians are going out there and saying “we need to fix this.” People are hurting. It sells politically and this gets back to the argument that we've had on this program over the years, John, that there is no tolerance in the country for economic pain. We're afraid of recessions in the cleansing process that it brings in. We're afraid of bear markets and the losses that it creates for investors. We're afraid of banks losing money on bad loans. Any time you have a financial crisis, John, you can always look to the banking system and they are right there as one of the root causes of it, which gets back to something Ron Paul talked about, which is a loose monetary policy. When Greenspan cut interest rates from 6% down to 1% and left them there, it created the environment –provided the economic and monetary fuel – to give us the boom in housing. And now we're dealing with the bust, which invariably always comes at the end of a boom that is artificially created. [22:40]
JOHN: Yeah. Let's face it. When we talk about pain, a lot of people lose jobs or are unable to hold on to their houses. There's a big etc etc on top of that. So the pain for many of the middle and lower classes is really intolerable. And of course, I guess the first question that everybody is asking right now, you can see that by some of the feedback coming into to the other network is: If we're going to have a bail out on some of these sub prime mortgages, who qualifies and who doesn't? You know, is there a cut off date? What about people whose adjustable rate mortgages have already reset? You were talking about the ones coming up in the first quarter of next year, but there are a bunch of people whose loans have already reset. Do they qualify? So that's probably the first thing we should look at here.
JIM: Well, let's talk about what is leading up to this and that was on the same day the president gave his speech. There was an economic report talking about that home foreclosures surged to a new high; and the number of homes that went into foreclosure were at the highest level since the Mortgage Banking Association kept track from 1972; and the fraction of homeowners behind in their payments rose to the highest level that we've seen in 21 years. So this is sort of the impetus. Everybody knows this problem is there. It's going to get worse. And even worse off for politicians, John, it gets worse in a presidential election year and a year when congressmen and senators will be running for reelection.
In fact, if you take a look at the report that came out Thursday, foreclosures rose in all four types of mortgage loans according to the Association's quarterly survey. It was the sharpest for adjustable rate mortgages –which would only be natural given all of the teaser rates – including, though, homeowners with better records who are considered to be in the prime loan category. And in the prime loan category, even borrowers with fixed rate mortgages were hit pretty hard on the foreclosure front. And most of that damage is coming from four states where you saw a bubble. Florida and California with the real estate bubble, Ohio and Michigan due to what's going on in the manufacturing economy. These are the states that are taking the worse hit from the housing correction, also borrowers are falling behind on payments for traditional reasons: Employment, the economy is slowing down, people are getting laid off, medical problems, marital problems, going through a d