Strategic Investment

Dear Reader:

You will see at the top of this month’s issue of Crisis Strategy Alert that it says Strategic Investment.

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Will Bonner

Publisher,

Crisis Strategy Alert and Strategic Investment

Back to the Future:
Strategic Investment 25 Years On

Pressure is building for major upheavals in world trade and finance – of the sort that followed, with a lag, the collapse of British supremacy early in this century. Nothing short of a revolution in military technology or the greatest upsurge of manufacturing productivity ever witnessed in America can change it.

– Blood in the Streets,1987

A quarter of a century ago, Lord William Rees-Mogg and I launched Strategic Investment. It was as an experiment in what John Stuart Mill termed “sophisticating heresy.” The heresy in question was our thesis that the Berlin Wall would soon fall and that the Soviet Union was on its last legs.

The goal of Strategic Investment was to identify the crucial geopolitical issues facing investors. And in doing so we drew heavily on contacts in the intelligence community. We even enlisted two former heads of the CIA as we chronicled the collapse of Communism in our monthly “intelligence bulletins.”

All of this seems obvious in retrospect. But Strategic Investment was ahead of the curve to a degree that is hard to credit now. For instance, when Strategic Investment published a forecast that Mikhail Gorbechev would preside over sweeping changes in the Soviet Union we were singled out and ridiculed by militant Cold Warriors on the “Today Show.”

Lord Rees-Mogg and I sought to publish a book-length summary of our argument under the title The Twilight of Communism. But every publisher we approached rejected the book as self-evidently preposterous.

Later, when Simon & Schuster gave us a contract to publish a broader compilation of our ideas under the title Blood in the Streets, a friendly editor allowed us to include “The Twilight of Communism” as a chapter. Even so, it is hard now to imagine how absurd our viewpoint was considered then.

A reviewer in Newsweek described Blood in the Streets as “an unthinking attack on reason.” Interestingly, considering today’s economic conditions, two features of our analysis that Newsweek found particularly ridiculous were our views on the death of Communism and our suggestion that another 1929-style stock market crash was possible.

What was once ludicrous has become respectable wisdom through the passage of years. This November will mark the twentieth anniversary of the fall of the Berlin Wall. And we are approaching the eighteenth anniversary of the collapse of the Soviet Union.

On Christmas Day, 1991, Mikhail Gorbachev resigned as president of the Soviet Union, declaring the office extinct. The Supreme Soviet then met for the final time to recognize the bankruptcy and collapse of the Soviet Union and to dissolve itself.

This dramatic and mostly peaceful revolution was punctuated when the hammer and sickle banner was pulled down from the Kremlin and replaced by the imperial flag – the white, blue and red standard designed by Peter the Great and used in Russia before the Bolshevik Revolution.

The Next Stage of the Revolution

Accidents of history and geography gave America disproportionate power, and to all appearances, the prospect for using it to police world economic institutions for the indefinite future. However, destiny’s accidents have a way of evening out… Economies, even in the United States and Europe, have begun falling into their foundations, like old houses with rotten beams. They have not yet collapsed. But here and there, flooring planks have given way. And whole structures are getting creaky…

– Blood in the Streets

Strategic Investment is now back to explore that other important facet of the “unthinking attack on reason” we first sketched out a quarter of a century ago.

The next stage of the revolution we anticipated involves a subject even more unthinkable and controversial than the collapse of the Soviet Union and the end of the Cold War.

The next stage of collapse involves the end of American economic predominance. Indeed, as we pointed out all those years ago in Blood in the Streets, the end of the road for American prosperity is at hand.

Although it is still heresy to say so, the current economic collapse is an effect of the end of “the American way of life” – that is to say the collapse of the post-World War II growth model, the end of the American seigniorage and the demise of the dollar.

For decades the U.S. economy has atrophied while we lived lazily off of unearned advantages of seigniorage (the ability to print legal tender) like the children of some Gulf sheik whose easy chair floats long on gushers of oil.

It is exactly this phenomenon of lazy entitlement that often makes easy riches a curse rather than a blessing – especially when those riches are lavished on undeveloped economies.

I still vividly remember a conversation I had one afternoon in the 1990s with Lee Kuan Yew, the first prime minister of modern Singapore. He told me in no uncertain terms that he attributed much of Singapore’s prosperity to the fact that it had been blessed by a gracious god who had put oil under Indonesia, not Singapore.

Of course, oil provides significant benefits, including cash-flow. But oil-rich countries are vulnerable to dips in the price of oil. And when the oil wealth cascades down on a nation that fails to invest in developing competitive economic skills, the result is economic stagnation and political dysfunction.

This introduces the problem your membership of Strategic Investment will help you overcome: the economic eclipse of the United States.

The ‘advantage’ America has long enjoyed due to its power of seigniorage has finally caught up with the economy after decades of slow-motion decline.

A Paper Empire

You see, the U.S. has used and abused the freedom to borrow and print dollars, because of the absence of the usual penalties that have stopped other economies when politicians have ran amok with the printing presses. The long run of the U.S. dollar as the world’s reserve currency (and thus currency of account in international trade) has allowed Americans and other dollars holders to enjoy a purchasing power premium.

To put it in the simplest possible terms, seigniorage enabled us to enjoy a higher living standard than we earned.

