The Room 4/14/08

Written: April 11, 2008

Dear Readers,

No question about it, we humans like to keep things simple. And no wonder; if the world is anything, it is chaotic.

And so we look for our philosophy in un-taxing nuggets, the sort, perhaps, that might grace the back of a cereal box, be squeezed onto a bumper sticker or unfold fully contained in a 5-second sound byte on the evening news.

"Ask not what your country can do for you, but what you can do for your country" pops to mind.

As does, "You are either with us, or against us."

But few hold a candle to, "From each according to his abilities, to each according to his needs."

Thus wrote Karl Marx, by reliable accounts a penniless, unpopular, slovenly loser throughout the entirety of his miserable existence. Yet, avoiding any deep contemplation, the masses gravitated to his slogan, resulting in hundreds of millions of deaths and untold misery that carries forward even to this day.

This willingness, nay, rush, to unthinkingly embrace the simplistic is very possibly coded into our DNA. And for good reason.

After all, if our club-bearing ancestors had paused to inquire more closely into the root reason that the rest of their hunting group was running screaming from the large growling sound emanating from a nearby bush, then we wouldn't be having this chat today. Instead, they took the cue and dedicated themselves to outrunning their companions (a race that our very presence here today attests they won).

Millennia of similar experience, and the need to efficiently sort through the daily onslaught of input our poor minds receive, has resulted in a tendency by humans to think in one of two ways, depending on our individual temperaments and the need at hand.

The first form of thinking is cue-based, or heuristic. The second is termed "systematic." To understand the difference, consider the process you might go through when looking for a new computer. You could do all the hard research yourself; that would be thinking systematically... or you could simply pick up the current edition of some suitable buyer's guide and flip straight to the "Best of 2008" award and you are done.

While we all think in both modes, most tend to shift between the two, some more frequently than others. And because it is more difficult, most of us look to reduce the amount of systematic thinking we are required to do by delegating that responsibility to those who are good at that sort of thing. For example, we might pay an accountant to do our taxes. Likewise, if you are collared for some real or imaginary offense, you could immerse yourself in all the various case laws that apply to your situation, or you could pick up the phone to call a lawyer.

In my view, it is essential in this modern age to keep this aspect of our human nature in clear perspective as you listen to all the electioneering, posturing and pontificating that now competes for your daily attention.

Or, put another way, when confronted with convenient explanations or fine-sounding platitudes, make a concentrated effort to shift into systematic thinking mode.

While I could point to literally hundreds of jingoistic but empty ideas floating through the ether just now, our globe-trotting chairman Doug Casey has just written in from Argentina with a good example , one that has specific relevance to us as investors. Namely that today's inflation is being caused by rising commodity prices.

Rising Commodity Prices and Inflation

By Doug Casey

Many people blame inflation on higher prices of gasoline, wheat, copper, or what have you. This is an old, idiotic, and tragic economic fallacy.

It's idiotic because it confuses the consequences of currency inflation with its cause. And tragic because it blames inflation on those who produce real wealth, as opposed to the government, which is the actual cause.

In today's world, governments, through the central banks, control the amount of money in existence. If they double the money supply, the general price level would double. Of course not everything rises at the same rate. Since inflation initially makes people feel richer, perhaps the prices of Ferraris would go up a lot - but the prices of old Chevys would drop - who wants old cars when loans are out there for a new one?

If the money supply is stable, and one commodity goes up a lot, the price of others must drop - the general price level, in terms of dollars, stays the same.

Inflation causes people to save less. That means there's less capital to invest for new production, even while it encourages more consumption now (to beat anticipated higher prices). This is the main reason inflation causes the standard of living to drop - in addition to causing the business cycle.

Bad Speculators

David again, though continuing on the same theme. This morning I heard an interview between a National Public Radio host and Robert Zoellick, head of the World Bank, about that august body's recently released report on rising food prices and the social unrest now beginning to break out as a result.

I have to say, while I tend to be very skeptical of supra- organizations such as the World Bank, Zoellick impressed me as a reasonable man when he failed to rise to the bait of the interviewer who must have asked the same question 5 times, along the lines of "How much are speculators having to do with the food price run up?"

