The Room 3/24/08

Dear Reader,

It used to be of no little pride in the small New England town where Casey Research is headquartered that school went forward, no matter the weather. Hail, 8-foot-high snow drifts, ice rain and, should they have occurred hereabouts (which they didn't), I am fairly sure that even hurricanes and tornadoes would not have kept the school administration from its daily labors in the brainwashing of innocent youth.

That all changed when, earlier this winter, a school bus missed the turn on a gently sloping hill and rolled onto its side, fortunately causing no serious injuries (for some reason, which continues to baffle me, the police will stop and ticket you for driving without a seat belt, yet school buses are systematically unequipped with same).

The accident, no doubt, made the school officialdom aware of some previously unexamined legal consequence because the school now delays the morning opening or closes down tight on what appears to me to be so much as a semi-reliable report that a single threatening snowflake has been observed in the general vicinity.

And so it is that, with a modest snowfall in process, the kids are home again today, lounging about and, because it is Friday when I write from home, crowding me out of my office (which counter-intuitively also serves as their toy room). Which leaves me to write to you from a couch upstairs, with stern instructions to the kids that while I may appear to be in residence, they should assume I am a figment of their youthful imaginations until I have finished writing this weekly epistle.

While it is typically with a good deal of pleasure that I sit down to reminisce about the action of the week just ending, this week again, the volume of news coupled with the magnitude of that news makes the task daunting. But no amount of dithering will make the task go away, so here we go.

"Commodities Drop, Rally in Dollar, Stocks Vindicate Bernanke"

That headline is not mine, it is from Bloomberg this morning. Bloomberg's enthusiasm is based, as hard as I find it to believe, on little more than that the Fed cut the rate it charges banks to borrow by "just" 75 basis points this week, and that the stock market rallied, then fell, then rallied again in response.

The herd was, apparently, expecting 1%. Further, not only were they expecting this, they were mentally prepared to accept a 1% cut as a sign that the economy remained in dire straits and that, as a result, the Fed would have to continue its loose money policy. According to the punditry, a 75 bps cut indicates that Bernanke and Co. have drawn a line in the sand, signaling they were going to be restrained in their approach to the crisis now stalking the land. Further, this show of confidence portends that the worst of the crisis is nearly behind us.

Ready to push the trigger to buy more commodities on a 1% rate cut, the market instead rushed into buy stocks and sell commodities... then changed its mind and sold stocks and commodities... then bought stocks again, but still sold commodities.

Gold, silver, oil, grain... you name it, if it shows up under the heading Commodities in the back of your favorite paper, then it got hit.

But of course, there was a whole lot more going on this week. We'll come back to the commodities momentarily. First, however, we need to walk up a few floors to get a better view of the bigger picture.

Problem Solved?

Now, you will excuse me if I seem a touch skeptical, but I can't help but notice that short of climbing aboard helicopters rigged to carry pallets of dollars, the Fed is now doing exactly what we have been expecting it to: provide all the liquidity it can muster using its near mystical powers of money creation.

In addition to yet another deep cut in the Fed Funds rate, they are now making the almost unprecedented move (at least since the Great Depression) of lending money to non-commercial banks, in the process effectively putting taxpayers on the hook for $30 billion in suspect collateral from Bear Stearns.

And that's just one of many moves of late, including cutting discount rates by a total of 1%, to 2.5% over the past week alone, and opening up new lending facilities that allow the investment banks to borrow directly from the Fed using as collateral the same sort of suspect paper that brought down Bear.

Playing their part, three of the biggest investment banks, Goldman, Morgan Stanley and, importantly, Lehman, announced that they were going to access this new lending facility, whether they need to or not, in order to remove the "stigma" (their term) of stepping up to the window, so to speak.

Give that some thought for a second. What they were saying for all the world to hear was that they were going to engage in what is effectively an institutional shell game... a deliberate attempt to obfuscate which of the banks are actually in trouble. As a shareholder in one of these companies, you won't have any idea whether your bank is accessing this emergency facility because it is, in fact, in trouble.