This is reflected in the chronic and massive trade deficits through which the U.S. has traded manufactured goods from the rest of the world for manufactured paper money.

In retrospect, it is clear why the U.S. as a nation was lured in the direction we took. Manufacturing money is, in the short-term at least, a more profitable proposition than manufacturing goods. This is why the “best and the brightest” minds in the U.S. left manufacturing to enter the financial sector and why, until recently, finance accounted for 75% of all U.S. corporate profits.

Superficially, it would seem that if other nations send America all the goodies you can find in a Wal-Mart store for a few pieces of script that we can print for a minimal cost, we have far the better of the bargain.

But have we really?

Only if you ignore Lew Kwan Yew’s warnings about the inherently corrosive nature of easy money. And no money is easier than that you make by rolling the printing presses.

One of the underlying symptoms of the hollowing out of the U.S. economy is that the financial sector soon ran out of solid businesses to monetize. The business deficit was first filled by the monetization of dot-com business plans scribbled on the backs of napkins in the 1990s. That seemed to work for a while. And a few solid businesses, such as Amazon.com, thrived as a result.

But when the dot-com bubble burst the financial sector, aided and abetted by politicians, set out to make everyone rich again by monetizing housing.

By the end of 2003, when the Fed pushed interest rates down to 1%, total outstanding mortgage debt in the U.S. accounted for 69% of GDP – fully 50% higher than in Europe. Mortgage refinance accounted for 25% of U.S. GDP in 2003.

That is the clearest statistical evidence you could ask for of Americans living beyond their means. And as the world now knows, that was a prelude to collapse.

Like Wile E. Coyote standing on thin air in a Looney Tune cartoon, the U.S. had long passed the point when it offered the rest of the world full value for the premium extracted through seigniorage. We started strolling off a cliff many years ago; only now are we falling.

As GM Goes, So Goes the Nation

The end of the Cold War two decades ago vitiated much of the benefit many countries previously enjoyed from the deployment of U.S. military power.

Of course, some countries are more dependent on the U.S. militarily than most. Japan still looks to us as a shield against China and North Korea. And the oil sheiks still want protection from Iran. So they may be suckers for our paper until some better arrangement can be struck.

That said, the credit collapse and the pressure it puts on the U.S. dollar signals the winding down of the American empire abroad.

Think about it. Most of the British Empire was liquidated within a couple of decades of the close of World War II, which left Britain too broke to project power globally. And you can expect the U.S. economy to fade in much the way that Britain’s did after World War II.

The recent congressional vote to cancel the expensive and problem-plagued F-22 program stealth fighter program is emblematic of the coming change. The first stage will involve a cancellation of expensive weapons systems. The next stage will involve the withdrawal and demobilization of troops. There are 476,000 U.S. military personnel stationed abroad under President Obama. Before long, they will be coming home.

Most of the reason the rest of the world once had for accepting our fiat money has faded away as the U.S. economy lost its competitive edge. That is not to say that all aspects of the U.S. economy are equally moribund. But General Motors and Chrysler are emblematic of exactly what’s been happening to the U.S. economy over my working lifetime.

The End of the Road?

California, America’s bellwether state, has gone hopelessly broke. It will not recover to pre-crash levels of prosperity for many years. The California of the Beach Boys is long gone. Even the California of 2007, where 144,000 taxpayers shelled out 25% of the state tax receipts of $111.8 billion is long gone. And many of the heroic few who have paid such a disproportionate share of the cost of government in California have certainly packed their bags and braved one of the state’s many freeways to sneak away.

The U.S., just like California, is built around the spine of an aging post-war infrastructure that was largely designed during the Eisenhower administration with 29-cent-a-gallon gasoline in mind.

Take the time to think about it and you’ll see that many of the equations of value upon which California’s and America’s post-war prosperity were based have gone haywire.

The Obama administration, more about rhetorical flash than coherence, has undertaken to make the sunk costs of the U.S. infrastructure system even more of an albatross in the future.

For instance, by raising the cost of energy through a cap-and-trade carbon tax, Obama is making investment in the auto industry more problematic. As the new president busily undermines the conditions conducive to auto sales, he also undertakes to run auto companies and re-build highways and bridges. This will be the American version of Japan’s “bridges to nowhere.”

As the depression deepens, it will become ever more obvious that prospects for economic growth and investment profits have migrated to other parts of the world. In this respect, I feel I have learned a lot I did not know a quarter of a century ago.

Back then, Lord Rees-Moog and I were proven right about a lot of unconventional insights. And we developed a new logical construct for interpreting revolutionary change in the world economy, which we called the theory of megapolitics. I believe this theory still has much value as the world economic paradigm undergoes a wrenching change.

We also have devoted a lot of time to reading “the classics” of economic and national decline. These include obscure works such as William Playfair’s An Inquiry into the Permanent Causes of the Decline and Fall of Powerful and Wealthy Nations (1805), a book that is brimming with insights into our current situation.

Follow the Money to China and Brazil

We also draw on years of patient and sometimes boring research into the progress of past depressions. Certain regular features of these episodes provide uncanny guidance about what is unfolding today.