It was only after much more of the same that the conversation turned to the actual biggest culprit identified in the World Bank survey; the shift toward redirecting food crops, and the land used to grow same, to the production of biofuels. A misallocation that would not have been made without government mandates and massive subsidies.

I recently read a pretty good book on the history of the U.S. dust bowl that has become iconic, along with soup lines, of the Great Depression of the 1930s. The book, titled The Worst Hard Time, was quite revealing... for example, of the stubborn optimism of certain people who -- despite year after year of failed crops and dusters that would cover the floors of their shacks in a foot of fine dust, kill the cattle and even close family members -- refused to move away, figuring it couldn't last forever.

If, in fact, they had done a systematic evaluation of the climate of the dissected areas where they had been encouraged with free land by the government to set up their farms in order to meet global food demands triggered by World War I,they would have found that drought in the Texas panhandle is the norm, not the exception.

In the latter years of the disaster, the Roosevelt administration commissioned an extensive study to reveal what had gone wrong. According to the author, Roosevelt and his merry men expected to find it was caused by climate change coupled with excessive speculation. What the study's leader eventually reported, however, was far less pleasing: it was the government's own well-intentioned but poorly considered machinations that were behind the dust bowl. That's because without the subsidies, the mass migration to an area that was climatologically ill suited to agriculture would never have happened.

Not one to suffer second guessing, Roosevelt pretty much disregarded the study. In fact, he went further and, disregarding the whole "climatologically ill suited to agriculture" part, attempted to solve the problem by ordering the planting of millions of trees... virtually all of which quickly died.

But back to the present. As food prices rise, along with virtually everything else, the sloganeering and rhetoric are going to reach a shrill pitch. The government will begin to point the finger at anyone and anything other than the real causes, starting no doubt with "speculators," who will be portrayed in the same light as war profiteers.

The practical implications of this -- other than stirring up the class warfare so fondly anticipated by Marx as he sat in his grubby chair scrawling a screed against the capitalists -- will be to unleash any number of government "solutions" that will sound high minded, but lead to low results. Price controls... interference in the free flow of foreign capital... trade sanctions... changes in margin requirements for commodities accounts... higher capital gains taxes. It's all coming.

At our recent Scottsdale Summit, one of the more memorable thoughts was shared by Dan Mitchell of the Cato Institute when he pointed out that the government was increasingly using higher taxes on tobacco to raise the costs and therefore curb the habitual use of the noxious weed. "And, you know what, the government got it right. Higher taxes do reduce consumption," Mitchell commented, adding, "So why is it the politicians don't understand that the same principles also apply to commerce and investment markets?"

A good question, but one that most people won't ask themselves as they applaud President Obama's proposed near-doubling of the capital gains tax from 15% to 28%.

Take cover.

Guess Who Will Soon Own 1,000,000 Homes? You Will!

A couple of weeks ago, I mentioned the view of real estate pro Andy Miller that, absent government intervention, the real estate meltdown would be incredibly painful, but relatively short lived. But if the government rolled up its sleeves and set about "fixing" things, the pain could stretch out 10 or even 20 years.

At this point, the odds greatly favor the latter.

In fact, we seem to be in a race to the bottom for the candidates, egged on by the professional posturers that hold forth in Washington.

Case in point, House Finance Committee Chairperson Barney Franks, maybe the least financially savvy human being I have ever heard discourse on the topic of finance, has teamed up with Senator Christopher Dodd to propose the nation set up a special $400 billion taxpayer-funded pool for the sole and specific purpose of buying non-performing loans from troubled lenders.

When confronted by such largess in the past, I have been known to make indelicate remarks. A plan of this degree of sheer disregard for anything remotely resembling the free enterprise system leaves me nearly speechless. $400,000,000,000 is a lot of money, no matter what anyone tells you.

And the democrats are not alone. Even John McCain, bending to the anticipated wishes of the voters this next November, has just done a brisk about-face and announced his own bailout plan. A plan that but for some modest window dressing, is almost identical to that which has been proposed by Mssrs. Barney and Dodd. To quote Bloomberg,

The (McCain) plan would retire old loans that homeowners no longer can pay and replace them with less expensive, 30-year, fixed-rate mortgages that are federally guaranteed. McCain said families would gain "the opportunity to trade a burdensome mortgage for a manageable loan that reflects the market value of their home."