Given the estimates that the assets being carried as capital on the books of Bear Stearns were worth only 10% of what was being posted, and the herd-like business practices of the big investment houses, the odds are fairly high that Bear Stearns is not the only institution teetering on the brink.

Yet this week investors seemed to actually buy the idea that the worst is now over, and that the all-clear signal will soon be sounded.

What to believe? Whom to believe? Could the Fed have finally figured out the right combination to re-open the safe of prosperity? And what of the commodities, especially gold?

This week I have received a larger than usual amount of incoming emails presenting all sorts of theories. Some have it that JPMorgan, the world's largest bullion bank, was in real trouble with shorts on gold and had been buying the metal back, helping to fuel its meteoric rise of late, but that the liquidity provided by the Fed has now taken the pressure off and allowed them to stop or slow their buying (our own Bud Conrad has been looking into this notion, but so far has uncovered no solid proof).

As for the financial sector and, by extension the rest of the market, we can't know for sure what's going on behind the scenes, because the government and the big banks are playing it very close to the vest. But we can, from our higher perch, try to sort the unknown from the known, and start with the latter.

  • This week we had a major bank failure (as predicted many months ago by Bud). Despite Jim Cramer's firm belief in the firm, Bear Stearns, the fifth largest U.S. investment bank and a firm tightly connected as a counter party to hundreds of billions in derivative agreements, suffered a good old-fashioned meltdown.

  • We know that the share price of Bear Stearns has fallen from over $150 last year to as low as $2.00, and what is left of the firm is now being sucked into JPMorgan, but only because the Fed has agreed to stand behind the deal to the tune of $30 billion, an intervention the likes of which was last witnessed in the Great Depression.

  • We also know that the vultures were starting to circle Lehman, another member of the big five U.S. investment banks. Absent the Fed's aggressive intervention, the odds were fairly high they would have been next to get hit with the equivalent of a run. This is why the Treasury and the Fed worked so hard to get the Bear Stearns deal cobbled together over a single weekend, before the markets reopened and Mr. Market could recommence beserking. From where I sit, it appears that we came within hours of seeing another of the nation's largest financial institutions crash, potentially taking down the whole house of cards.

  • And we know the Fed dropped the Fed Funds rate by 0.75, only the second time in the last decade that it has cut rates by an amount that large.

We know some other things as well. For instance, that commodities have been on the equivalent of a one-way-up escalator in recent months. And we know that no market goes in only one direction for any sustained period of time, and so a correction was inevitable. Gold, oil, the grains... they all had to take a breather. And so they have.

But Let's Try to Keep This All in Perspective...

What has actually occurred over the last month, between February 21 and March 20?

 
Gold
Silver
Copper
Oil
Bear Stearns
JPMorgan
Lehman
21-Feb-08 $945.00 $17.98 $3.77 $98.39 $82.23 $43.07 $54.14
20-Mar-08 $925.75 $17.53 $3.62 $104.49 $5.96 $45.97 $48.65
Gain or Loss -2.0% -2.5% -4.1% 6.2% -92.8% 6.7% -10.1%

Okay, so gold and silver are off a little, copper a bit more, oil is still up, Bear Stearns is a smoking hole in the ground, JPMorgan is up a bit, and Lehman is down 10%. Other than Bear Stearns and, to a lesser degree, Lehman, I'm not seeing anything so earth shattering. (Sure, gold recently took a high dive off the $1,000 per ounce mark... but it is still over $900, a level that not one in ten thousand investors, if asked a year ago, would have expected it to trade at. And oil over $100? Forget about it.)

There are a few more things we know. For instance, that consumers are debt strapped and the housing bubble has burst and is deflating rapidly. And that falling home prices are wiping out the net worth, discretionary spending power and positive sentiment of the U.S. consumer who has, heretofore, shown a seemingly unlimited willingness to go into debt up to their eyeballs to keep the world economy afloat. That is now changing.