Having said that, I was myopic a quarter of a century ago in thinking about which countries were candidates to succeed the U.S. as the main venue of opportunity in the world. When I re-read Blood in the Streets today, among the few parts that make me wince are those that argue that Japan might emerge as the next world economic superpower.

As you know, Japan endured a devastating crash in 1989 that pricked its asset bubble (which we identified before the event in Strategic Investment, making a handsome profit for readers.) This turned out to be the beginning of Japan’s “Lost Decade” – a phrase that must make Japanese mathematicians wince; it has actually lasted two decades.

Far from emerging as the world’s leading economic superpower, Japan became something of an economic basket case. Our mistake those many years ago was to underestimate the dynamic potential for economic growth that was released when previously backward countries were at last able to institute a framework for market development. In just a quarter of a century, countries that were almost completely “beneath the radar” have emerged as the strongest and most dynamic areas for investment.

Although the “green shoots” nostalgia for growth celebrates the 7.7% rally of the S&P 500 this year and Japan’s Nikkei 225 has struggled to tack on 7.5% gains, the real money is being made in the two dynamic BRIC economies: China and Brazil.

According to data compiled by Bloomberg, China’s Shanghai Composite Index has soared 85% in dollars and Brazil’s Bovespa Index has risen 76%.

In other words, you would have made ten times more money so far this year by index investing in China or Brazil than by buying the U.S. market.

It is also a sign of things to come that the world’s two biggest initial public offerings this year are were not launched on Wall Street or Tokyo but in Shanghai and Sao Paulo.

China State Construction Engineering Corp., the largest housing contractor in China, raised 16 billion yuan ($7.3 billion) in the largest IPO in 16 months. It was oversubscribed by 36 times. Prior to this, the world’s biggest IPO this year was Brazil’s Cia. Brasileira de Meios de Pagamentos – also known as VisaNet – which raised 8.4 billion reais ($4.4 billion) in its Sao Paulo offering last month.

As reported in the Wall Street Journal, “The São Paulo company represents a bet on the rise of the Brazilian consumer, thriving amid economic stability and years of export-driven growth. Brazilian banks emerged from the financial crisis intact because they largely shunned the risky investments at the center of the global crisis.”

To a degree that will shock most Americans, the fixed idea that America is the place to benefit most from innovation and economic growth will be tested and disproven in the “lost decades” to come.

A Wealth of Contacts

We’re prepared to help you profit from the dynamic growth of the BRIC economies, especially Brazil, in which we have excellent contacts and highly-placed sources for economic intelligence. To this point, we have already racked up some handsome profits in several Brazilian stocks, including Petrobras Brasileiro (NYSE:PBR), Banco Itau (NasdaqGS:ITUB) and our Brazilian Government Bonds (CUSIP:105756BJ8).

But our 40% gains in Petrobras will pale in comparison to the gains we have already accrued, and expect to continue to compound in our “Trade of the Decade” – our creative short of the United States number one export, the U.S. dollar (and by extension) U.S. Treasuries.

We went short the dollar in a conservative way by buying Brazilian government bonds, priced to yield 12.9% to maturity. Meanwhile, the real has rallied all the way from 2.3275 to 1.89 – raising our yield in dollar terms by 19% to 15.35%, as compared to 3.31% for U.S. Treasuries of a similar maturity. Effectively, this means we’re being paid more than 460% higher interest rates to position ourselves for the inevitable fall of the dollar.

When I was a child Americans enjoyed a national inheritance, a lucky accumulation of historic advantages that made the U.S. the richest large country on the planet. These advantages have gradually and not so gradually been frittered away during my adult life.

Today, the greater part of the U.S. population and certainly many investors chasing the “green shoots” are in denial. They pretend the current disturbance is just another recession that will soon end and that everything will then go back to being as it was before Lehman Brothers went bankrupt.

I don’t think so. We are actually in the early stages of a global depression. News that the British economy contracted in the second quarter at a rate of 5.65% – the steepest contraction in the GDP series since it began in 1955 – underscores that this is a depression, not a normal inventory correction.

The bigger question is not whether this is a depression but whether it will ultimately prove to be a deflationary collapse or an inflationary depression.

These are the issues we intend to address with you going forward.

James Davidson

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Answering “The $64,000 Question.”

“Disturbances in these two factors – debt and purchasing power of the monetary unit – will set up serious disturbances in all, or nearly all, other economic variables. On the other hand, if debt and deflation are absent, other disturbances are powerless to bring on crises comparable in severity to those of 1837, 1873, or 1929–33.”

– Irving Fisher,

Debt-Deflation Theory of Great Depressions (1933)

This month’s “$64,000 Question” is whether the recession is ending or the Greater Depression is just beginning?

In my innocent youth we used to think of any overarching puzzle as the “64,000 Question.” That I still think in those terms bears witness to the power of mass media and the depreciation of the dollar.

As you may remember, “The $64,000 Question” was a popular TV game show that aired on CBS from 1955 through 1958.

Back in those days, when I was running rampant in my Keds and probably spending too much time watching TV, $64,000 seemed like a lot of money.

By the standard of today’s fiat script it was. Silver dollars still circulated then, and I instinctively favored them over folding money to hoard in my “piggy bank.”

Of course, silver dollars were already on the way out; none had been minted for circulation since 1935. But as a boy I didn’t understand Gresham’s Law (that “bad money drives out good”) or the remorseless power of compound interest.

