Storm Date: March 23, 2006 Vol. 1 Issue 4

Looking for the Next Bubble

The one distinguishing feature of monetary policy over the last two decades is that it is having less of an impact on the economy. In the 1950s it took $1.77 of debt to create $1 of GDP. Half a century later, it now takes $4.42 of debt to create $1 dollar of GDP. Where does all of that debt and money go to if it isn’t going into GDP? The answer is that money goes into imports and into speculation.As consumers take on more debt to maintain consumption, a good majority of that spending is going into foreign-made goods — hence the record trade deficits. Go to any store these days whether it is Wal-Mart, Costco, Nordstrom, Best Buys or Circuit City and ask yourself where do these goods come from? Not here is the answer. Most of the goods on the shelf aren’t made in the USA.I recently went to Circuit City to buy a DVD. Just about everything on the shelf came from Asia from the big screen TVs, digital cameras, and computers to the stereo equipment. I was surprised when I got home and unwrapped the DVD to find that even the DVD wasn’t made in the US. It was made in Mexico. Come to think of it, even the gas in my car was probably imported as well.

Current-Account Balance
U.S.Current Account Deficit Increases in Fourth Quarter 2005, BEA 3/14/2006

The other avenue—or outlet—for all of that money creation is asset bubbles. The graph below of M3 under the Greenspan Fed shows how the Federal Reserve found a convenient outlet in the stock market during the 1990s.

Greenspan's M3 Money Supply

All of that money and credit gave us a 5,048 Nasdaq, a 11,722 Dow, and a 1,527 S&P 500. When the U.S. economy went into a recession in 2001 the Fed dramatically lowered the federal funds rate, bringing interest rates down to a half-century low. The result has been the weakest income and job growth of any recovery. Fed policy had a greater impact on the financial and asset markets. Most of that money went into a feeding frenzy in the real estate market, the mortgage market, and in the bond market. This gave us 3 & 4% mortgages, double-digit annual real estate appreciation, and a frenzy of cash-out financing that fueled a debt and spending boom here in the U.S.

Today real estate prices are now starting to soften in San Diego. Yet as the table below indicates, most home and condominium prices have gone beyond the reach of most households.

Resale and New Homes (as of February 2006)
	Single Family	Condominium	New	All Homes
Central San Diego	$540,000	$420,000	$352,000	$473,000
East County	$490,000	$307,000	$657,500	$484,000
No. County Inland	$580,000	$375,000	$643,500	$553,000
No. County Coastal	$642,500	$424,500	$831,000	$625,000
South County	$560,000	$385,000	$462,000	$503,000
Source: DQNews.com

Starter homes—if you can find them—are running closer to $600,000 - $700,000, depending on the neighborhood. Big Sky Ranch homes are still averaging over $800,000 with condo prices closer to $500,000. With fixed rate mortgages falling to 6.31% last week, it takes between $3,500 to $4,120 a month to buy the average homes listed above. In addition to the mortgage payment, property taxes can run as high as 1.5-1.8%. This adds another $900-$1,050 a month just for taxes. Add in association fees, which have become ubiquitous, and utilities and insurance, and you get another $500-$750 a month. It is one reason why the Center for Housing Policy reported on Wednesday that fewer middle class families can afford to buy a home.

Without wage growth to keep up with inflation, most families—if they do buy a home—can only do so with larger debt balances. Very few households have the savings to put down 20% on a fixed rate loan. In order to qualify, they buy with as little as 5% down and take out a low variable rate mortgage. The problem for these families is when their loans are due to reset. My realtor told me of a home he recently listed for a young couple who had a VRM taken out in 2003. Their monthly payments increased by over $700 a month. They couldn’t afford to make the payments, so they are selling. He also told me they expect a flood of new listings as the year progresses as more VRM loans are reset. This will bring selling pressure into the markets.

The point being made here is that the real estate market is rolling over. Eventually that rollover will pick up steam as variable rate mortgages are reset over the next two years. There is danger here. Unlike the stock market, the real estate market is connected directly to the banking system with banks having over 60% of their loan portfolio in mortgages. If the housing sector gets into trouble, it carries over into the financial sector.