Karl Marx would be proud.

But am I being too harsh in condemning government action? After all, when we are talking about collapsing housing prices, we are talking about real hardship being felt by real people... with lots more to come.

It's a good question, even though I asked it myself. But the answer is relatively straightforward, albeit in the form of another question.

"Which economic system has history proven to provide the maximum reward to the maximum number of people over a sustained period of time?"

I think the answer is clear. So, faced with an economic distortion encouraged by decades of government meddling, do we step further away from free-market capitalism and toward yet more meddling? Or, do we accept that there is a price to be paid and the longer the bill remains unpaid, the steeper it inevitably will be?

Humankind is remarkably adaptable and, when pushed to it, resilient. If the government could resist doing anything at this point, lenders would fail, house prices would return to a market clearing level, people in the housing trades would find other employment... but the world would not come to an end.

That said, I can't see any way that the government is going to be able to resist organizing a big bailout... so all I can do is the next best thing: position my portfolio to profit by betting on the inflation that such a bailout makes inevitable.

The Ascent of Humanity

My friend and favorite partner of all times, Doug Casey, is well known to be a pessimist in the short term, but is, I can assure you, equally so a raving optimist in the longer term. Viewing the world through his longer lens, he sent me an interesting, albeit brief, essay from John Robb this week.

It is an update of sort on humankind's progress in trying to create artificial intelligence. Robb's thesis has it that we are very, very close – a few years at most – from being able to reliably duplicate the intelligence of an insect. Within a decade, he expects we will have reproduced the intelligence of a mammal. Say, a rat. And by the end of the next decade, we will have succeeded in duplicating the intellect of a human being.

Each of these milestones, according to Robb, will change the face of the world as we know it. You can read his full essay by following this link here: http://www.blogdimension.com/en/cache?s=36282661-of-rats-and-superempowerment

In making his case, Robb links to a video of the Big Dog robot, which is quite amazing. You can skip straight to the You Tube clip by clicking here. www.youtube.com/watch?v=W1czBcnX1Ww

And this is just one of many areas where humans are making rapid progress toward a more promising future. For instance, if you credit the reports out of the Swiss firm, CERN, they have figured out how to make the Internet 10,000 times faster.

Given that I am already able to use the current version of the Internet to view a wide selection of movies from Netflix, near instantly, it's hard for me to fathom the possibilities inherent in an exponentially faster Internet.

The new system will be available to universities this summer and, I have to believe, will roll out pronto thereafter.

Is there an investment angle in this stunning new development?

While a topic for greater exposition than time allows now, there are two companies (in addition to CERN) that are standing squarely in the path of this breakthrough, and both are related to fiber optics, which is a prerequisite for delivering information at this speed. The first is JDS Uniphase (JDSU), the leader, by a wide margin, in the manufacturing of fiber optics switching equipment. The second, my friend Porter Stansberry told me last week on Jekyll Island, is Verizon (VZ), which has been spending the majority of its revenues in recent years building out the most extensive fiber optics system in the United States. The build-out will soon be done, allowing the company to redirect the billions they have been spending on infrastructure back to the bottom line. And, more importantly, to sally forward as a primary beneficiary of the new and vastly improved Internet.

Watch Out Below

As predicted by our own Bud Conrad, bond insurer MBIA, Inc. was downgraded this week by Fitch Ratings to AA from AAA.

The knock-on effect of this has yet to be felt, but the way these things work is that any of the AAA bonds insured by MBIA will now have to be similarly downgraded, because no bond can have a higher rating than the company that insures it. Holders of these bonds now have to revalue them in their portfolios, especially if, as expected, the other rating agencies follow suit.

For a quick snapshot of the sort of turmoil this could unleash, here is an excerpt from the January 2008 edition of the International Speculator.