Half a century later, it is now obvious that even a seemingly low annual inflation rate (about 4% since 1950) compounding year after year destroys the value of money.

In melt value the silver dollars I collected as a boy in the 1950s were worth $10.43 at the July 21 2009 silver price. So to keep up with inflation, “The $64,000 Question” would now have to be “The $667,520 Question”.

I admit that it may seem trivial to worry about updating what is still stubbornly “The $64,000 Question.” Regardless of the devastating effects of inflation since I was a boy, the dollar’s value in the collective imagination of America is fossilized in a figure of speech at a higher exchange rate than any bank will honor.

You can blame something called the ventromedial prefrontal cortex for this. This turns out to be a central location in the brain for what economists called the “money illusion.” This illusion occurs when people ignore obvious information about the effects of inflation on a purchase and irrationally conclude that the thing is worth more than it is.

According to Scientific American, this is nothing more than a neurological tick cooked up by the brain’s frontal lobes. This may go some way towards explaining the “money illusion” as well as the challenge of keeping your mental constructs up-to-date.

It is hard to do.

Deconstructing the Market Euphoria

I suspect that a big part of the current sucker’s rally, for instance, reflects fossilized mental constructs rather than astute analysis of the actual condition of the economy.

Witness what the Associated Press described as a “euphoric” equity rally on news that existing home sales in June inched higher for the third month in a row.

Not incidentally, of course, these sales were spurred by discounts of up to 80% or more as foreclosed houses flooded the market in many areas. For those familiar with Irving Fisher’s Debt Deflation Theory of Great Depressions, evidence that homes are now selling at steep discounts is an equivocal signal of strength at best. Yet the contractionary forces pushing down housing prices and deflating the collateral of an insolvent banking system have become a cause célèbre for stock market bulls.

See, economists and conventional investment analysts are trapped by dated presumptions about the business cycle that are informed by the post-World War II experience.

These presumptions are informed to a large degree by a relatively benign template of post-war “recessions” (repeated in 10 previous instances). These mainly reflected imbalances in the inventory cycle, rather than disruptions in the credit/leverage cycle that are so much harder to repair.

Still, people tend to believe what they are told. Most people have probably read too many of Paul Samuelson’s old Newsweek columns where he bragged that the business cycle had been eliminated.

That didn’t quite turn out as he promised. But most people, including Larry Summers (Samuelson’s nephew, incidentally) still believe the milder version of this fantasy: that governments can prevent depressions by spending gobs of money out of an empty pocket.

Whether this is true is the $64,000 Question. We are about to find out.

Prosperity Isn’t “Just Around the Corner”

U.S. politicians have certainly not disappointed expectations on the spending side. In fact, Washington has made athletic efforts not just to spend as much as possible but also to spend even more than is possible.

We are now about to find out whether Washington’s spending spree proves more effective at reviving the economy after a credit bust than President Hoover’s efforts did after 1929.

Remember Hoover’s famous assurance that “prosperity is just around the corner”? It was not a single catch phrase but sincere CNBC-style optimism that found repeated expression in 1930.

Early in that year, Hoover’s Treasury secretary Andrew Mellon predicted “a revival of activity in the spring.” And in February, Hoover’s commerce secretary Robert Lamont opined, “There is nothing in the situation to be disturbed about. There are grounds for assuming that this is about a normal year.”

A month later, Lamont was more optimistic still: he predicted that business would be normal in two months. And a few days later, Hoover set a definite date for the promised recovery: unemployment would be ended in 60 days.

On March 16, another of Hoover’s professional optimists Julius H. Barnes, the head of the National Business Survey Conference, spoke as if trouble was already a thing of the past: “The spring of 1930 marks the end of a period of grave concern… American business is steadily coming back to a normal level of prosperity.”

The sentiments Hoover, Mellon, Lamont and Barnes expressed so emphatically and often in 1930 find many echoes today.

Can $25 Trillion Paper Over a Depression?

In July 2009, however, you face a relatively rare circumstance: you may actually enjoy an eye-opening moment of clarity.

By the fourth quarter it should become obvious whether we are knee deep in a Depression with a capital “D” or we are percolating higher in a bubbly recovery thanks to the commitment of some $25 trillion in bailout/stimulus funds to counter what the conventional thinkers insist is just another garden variety recession.

Huh?

Am I the only one who detects some “cognitive dissonance” in the fact that Feds have lavished a sum more than double the annual US GDP to merely slow an economic downturn that the conventional thinkers pretend is nothing out of the ordinary?

The really frightening thing is this $25 trillion figure, although it is something of a “worst case” tally, is no wild invention. Consider the following testimony from Neil Barofsky, the Special Inspector General for the Troubled Assets Relief Program (SIGTARP).

He says $23.7 trillion has been committed to bailouts of the financial sector alone. And this does not include the $787 billion stimulus package and other outlays that have ginned up the cost of government to an unsustainable height. This from page 137 of SIGTARP’s recent quarterly report to Congress (for the full report, click here):

TARP IN CONTEXT: OTHER GOVERNMENT PROGRAMS TO ASSIST THE FINANCIAL SECTOR

By itself, the TARP is a huge program at $700 billion. As discussed in Barofsky’s April quarterly report, the total financial exposure of TARP and TARP-related programs may reach approximately $3 trillion.