So what will the Fed do? They are going to reinflate which is why they are getting rid of M3. The last reported figure for M3 was $10.340 trillion as of the end of February, up 7.8% or $748 billion. With the government’s budget deficit rising to over $400 billion, with the current account deficit set to rise to $900 billion, and with mortgage and credit card debt still rising the Fed will have to ease the burdens of debtors. At some point with all of the incentives removed such as taxes and low interest rates the economy is set to weaken. The Fed will start easing but unlike past easing it will take more money and credit to keep the economy afloat. Like the past the majority of that money is going to go into imports and into financial assets. The result will be even larger trade deficits and bigger asset bubbles. If I had to guess the next asset bubble to get reinflated is the stock market and commodities, especially gold and silver. I still expect a new record on the Dow this year, which is less than 500 points away from the old record of 11,722.98 set on January 14, 2000.

S.O.S. - Stealing Our Social Security

If corporate executives did what our congressmen are doing to our social security system, they would be behind bars, wearing orange stripes instead of pin stripes. Congress has been spending the entire surplus funds created each year from Social Security. There is no trust fund. The money has been stolen. The media knows it as well as the government. Yet the myth of the trust fund continues to surface in any political discussion. The trust fund that so many politicians and the press refer to consists of nothing more than I.O.U.s issued by the government. Each year Social Security taxes exceed the benefits paid out to recipients. The money was supposed to be invested so that future liabilities for retirees would be protected. Instead, each year these surplus funds are transferred over into the government’s general fund and spent. In place of real investments, the government issues I.O.U.s in the form of zero-coupon bonds. These bonds will have to be redeemed and refinanced when they come due, putting further pressure on the financial system. There simply won’t be enough money to fulfill the promises made to future retirees.

In a speech given at Jackson Hole, Wyoming in August of 2004, then Fed chairman Alan Greenspan said the following: “As a nation, we owe it to ourselves to promise only the benefits that can be delivered. If we have promised more than our economy has the ability to deliver, as I fear we may have, we must recalibrate our public programs so the pending retirees have time to adjust through other channels. If we delay, the adjustments could be abrupt and painful.” [Speech]

Be prepared. A painful adjustment is coming. Means testing, a later retirement date, and higher payroll taxes will shortly be upon us. There is no trust fund. The money has been stolen. Eventually, as the surpluses run out over the next 5-10 years, that painful adjustment will be upon us. Forget the year 2040 and any other future date given as when these surpluses run out. Those dates are pure fiction. We will hit the wall long before then.

With this approaching crisis, you would think the thieves in Washington would become more forthright with the voters. Think again. Last week the Senate voted 53-46 against the Jim DeMint and Mike Crapo debt ceiling amendment. The Senate voted to raise the national debt ceiling to $8.96 trillion.

The DeMint and Crapo amendment would have put a "lockbox" around Social Security. The DeMint-Crapo proposal would deposit surplus payroll taxes in personalized bank accounts for each U.S. worker. It would have made the surplus Social Security funds the property of individual taxpayers. This would have prevented politicians—in this case, Congress—from stealing the surplus funds.

Based on current surplus projections of 8 years, this surplus would amount to over $40,000 in tax-free wealth for each worker contributing to Social Security by the time they retire. Instead, every Democrat and 8 Republicans voted against the measure that would have protected the surplus.

The reason they voted against the amendment is government spending is now out of control, beyond balance, through taxes or borrowing. Just as the Treasury raided Civil Service pensions, Congress has plans to spend all of the surpluses generated by Social Security over the next 8 years. Social Security will generate an estimated $436 billion of surplus savings over the next five years—over $80 billion in this year alone. Cumulatively, as of the end of 2005, Congress has siphoned [stolen] $1.616 trillion of incoming surpluses since 1991.

With a $2.8 trillion budget for its next fiscal year, the government has a need for those surplus savings. So this outrageous ponzi scheme will continue to the detriment of the next retirement group—the baby boomers. Plan now because the promise of future Social Security benefits will be reduced and reneged. Don’t expect a change in political leadership to change things. The leading Democratic candidates for President—Hillary Clinton, John Kerry, and Joe Biden—all voted against the DeMint-Crapo proposal.

The Perfect Storm

Everyone remembers the Halloween Storm of 1991 and the Wolfgang Petersen film that brought it to our attention. The storm was the result of three different weather fronts colliding with each other to form the Perfect Storm: a Nor�easter, an artic cold front and Hurricane Grace. Weather forecasters are now forecasting a similar possibility over the next few years. AccuWeather.com believes that the northeast U.S. coast could be the target of a major hurricane as the warm, southern ocean currents head further north. According to the weather service, this year�s hurricane season will be an active one. �The Northeast is staring down the barrel of a gun,� said Joe Bastardi, Chief Forecaster. Similar weather cycles in the past have led to horrific storms hitting the east coast. The '30s, '40s and '50s were very active decades for storms on the east coast. One storm in 1938 struck Providence Rhode Island and Long Island killing over 600 people.