Credit Insurance. The smaller corporate and municipal borrowers (which together represent a large segment of the bond market) depend on credit insurance. Now the credit insurers are in trouble. S&P cut the credit rating of ACA Capital Holdings by 12 levels, to CCC (junk), after the company posted a $1.04 billion third-quarter loss in November. ACA has $1.1 billion to cover potential losses on $7.1 billion of bonds it insured. It turned itself over to the regulators for protection in late December. The credit rating companies are now reviewing MBIA Inc., Ambac Financial Group Inc. and other bond insurers because of concern they don't have enough money to cover losses on accelerating downgrades of the debt they guarantee. Weakness in these companies would endanger the value of $2.4 trillion of securities they've insured.

It goes on and on. Certain money market funds have been hurt by the commercial paper meltdown. More may follow. Because of their bond investments, some insurance companies are in the crosshairs as well. Stay tuned...

China's Olympic Torchture

In the March 14, 2008 edition of this weekly feature, I touched on the decision by the Chinese to hoist the Olympic torch to the top of Tibet (Mount Everest, to be more specific) as possibly being one of those accidents of history with serious repercussions.

But I didn't foresee how fast and how far things could have gone off the tracks. In the lead-up to previous Olympics, being selected to run with the torch was a high honor. The sort to be photographed for your personal posterity and dropped in passing into every cocktail conversation you might be drawn into. This time around, however, carrying the torch is akin to being selected by Native Americans of antiquity for the dubious honor of running the gauntlet. You might survive, but it's no sure thing. And it is certainly nothing you'll be bragging about to anyone in particular, lest you be accused of being a keen supporter of oppression.

Even if the Chinese, who have assigned a cadre of toughs to protect the flame, go one step further and borrow the Popemobile to finish delivering the torch to Beijing, the public relations damage they are suffering is akin to the death of a thousand cuts, with each step along the route bringing another cut. (For those of you with strong stomachs and curious about the origins of that term, I provide this link... http://en.wikipedia.org/wiki/Slow_slicing)

While we can't yet know how the Chinese will react to their global humiliation, if you look at the language used by China's foreign ministry in objecting to a U.S. resolution calling for China to stop beating up the Tibetans, you can get a sense of the emotions involved...

Foreign Ministry spokeswoman Jiang Yu labeled the resolution passed Wednesday by the House of Representatives anti-Chinese, saying it "twisted Tibet's history and modern reality... seriously hurting the feelings of the Chinese people."

(I suspect that whoever it was that conceived the idea of taking the torch to Tibet has already received some indication of the leadership's displeasure.

I can imagine a short conversation along the lines of, "Mr. Han, please come in. We would like to talk to you about that idea you had about taking the Olympic torch to the top of Mt. Everest. No need to sit down; in fact, if you'd be so kind to just stand up against that wall over there... yes, that should be fine.")

Given the clout that the Chinese currently have in the global economy, and given the fact that they are actively competing for all manner of natural resources with many of those nations whose spokespersons are now lining up to condemn them over their human rights record, this is definitely a geopolitical situation to keep an eye on.

On that latter point, this week the news came out that China is looking to buy 9% of BHP Billiton, the world's largest mining company... a move that follows their purchase of 9.3% of Rio Tinto in February for $14 billion. And last week it was revealed that they had dropped $2.8 billion to buy a stake in Total, the French oil producer.

This week the market was moved by news that the Chinese are on the hunt to acquire Canadian uranium companies. Referring to its quest for uranium companies, according to Bloomberg...

State-owned China National Nuclear is considering options including takeovers and supply agreements that range in value from "several hundred million dollars to more than a billion," Cui Jianchun, general manager of subsidiary CNNC Finance Co., said in an interview yesterday in Toronto.

Call it what you will, but I think you can safely call it a War for the World's Resources, with U.S. dollars being used as ammunition.

It is too early to discern what will be the ultimate consequences of China's Olympic-sized embarrassment – which will continue through the event's closing ceremonies on August 24 – but they could be serious.

[Ed. Note: In my reading this week, I came across a pretty good essay on this topic on the BBC web site. You can read it here... http://news.bbc.co.uk/2/hi/americas/7339764.stm]

And There's This...

While we are on the topic of China, I thought I would share an email from one of our many fine subscribers. He penned the following in response to my previous skeptical musings on what I see as the myth of Chinese invincibility....