We also have proof, if proof was needed, that the government will do whatever it takes to avoid a meltdown. While they are shoving the walnut shells around so fast that it's hard to figure out where the pea is these days, what is increasingly clear is that there is only one real plan at this point: to apply as many billions of dollars as they feel is necessary to keep the ship of state afloat.

And while some might like to think that the country is not in a recession, at this point I am going to put it down as fact that a recession is now underway and that we need to be worried about it becoming much uglier than that.

Blame it on Smokey the Bear

A good way to understand both the degree and the nature of the current crisis is to look at the state of the nation's western forests. Before the 1940s, forest fires were allowed to run their course, just as they had over the millennia. But then the government adopted a policy to fight every fire, a battle epitomized by the introduction of the iconic Smokey the Bear. What has happened since is a massive build-up in the fire risk in federally managed forests.

The following is from a CATO Institute document on the topic...

Since the advent of the Smokey Bear era in the 1940s, tree density in federal forests has increased from 50 per acre to as much as 300 to 500 per acre. Federal forests are filled with dense stands of small, stressed trees and plants that combine with dry deadwood to provide virtual kindling wood for forest fires.

According to Forest Service statistics, some two-thirds of federally held forested lands are in deteriorating health.

The consequence of governmental meddling in the forest is that when a fire now breaks out, it is exponentially larger, more dangerous and more expensive to fight. Nationwide, the forested area now at extreme risk is equal to an area about the size of the state of California.

One of these days, and probably sooner rather than later, there will be a forest fire of biblical proportions... and Smokey's real-life brethren, along with houses and all that moves or doesn't, will go up in smoke.

Similarly, by continuously tampering with the business cycle, the government has led us to the point where the dried underbrush is piled high and just waiting for a match. The Fed was able to throw a quick tanker load of water onto the Bear Stearns fire... but that doesn't mean we are anywhere near out of the woods. (Don't you just love it when your metaphors snap so nicely in line? I sure do!)

Which Brings Up an Interesting Question

Given virtually unlimited power, including the ability to create money out of nothing, or to change any rule or law or convention, bend any arm, or ban or hinder trading in any commodity... just how much power can the U.S. government apply to the problems now besetting our economy and, by extension, the world?

Or, looked at from the reverse angle, given its unlimited power, is there any way Paulson, Bernanke, et al can fail to stabilize things?

It is an interesting discussion, and one that requires more analysis and data than I'm in a position to provide sitting here on my couch on a Friday morning. (We will go into it in more detail in a special report on the crisis that is being worked up for paid subscribers, and which should be issued following our Scottsdale Crisis & Opportunity Summit next week.)

I will, however, comment just a bit further.

Let's start with the proposition that the government has absolute power, which is largely the case these days, especially because the populace is so numb to large numbers that outrage at the beggaring of future generations no longer seems to be of any concern to anyone.

So, the Fed can effectively pump out all the money it needs to "get her done" and if that doesn't do it, then the Treasury can step back in. This approach, from a policy maker's perspective, is quite attractive because it essentially papers over the problem. Look at it this way. If housing prices fall, on average, 20% nationwide, but the currency depreciates at the same level, then housing weakness would be masked... ditto 20% of stock market losses. In case that point is not clear, look at it like this. If your house is worth $100,000 and it loses 20%, its value would fall to $80,000. But if the dollar was to simultaneously lose 20%, then the price of the house would remain $100,000. The average person would be clueless they have just taken a 20% haircut. Pretty cool, eh?

Unfortunately for the government, there are natural limits to everything. In this case, the most immediate threat to this plan resides in the trillions of dollars held by foreigners.

In recent decades these foreigners, trading partners mostly, have been willing to swap our inflation in exchange for market share within the U.S., the greatest consumption engine on the planet (as an FYI, the eurozone just surpassed us).

But that inflation is beginning to be felt back home: in China, in the Middle East, Russia and everywhere between. At some point, the pain, and the realization that inflation in the U.S. is only going to get worse, is very likely to make these dollar holders get serious about breaking their links with the dollar, and dumping the trillions they now hold.