Although large in its own right, TARP is only a part of the government’s combined efforts to address the financial crisis. Approximately 50 initiatives or programs have been created by various federal agencies since 2007 to provide potential support totaling more than $23.7 trillion.

The Fed has been one of the lead agencies responding to the financial crisis — increasing its balance sheet to more than $2 trillion to implement a wide range of programs designed to stimulate liquidity in financial markets, as well as several institution-specific interventions. The Federal Reserve’s $2 trillion balance sheet (which grew from approximately $900 billion prior to the financial crisis to a peak of nearly $2.3 trillion in December 2008),322 however, does not reflect the true potential amount of support the Federal Reserve has provided to those programs, which is estimated to be at least $6.8 trillion. This is because many of the programs involve guarantees that, although not listed on the balance sheet, expose the Federal Reserve to significant losses if the assets they are backing deteriorate in value.

Other players in the Government’s efforts include the Federal Deposit Insurance Corporation (“FDIC”), which has contributed more than $2 trillion in new gross potential support. The newly created Federal Housing Finance Agency (“FHFA”) — under whose auspices fall the Government-Sponsored Enterprises (“GSEs”) such as Fannie Mae, Freddie Mac, and Federal Home Loan Banks (“FHLBs”) — has effectively provided more than $6 trillion in gross potential support. Meanwhile, Treasury itself has programs outside of those authorized under the Emergency Economic Stabilization Act (“EESA”), and has supplied potential support beyond TARP of approximately $4.4 trillion. An overview of the Government’s new potential support relating to the financial crisis is listed by Federal agency in Table 3.4.

Of this $23.7 trillion in assistance to financial institutions, participants in non-TARP programs are not subject to TARP’s restrictions and conditions, such as executive compensation, nor do they necessarily require specific Congressional approval. Although SIGTARP’s oversight responsibility is for the operations of TARP and directly related programs (such as TALF and the Public-Private Investment Program (“PPIP”)), it is necessary to understand the larger context in which TARP operates, the linkages between TARP and the trillions of dollars of other Government initiatives. As noted earlier, SIGTARP has no authority over any of the non-TARP activities of the agencies discussed below.

Think about that. Is it any wonder that the banks were able to post profits in the last quarter?

It should hardly come as a revelation when big banks, drawing on trillions of dollars of practically free money and with almost all potential losses backstopped by government guarantees, can manage to report “earnings.”

The shills on CNBC hailed these profits as proof that the recession is winding to a close. What rubbish.

Surprise Earnings and Recovery Hogwash

Anything approaching an objective assessment would take into account that the multi-billion dollar profits realized by the big banks were heavily subsidized and accompanied by indications of trouble to come. This from the Washington Post:

The huge profits reported this week by some of the nation’s largest banks showed that the government is succeeding in its rescue of the financial industry, but the details of those earnings reports made it clear that the broader economy is not seeing the benefits.

Commercial banking, as David Oakley, Ralph Atkins and Gillian Tett, have argued in the Financial Times, has become like a stopped drain blocking the transmission of liquidity. Make no mistake: the conditions outlined by Fisher for another descent into a deeper depression are firmly in place.

Banks have found they can safely make money by depositing excess reserves at the central bank, buying government bonds, and even buying the bonds of other banks (on the theory that the big banks are tacitly guaranteed by the government.)

Of course, the big banks made profits in the last quarter. How could they not? A sum approaching one quarter of all the wealth in the world has been committed to subsidizing them!

Ask yourself another $64,000 Question. Could you make $13.6 billion in profits if the U.S. government subvened your business with $23.7 trillion? I promise you that I could.

Let’s see. That is a return of 0.00057% in an environment where you have been more or less assured that someone else, the taxpayer, will cover any losses you might incur.

I could hire a bunch of wild-eyed traders and let them fire away. I would certainly make more than a 0.00057% return. How about you?

I can also confide another valid inference from the evidence. Given the utterly mind-boggling subsidies lavished on the big banks, any profits they made are hardly indicative of underlying strength in the economy.

This from the New York Times:

While both banks said they were again turning handsome profits, the cheery headline figures masked a sober reality: the results were driven by one-time gains — bonanzas without which both banks would have lost billions.

At the heart of the banks’ troubles are hard-pressed consumers. The question, analysts said, was whether the banks have braced themselves enough for the next wave of bad debts as people slog through a long, dreary recession.

Like Goldman Sachs and JPMorgan Chase, two banks that stunned Wall Street this week with robust earnings reports, Bank of America and Citigroup got big lifts from their trading operations. Bank of America reported a $3.2 billion profit for the second quarter. Citigroup said it earned a $4.3 billion profit.

But the pain being felt by ordinary Americans hurt these giants even more. Both set aside billions of dollars to cover potential losses on consumer loans and warned that, given the tough economy, the road ahead could be rocky.

Both banks said they were in better financial health than they were a year ago, when each was brought to its knees by the storm that swept through the markets. Neither has repaid the nearly $100 billion in government money they received, while rivals like JPMorgan and Goldman have.

Yet with the economy still shaky — losses on consumer debt like mortgages and credit cards continue to rise — the biggest concern remains whether either bank has built up enough of a financial cushion to withstand further pain.