Dear David,

I have been a Casey subscriber for a number of years now and find that one of the highlights of my week is 'The Room.' Your easy style is always a pleasure and it never detracts from the clarity of the underlying message; however, when discussing China - its massive (and growing) economic influence and the ability, or otherwise, of its ruling elite to "manage" the immense changes taking place - I find it odd that no mention is ever made of the demographic time bomb inherent in the One Child diktat.

My wife and I traveled through China in the mid-1990's and wherever one went, you would see groups of parents and grandparents fawning over a single child. Fast forward to today and consider the consequences. Those children have no uncles, aunts or cousins. A typical family would now comprise - in it's entirety - one grandchild, two parents and four grandparents! Also consider the fact that traditionally, boy children are preferred to girls. The result is a significant gender imbalance eventuating in a preponderance of males.

In a society where security in old age has always depended on the support of an extended family, an intolerable burden is now placed on a single grandchild and that grandchild, if it is a male, is also going to have a tough job finding a wife! As this imbalance works its way through the Chinese population, we can expect severe, and unpleasant, consequences.

Yours sincerely,
R.H.

Not a new story, but one that has yet to really play out. Food for thought, to be sure.

Miscellany

Lunch Money. Follow the link here to read another reason for keeping some of your money in gold. I love the bank's response, which is pretty much, "Sorry about that." http://news.bbc.co.uk/2/hi/south_asia/7334033.stm

Out of Silver? There has been a lot of discussion in the blogosphere about the lack of silver coins at dealers. We did some research on the topic and the situation appears to be nothing more than a miscalculation by the mints leading to a temporary shortage in the circular blanks required to make coins. Proof of that point comes from one close acquaintance of ours who placed an order for $1M in silver the week before last and had the bars promptly delivered.

A Solution for Global Warming! I had a good chuckle this week when reading a story by Bloomberg on a study issued by the Proceedings of the National Academy of Sciences about the possible consequences to the environment by a nuclear war involving "100 Hiroshima-size bombs." The story relates how, should such a conflagration occur, it would cause damage to the ozone layer, resulting in an increase in skin cancer, eye damage and similar illnesses caused by more extreme exposure to sunlight. But nowhere in the story was there a single mention of the straight-up death and destruction caused to people by "100 Hiroshima-size bombs" going off, or the ill effects of the clouds of radiation that would soon blot out the sun. They did mention, however, that one possible outcome was that global land temperatures would drop. So, there's that to look forward to.

* Errata. Last week, while writing in the fog of early morning, I misplaced a decimal point when discussing the percentage of GDP represented by Mexican oil exports... which, based on the Export Land Model, should cease in, or before, 2014. While the error was fixed on Monday morning -- to more accurately reflect the total at about 6.5% of GDP versus the errant 65% -- if you viewed this missive over the weekend, you might have seen the erroneous number and so have sallied forth with poor information, for which I apologize. While not nearly so significant, the lower number is still very significant.

That's It for This Week

As I prepare to sign off for this week, it came across the screen that consumer confidence in the U.S. has now fallen to a 26-year low. One of the drivers of this pessimism, according to the report, was the price of gas... a commodity that indeed hits consumers straight in the pocket. Earlier this week, I read a report by the International Energy Agency that they expect oil to remain above $100 per bbl for the rest of the year.

This is one of those stubborn economic inputs that the U.S. government, despite all its real power, is helpless to affect. That's because the U.S. imports over 65% of its oil. We can't, therefore, force producers to sell it cheaper to us... because the Chinese, among others, will simply step in and pay the market price. Confronted with consumer backlash, the only real action I can see that is left to the U.S. government, should it wish to be seen as "doing something," is to subsidize prices. In other words, reach into the public coffers to pick up some of the tab. But that, of course, simply adds fuel of a different sort to the inflationary fires. There is no positive way to view this situation, especially for those who have a long commute, or for businesses – airlines for example – that are so solidly impacted by persistently high fuel prices. On that last point, you might want to check your portfolio for exposure to any companies where fuel looms large in their P&Ls.

As always, thank you for reading, and for subscribing to a Casey Research publication. (If you had this edition passed on to you, and you would like to subscribe... visit us at www.CaseyResearch.com).

Sincerely,

sig

David Galland
Managing Director
Casey Research, LLC.





Posted 04-14-2008 2:05 PM by David Galland