And while U.S. consumers are well aware that everything costs more these days, no matter what the jury-rigged CPI tells them, it is when the foreigners start repatriating our dollars that the real pain of inflation will begin. At that point, the fire starts in earnest.

I call this the Point of Mugabe, named in honor, of course, of Robert Mugabe, the supreme overlord of Zimbabwe. A dictator with absolute power in all matters, Mugabe's maladministration of his country's economy has finally reached the point where today, as much as he dictates against it, inflation runs in excess of 100,000% annually. While the sheeple of that country seem either particularly stupid, beaten down or tolerant, sooner rather than later Mr. Mugabe's ridiculous regime will come to an end, and probably not in a manner that he will find personally pleasant.

In the final analysis, I remain convinced that the praise of Bernanke et al based on their extreme actions this past week will find its way into the history books along with quotes such as these...

"The end of the decline of the Stock Market will probably not be long, only a few more days at most." --Irving Fisher, November 1929

"I see nothing in the present situation that is either menacing or warrants pessimism... I have every confidence that there will be a revival of activity in the spring, and that during this coming year the country will make steady progress." --Andrew W. Mellon, U.S. Secretary of the Treasury, December 1929

And, of course, my favorite recent example... Jim Cramer's rant that people should not take their money out of Bear Stearns, just a day before that firm collapsed. You can watch history in the making by clicking here.

We'll have a lot more on this topic in our upcoming special update report on the crisis, which will be sent to all paid subscribers the week after next.

What's Coming

In my reading for the above, I came across the September 2007 edition of the International Speculator and its lead article, Preparing for Crisis . I thought the following excerpt was worth sharing, not just because it shows how spot-on Bud Conrad, the chief economist of this operation, has been in forecasting the specifics of the unfolding crisis, but because it is still as useful today as then in understanding how things are likely to keep rolling out (the full article has much more detail, well worth reviewing). Here's the excerpt.

The credit crisis will not end soon. Here's what we think is coming.
  • More Defaults. The bulk of the subprime loans are adjustable rate mortgages. The continuing reset of up to $50 billion per month of subprime ARMs will keep mortgage defaults growing, which will keep home prices falling, which means that more of the defaults will turn into unrecoverable losses for the investors holding the paper. The hedge funds that haven't thrown in the towel on subprime mortgages will collapse one by one.

  • The economy will slow down. Lending to risky customers has dried up. Earnings of most corporations will slide because consumers, who can no longer turn to home equity loans and whose credit cards are already maxed out, will cut spending. The mounting losses in CDOs and the continuing defaults in the housing industry will precipitate a severe credit crunch. The capital of many banks is about to shrink, which will hamper their ability to lend.

  • Stocks will fall. The next phase down in the stock market will come from reduced earnings estimates for 2008. We could see an auto company or a big bank announce insolvency. Fear, and then the fear of fear itself, and the fear of being the last one out the door will take over. Big, 300 or 400 point moves - mostly down - will become regular events. People have forgotten, but they are going to be reminded, that stocks have, until fairly recently in history, normally yielded about twice as much as bonds, simply because they're riskier.

  • Dollar down. While U.S. citizens are looking to build cash - another source of pressure on spending and investment - few foreigners now want U.S. dollars or dollar-denominated debt. After the failure of large U.S. institutions begins and the Fed turns the printing presses on full blast in an attempt to keep liquidity in the system, flight to safety will mean a flight from the dollar. How fast they will print is hard to guess. They've already started, but will probably panic as the economy slows, and then turn the presses to high. The dollar will fall in purchasing power. Interest rates will rise across the board, with low-quality paper hurt the worst.

If you are not yet receiving the International Speculator, now is a great time to sign up. With the 3-month risk-free guarantee, you can take a leisurely look at the publication to see if it's right for you. Check it out.

Show Me the Money!