Kenneth D. Lewis, the chief executive of Bank of America, conceded in a conference call with analysts Friday that the second half of the year would be tougher than the first.

Vikram D. Pandit the chief executive of Citigroup, echoed that view.

“Our credit card and mortgage losses are elevated because of where we are in the cycle,” Mr. Pandit said in a conference call.

Commercial real estate has also been a bugbear for many banks, including Bank of America, as businesses trim their employee rolls and retailers close franchises. The firm reported 3.34 percent in net losses in the sector, more than 60 percent of its second-quarter real estate losses. (Citigroup officials argued that their bank had less exposure.)

Still, officials at Bank of America and Citigroup said they were preparing for a rougher second half of the year. Citigroup added nearly $4 billion to its reserves against future loan losses. Bank of America did not add more capital, but said it was adequately protected with a $13.4 billion provision.

Some analysts questioned whether that would be enough.

Take this in, if you will.

Conventional investment advisors tell you the economy is headed for recovery. And Merrill Lynch went as far as to say that “the recession ended in April.”

Exhibit number one in this collective hallucination is that earlier this month big banks posted quarterly profits of $13.6 billion. But far from being a sign of robust banking, the profits masked that the core business of the banks is actually getting worse. Bank of America, JPMorgan Chase and Citigroup all reported that they lost more money on loans during the second quarter.

As Ken Lewis of Bank of America put it, “Profitability in the second half of the year will be much tougher than the first half.”

The prospects don’t look good because banks will have to rely less on government bailouts and more on customers who are losing their jobs or earning less money. The banks will suffer as long as their customers do.

Earnings: “Lipstick on a Pig”

And this brings us to exhibit number two the collective hallucination of an early recovery: the better-than-expected earnings of non-financial companies.

Superficially, this seems convincing. It has been nine months since the Fed doubled its balance sheet, effectively printing a trillion dollars of high-powered money (currency plus commercial banks’ reserves with the Fed). Given typical lags, this should be expected to show up in the form of higher asset prices at about this time.

But look more closely and you see that much of the improvement in profitability reported by major corporations came as the result of cost-cutting rather than top-line growth.

One of the few exceptions was Apple Inc (Nasdaq:AAPL). It posted its best non-holiday quarter ever, after sales of its Mac computers surged 18% and iPhone sales hit an all-time high.

Not only did Apple’s revenues surge but also the company’s overall gross margin grew to 36.3% from 34.8% in the same quarter a year ago. Apple is a rare example of a company gaining market share in a weak economy. Half of its computer buyers had never owned a Mac before.

Of course, markets are never tidy, and results are not uniform. Amazon, Microsoft and American Express all sold off sharply after their quarterly results disappointed eager bulls.

The light numbers on Microsoft’s top line reflect its transition to marketing a new operating system and general economic weakness. They also reflect the fact that increasing numbers of former Microsoft customers are opting for Apple’s less cumbersome operating systems. The fact that half of Mac buyers never owned a Mac before implies they abandoned Microsoft systems when the bought Apple products.

Look at some of the other results that buoyed the market and you see a lot of “lipstick on a pig.” Profits at Yahoo! improved 8%. But this was a tribute to cost cutting, as top line revenues declined 13% in the second quarter.

Starbucks posted its first quarter of earnings growth since 2007. Bullish news? Not really. Sales in stores open for at least a year declined 5% and overall revenue dropped 6.6%.

Coca-Cola reported a jump in second quarter profit of 43%. But sales fell 9%.

Go through the list of profit surprises and they don’t augur well for a swift economy recovery.

UAL, parent of United Airlines, reported a surprising profit. But it was not based upon its airline operations. And revenues tumbled by more than 25%. All the UAL quarterly gain was attributable to trading profits on its fuel hedging operation.

Worse still, industry-wide passenger revenue dropped by 26% in June – the eighth consecutive monthly decline. Southwest Airlines also reported a profit even though its revenue fell 8.8% – a relatively strong performance as compared to United.

Note that Southwest, United and Continental (which posted a deeper loss) announced service cutbacks and more job cuts in conjunction with their results for the last quarter.

An Epidemic of Cost Cutting

When you drill into the earnings news that so entranced Wall Street the surprisingly profitable companies, with a few notable exceptions, did not enjoy top-line revenue growth. Instead, they made their profits by cutting costs as their sales fell away.

The picture that emerges is one of weakening sales and aggressive cost cutting. This process may squeeze a one-time profit from falling top-line revenue. But it does so at the expense of further job cuts and thus a weaker economy in the future.

Indeed, the epidemic of cost cutting is one of the main mechanisms identified by Irving Fisher in 1933 as magnifying the deflationary forces that caused the Great Depression.

Fisher wrote: “(4) A … fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a ‘capitalistic,’ that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to (7) Pessimism and loss of confidence, which in turn lead to (8) Hoarding (of money) and slowing down still more the velocity of circulation. “

In other words, the evidence upon which the current euphoria depends is equally compatible with the conclusion that the Depression continues to deepen.

Even the big banks profits were obtained at the cost of the most lavish subsidy ever imagined in the history of the world. And it should be noted that the less subsidized regional banks, such as Fifth Third Bancorp (NasdaqGS:FITB) and Huntington Bancshares Inc. (NasdaqGS:HBAN), reported losses reflecting consumer weakness and non-performing commercial real estate loans.