Today those regions of the country are more densely populated. In addition to the east coast particularly vulnerable is the Gulf Coast along the regions of Texas and Louisiana. The Gulf of Mexico accounts for a third of our energy production and the Gulf Coast also houses a major portion of our refinery capacity. We still have close to 20% of our energy capacity offline as a result of last year's storms. This year�s storm season will soon be upon us. In addition to a geopolitical premium embedded in the price of oil, you can also add a weather premium. The current decadal oscillation cycle, which is dominated by a warming trend, usually lasts 25-30 years. The current warming trend began in 1995. So we still have another 15-20 years of warming temperatures, which translates to more violent storms. The Gulf oil platforms were mostly built during the cooling trends of the '60s to '90s. These platforms weren�t built to withstand today�s violent storms where wave height can exceed 70ft. The Perfect Storm recorded wave heights of over 100 feet. At a time when energy consumption keeps rising globally, America�s energy infrastructure is at risk. Hopefully Washington is paying attention.

Not Cheap, but Reasonable

In today’s age of inflation it is rare to find anything that is cheap. The cost of living has been going up faster than wage growth and asset bubbles are visible everywhere from the price of real estate, mortgage rates, bond interest rates and credit spreads to the price of Google. Believing as I do that another round of reinflation is in the works for the U.S. economy, one outlet for the next wave of money and credit creation is our good ole' stock market. In many of the inflationary episodes of the last century you’ll find that stock markets responded to government and central bank money printing. During the Great German inflation of the 1920s the German stock market went from 88 in 1918 to 26,890 million in 1923. As the central bank printed Reichmarks, the public speculated with those funds in an effort to keep up with the runaway inflation of that era.

As I have written previously in “The Great Inflation”, and “The Two Bens,” inflation can manifest itself in either of two ways. It can show up in the real economy in the price of goods and services as it is doing now or it can surface in the asset markets in the form of higher prices for assets be it bonds, stocks, commodities or real estate. Just look at the '80s and '90s for financial inflation and this new decade for hard asset inflation in the price of real estate and commodities.

This brings me to the next reinflation effort which has now begun. Why else would M3, which has been growing at an annual rate of 8%, no longer be reported by the Fed? Monetary inflation is the reason. The U.S. is spending and borrowing too much money. Our current rate of spending is out of control and beyond balancing through tax increases, so monetary inflation through monetization is next. As the Fed goes on hold—perhaps after the Fed funds rate is taken to 5-5.25%—the dollar will begin its relentless decline.

Who Will Benefit?
One beneficiary will be large cap international stocks with a large concentration of overseas sales. A lower dollar boosts domestic profits as overseas sales and profits are translated back into dollars. With this thought in mind ,it is worth looking at various sectors that would benefit from the next reinflation. The natural resource sector would be an obvious beneficiary. Energy, base and precious metals as well as alternative energy will do well. Other beneficiaries would be large cap stocks. I’ve listed an array of four groups of companies listed below that could become beneficiaries of the next reinflation trend. They include consumer staples, discount retailer, select technology, and industrial stocks along with energy. Many of these companies are selling at a third of what they once traded for in the bubble years of the late '90s. They’ve all increased sales and profits since their peak. Prices have come down along with multiples.

I’ve found it amusing that so many investors loved these stocks when they were selling at 90-100 times earnings in the first quarter of 2000, but are no longer willing to look at them now. Being flexible to monetary trends and understanding the many forms of inflation is necessary in order to survive and prosper during an inflationary era. If you want to find “cheap,” there are very few areas to look at in today’s markets. Late stage development junior gold and silver companies are my favorites. Next to juniors precious metal stocks, the only other area I find is energy, which despite the run up in energy stocks, still remains grossly undervalued.

Listed below are examples of sectors and companies that have higher sales and profits and whose stock prices have fallen or are selling at lower P/E multiples. My point is to illustrate the fact that sales and profits have grown, while in most cases, P/E multiples and prices have fallen. In an inflationary era, it is hard to find things that are really cheap. Perhaps the best one can hope for is to find things that are reasonably priced.

FOUR TABLE CHARTS GO HERE

Finally, in an age of inflation, money has two outlets: it can go into paper or things. The favorite course for this money over the last 35 years has been to asset bubbles. In the 1970s it was commodities or things. In the '80s and '90s, it was paper. In this decade it has been both paper and commodities—atrend I expect to continue until peak oil hits.

Until the next time... fair winds and clear skies!