This week we have, as you'd expect given gold's steep plunge, received some email wondering when the junior gold stocks we tend to favor in the International Speculator (among other investments that we feel are appropriate to the current environment) will pick themselves off the mat and get on with the business of making serious money.

This is, of course, a topic I have discussed at some length recently, so I won't go into the topic much again here (look back over the past couple of issues, using the archive link below).

But I will say, again, that I remain convinced that the next big move in the junior explorers is still ahead, and will come as the big gold stocks once again confirm the new reality that they are becoming cash machines. And they begin using their newly beefed-up balance sheets to acquire the deposits needed to replenish their depleting reserves. If you keep selling ounces without replacing them, in time, you are nothing but a shell... and so replacing reserves is a business dictate.

On that front, Barrick just announced that it will spend $10 billion to acquire new mines and resources over the next little while. You can read the story here:

And there's this. This week, PricewaterhouseCoopers released its Mining Deals 2007 Annual Review... which, among other prognostications reported on in an article on same by the folks at MineWeb, included these...

"2008 looks set to see mining deals reach very high record levels as super-consolidation takes place in the market."

Despite the credit crunch, the report finds "little evidence of a slowdown in [mining] deal activity."

"Underpinning these trends is the quest for world scale, resource acquisition and resource diversification," the analysts asserted.

The study noted that exploration costs are at all-time highs, permitting takes longer, and mining companies are facing skills' shortages. "These are significant barriers to meeting what is a major upturn in world demand."

(read the full MineWeb article on the topic by clicking here.)

This is all just the tip of the iceberg if you ask me, and it bodes very, very well for the juniors that are already sitting on a discovery. Yes, it is frustrating that some of our favorites have fallen with the broader markets lately... but this is a sector you need to be patient with.

On that topic, yesterday someone asked me if our subscribers were early adopters. And, after a moment's thought, I answered, "Yes. They are looking to get in early on a trend, and in investments that will provide far bigger returns than average."

Early adopters, however, have to possess both patience and a tolerance for risk. If not, then you may be invested in the right sector, but with the wrong temperament... a recipe for disaster. To wit, you won't have the emotional staying power to get you through the inevitable down swings and so you will invariably sell at exactly the wrong time, on a big setback. By contrast, an individual with the right temperament will continually look to buy under the market and, when that corner of their portfolio dedicated to the quality gold juniors is topped off, will look to continually upgrade at lower prices. Because they won't be chased out by the volatility, they'll still be there to collect the big profits as the endgame unfolds.

This is also why investing only with money you can afford to lose and still sleep well is so important. It assures you don't get over-emotional and greatly improves your odds of staying the course. And in the worst case that we are wrong and these stocks only head down to more or less a total wipeout, you might be discomforted, but you won't be put out of the house.

I guess what I am saying is that we have never made any bones about the volatile nature of these stocks. Please be clear on why you are buying them, and don't kid yourself into thinking they couldn't go down 50% even from here. They can. But we wouldn't be recommending them, or investing in them ourselves, if we didn't think this was a play that will blow the doors off almost any other investment you could be making just now.

Energy Chart of the Week

Public displays of hand wringing over America's dependence on foreign oil have become very popular, but little attention has been paid to how natural gas imports fit into the U.S. energy equation.

1206374157-energyChartoftheWeekforpdf
[click to enlarge]

Twenty years ago, the United States' natural gas production met nearly all domestic demand, but that is changing - and quickly.

The current situation is nowhere near as dire as America's predicament with oil supplies, of which 60% come from net imports. But the trend of imports making up a greater share of consumption is accelerating at a more rapid pace for "natty" than it is with crude oil. From 1985 to 2007, America's reliance on crude oil imports doubled, but its reliance on natural gas imports has nearly quadrupled.

Because the vast majority of natural gas imports come from Canada - normally considered a safe source of supply - little fuss has been made. If America has to buy more natural gas from its neighbor to the north, what's the big deal? They've been a steady supplier in the past, and it's not the sort of place where rebels run amuck blowing up pipelines, disrupting the supply chain (as has been the case in Mexico).