The Grandest of Grand Larcenies in History

It is hardly a trivial footnote that the big banks posted gains fresh on the heels of being bailed out in an array of programs, the sum of which, according to SIGTARP, comes to $23.7 trillion. That’s about twice the size of the entire U.S. economy – and a substantial fraction of the liquid wealth of the world.

I find it even more astonishing that only about $700 billion (less than 3%) of the $23.7 trillion – a sum, by the way, that is greater than the nominal total of all U.S. government spending from the beginning of the Republic – was even approved by Congress.

This is perhaps the grandest of grand larcenies in history. And on current evidence, it won’t even forestall a Greater Depression.

Unhappily, most experts on the economy know no more about the Great Depression than could be learned by watching a 1950s quiz program. And even that rather skimpy foundation of expertise is inaccessible to the majority of Americans born after 1966.

No matter when you were born you should not let yourself be carried away by the current market euphoria. Although an emphatic answer to the $64,000 Question of whether this is the end of the recession or the beginning of a “Greater Depression” is still to be confirmed, I think I know what it will be.

This is a Depression, a credit cycle gone bad that still has many chapters to unfold.

If I am right, you can expect the stock market to work its way, after many adventures, to valuations lower than the March lows. Secular bear markets seldom, if ever, bottom at 12.6 times earnings, where the S&P 500 stood on March 9. That is approximately twice as rich as the multiples you can expect to see at the ultimate bottom if history is any guide.

PE Chart of the S&P 500

Two further points.

Over the past century, the stock market has provided an average dividend yield of 4.4%. Today, the S&P 500 yields just 2%. This implies well below average returns from here on in.

Another fact you should consider in plumbing the bottom is that financial sector profits, illusory though they may have been, accounted for as much as 75% of all corporate profits in the US in the early years of this decade. These financial sector profits were exaggerated by the explosion of leverage in the corporate sector at that time.

As deleveraging is now the rule of the day, a return to highly leveraged earnings in the financial sector is unlikely. It is far more likely that stock valuations will “revert to the mean.”

And this means a much longer bear market than anyone on CNBC imagines.

James Davidson

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Crisis Strategy Alert
Portfolio Review

We forecast last month that the June unemployment figures might shock the market and refocus the attentions of investors on the actual state of the U.S. and global economies.

I anticipated that this would reignite interest in the deflation trade: short stocks, short commodities and long the dollar.

The first part of the forecast was correct. Unemployment surged far more than the green shoots brigade had anticipated. My estimate of the market consequences of the shocking unemployment numbers was well gauged – for about 48 hours.

Then green shoots optimism took over again: stocks rallied, commodities rallied and the dollar sold off.

Ironically, the big impetus behind the continuation of the rally on Wall Street was the view that encouraging earnings were confirming the green shoots hallucination. It would be hard to conjure a proposition more remote from the facts.

You would never know it by looking at the tape, but U.S. corporate profits fell by an average of 35% in the second quarter. Of course, the reported numbers masked the fact that profits and production are collapsing in a manner similar to, or even worse than, the Great Depression.

This is how it works. Wall Street analysts publish “low ball” estimates of what corporate earnings are expected to be. Then the results, bad though they may be, are reported in comparison to expectations. The media headline thus becomes “earnings top expectations,” and stocks rally on the premise that a recovery is in sight.

A deeper analysis of the production process shows that the output of real economic goods in the U.S. is crashing. A good barometer of this is the level of total U.S. commercial paper outstanding. This is close proxy for future production because it is used to finance the production process.

As William Buckler reports, “Total U.S. commercial paper outstanding has sunk another $39.7 billion to $1.097 trillion. These numbers might look huge, but compared to former times, they are stunted indeed. Commercial paper has declined by $585 billion so far this calendar year. Annualized, that is a 65% rate of shrinkage.”

What the recent earnings figures actually tell us is that that U.S. economy is vulnerable to collapse from the dynamic outlined by Irving Fisher in Debt Deflation Theory of Great Depressions: production is collapsing; cash flow is collapsing; profits are collapsing; employment is collapsing; and tax revenues are collapsing – just look at California.

This total disconnect between the fall off in corporate profits and the rally in stocks underlines the fact that you sometimes need more than a compelling syllogism to make money in times of discontinuity. If the market responded instantly to the implications of the evidence, we would not be seeing a rally on Wall Street.

The current disconnect is less vigorous than the comparable sucker’s rally of 1930. But it has nevertheless transfixed investors in the U.S.

One reason I closely follow the patterns of the past is to try to gauge how quickly the delusion of impending recovery might be seared off by hot breath of evidence. You might think that the instant communication available now via the internet would accelerate understanding. Perhaps it will. But to this point there seems to be a common view that we will soon reflate the bubble and return to business as usual.

“Happy Hype” Consensus

This view seems to have carried the day, not only in the stock market but also in commodity pits. Oil prices rallied despite weak oil demand.

Did the rallies in stocks and commodities reflect the predominance of the Wall Street-Washington “happy hype” consensus? Or was it something else?

Real evidence that the economy is recovering and that the post-World War II growth model is about to be resuscitated is too skimpy to convince thinking investors.

An alternative reading may that the “smart money” – meaning “smart people with money” – knows the system faces a solvency crisis and is looking to position itself for the next phase. The budget deficit, after all, is not a state secret.

As Eric Sprott, one of the smartest investors in Canada, recently pointed out, the U.S. Treasury issued $705 billion in new debt in 2008. And this year, the Treasury must place about three times as much debt as it did in 2008.

Sprott concludes that it “is a mathematical impossibility” for the new debt to be placed through normal investment channels.

There is simply not enough money in the present economy to support a tripling bond issue in the normal course of business. [...] As the lender of last resort, the only purchaser left is the Federal Reserve.

The Federal Reserve ‘solution’ to the problem is the problem. [T]he future solvency of the U.S. as a nation state is currently in jeopardy. It is in far deeper trouble than the mainstream press cares to admit. There are simply not enough new buyers of debt on this planet to support the spending programs of the U.S. government.

The U.S. budget is ludicrous, spending is out of control, spending promises are out of control, the world knows it – and we know it. For all the pundits who see the economy improving over the next year, we invite you to explain to us how this debt crisis will resolve itself without significant turmoil. We’ve tabulated the numbers above – and they do not lie.

It is at least conceivable that some of the investors who appear to be munching contentedly on a low calorie buffet of “green shoots” may not have swallowed the quick recovery hypothesis. Instead, they may be positioning themselves in an unorthodox way for a big surge of inflation.

That hypothesis is worth exploring. But I am skeptical that it explains much of the recent market action. For one thing, evidence from past depressions suggests that it is far more common for bulls to cling to hope that the recently ended bubble can be re-inflated.

If you read the Wall Street Journal from this time in 1930, you can see this in the interplay of stories reporting the shifting balance between the bulls and the bears that eventually played out as a 90% collapse of stock prices from the 1929 highs. You see very little evidence of forward vision. At this time in 1930, as now, most people were years away from recognizing that they were sinking into a Great Depression.

Consider these items, summarized from The Wall Street Journal at the end of July 1930. Most could have been written today – except that the underlying macro environment and earnings news were healthier then than are now:

Market encouraged by ability of US Steel and GM to earn almost all the full year’s dividend requirement in first half. Many other companies have also reported earnings better than expected (“the reports of many corporations for the second quarter have been a disappointment to traders on the bear side”).

Some positive feeling from weekly business reviews expecting bottoming out and seasonal upturn, though this expectation so far “has been based on hopes rather than actual signs of increasing activity.” Many industries have consumption running ahead of production and low inventories; credit is also very easy. In particular, resumption of car production soon is seen as positive for steel and other industries.

Note that GM in 2009 would have been ecstatic to have booked “a first half net of $2.32/share vs. $3.28 in 1929. Earnings were 77% of $3 full year dividend.”

Of course, you’d know immediately that any report you read about GM paying a dividend would have to be ancient history.

Oil and the “Peso-ization” of the Dollar

All this said, we have to be cautious and use money management stops on our proxies for short oil.

Despite the fact that U.S. oil demand has tanked, oil has come to be traded almost like gold as store of value for the future and a hedge against the “peso-ization” of the dollar.

I see the U.S. becoming like Argentina was for decades from 1960 – an economy with runaway inflation and little or no sustainable GDP growth.

A billion dollars worth of pesos buried in 1960 would have been worth only about 80 cents three decades later. If you had enjoyed perfect forward vision when Argentina was prepared to enter its lost decades of chronic insolvency, you might have wished to hoard oil.

But oil, then and now, has drawbacks as a store of value that gold does not. Oil is expensive to store, volatile in refined form, and once used, it goes up in smoke.

Oil has also tended to be highly correlated with GDP growth. Since 1997, oil use has followed GDP by an average of more than two percentage points. In 2006, the spread widened to 3.8 percentage points. And demand for oil has dwindled over the past two years – for the first time since the early 1980s.

I think oil demand will remain low. When speculators realize that there will not be an early recovery, the price will break later this year. I am staying short.

To repeat, you should use money management stops on your oil positions. Note, also that Crisis Strategy Alert subscribers will receive a weekly trading bulletin that will update our strategy, based on movement in the Dollar Index and the latest bearish inventory news.

Exploring the Prospects of PSEC

I am not overly bullish about U.S. equities. But specific situations can be attractive. This is the case with Prospect Capital Corporation (NASDAQ:PSEC), a mezzanine lender to small business, particularly in the energy sector.

What amounts to a doubling of the annual growth in the monetary base in the U.S. has yet to generate meaningful flow through. This implies continued systemic liquidity stress, and it creates opportunities for PSEC. It also provides a backdrop to challenge their success.

Here I think of historian Edward Gibbon’s adage that “the wind and the wave are always on the side of the ablest navigator.”

PSEC will gain share in a beaten down sector. With about $113 million in net debt versus $428 million in equity, PSEC should get about $50 million in distributable cash flows for 2009. In the last quarter, interest costs totaled approx $2 million. And PSEC pays an annual dividend of $1.60.

At its recent trading price of $9.86 an attractive way to acquire a position is to sell puts at a $10.00 strike price. If the stock goes down, you will pocket the premium. If it goes up, you will effectively pay less for it.

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