Under NAFTA's proportionality clause, Canada is bound to send 60% of its natural gas to the United States. The problem is that Canada's natural gas production is declining. Making a bad situation worse, the tar sands require huge amounts of natural gas to ramp up their heavy oil operations. Canadian winters aren't getting any warmer either, which - coupled with a growing population - has meant steady growth in Canada's natural gas consumption.

At recent debates, Hillary Clinton and Barack Obama have been arguing over who would be most qualified to tear up the NAFTA agreement. Lost in this storm of campaign rhetoric was Canada's response. "You might not want to renegotiate NAFTA if you knew how badly you need that oil and gas" was the message from Jim Flaherty, Canada's finance minister. The Canadian government would jump at any chance to wiggle out of NAFTA's proportionality clause, and a Democratic president might give them the opportunity.

The good news is that natural gas imports no longer arrive solely via the pipeline; they also arrive by ship through the emerging global market in liquefied natural gas (LNG). So the United States is not restricted to Canada when looking for natural gas supply, as it was even just twenty years ago. The bad news is that many of the biggest suppliers of LNG are located in the Middle East and Russia - precisely the regions that America wants to become less reliant on for its future energy needs.

[Ed. Note: Over coffee early this morning, I re-read the latest edition of the Casey Energy Speculator. In addition to a number of other excellent articles, it included a fascinating article on "run of river" energy projects, a "green" energy technology that has tremendous upside. It produces power from rivers, without damming them, and with relatively minor disturbance to the environment. The article includes two recommendations, one low risk, one high risk. If you are not yet a subscriber, learn more about giving it a trial run. ]

China Still Is Selling Us More and More

Bud Conrad took a break from his preparations for our sold-out Scottsdale Summit to send over the following chart he thought you would find of interest.

1206374158-IMPORTChina
[click to enlarge]

There are a couple of take-aways from that chart, but the one that pops out at me is that it is a picture of American manufacturing being shipped overseas. As a result, while there is no question that a weakening dollar will help American manufacturers, the fact that their ranks have been reduced to such a degree, will likely mute the benefits.

Real Estate, Real Trouble

I ran into the mother of a close friend and a former partner at the store the other day. I don't think I would be exaggerating if I said she was the powerhouse real estate broker here in the resort town that is the headquarters of Casey Research. She is the quintessential über-agent, "can do," "get it done" and "never say die" kind of individual. Always an upbeat word about the local market and tough as nails, when needs to be, to get the sale. Yet, in our check-out conversation she made no bones about the fact that her views on the local real estate market are far less positive these days. In fact, her words were along the lines of, "I don't think that house prices are going to come back for another decade."

In a discussion on the topic of real estate with my mother, who holds down the family fort on the Big Island of Hawaii, she related a tale that I had heard before, but thought relevant to the current market, and so asked her to write down the facts of the case. Here they are:

"Grandpa bought a large house in August of 1929. The address was 10 Sutherland Road, Montclair, N.J. The price was about $45,000. He finally sold it for slightly less in 1945 after trying for years. I have an excellent photo of the house but can't send it until later today when (and if) I manage to reinstall another all-in-one with scanner. Love, Mom"

Could real estate really go down and stay down for 20 years? As hard as it seems to imagine, the answer is yes. This is a topic I'll have more on next week, when I share an interview with one of your fellow subscribers who is a professional real estate appraiser of many years and great experience from Northern California.

And That, Dear Readers, Is It for this Week...

I'm off tomorrow to our Scottsdale Summit. Next week's edition, written on the fly (literally) will likely be a bit reduced. The U.S. stock market is closed for Easter, but I can't even begin to imagine what thrills and chills it has for us next week.

We live in interesting times, indeed.

As always, thank you for taking time to read these hastily assembled thoughts... and, of course, for subscribing.

Warm regards,

sig

David Galland
Managing Director
Casey Research, LLC.





Posted 03-24-2008 2:52 PM by David Galland

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