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July 29, 2006

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The Full Spin Zone: the truth about oil

O’REILLY: Tonight, profiteering during a time of war. Most of you know I believe the big oil companies, led by Exxon, are doing just that. Today, Exxon announced another incredible quarter, profits were up 36% over the last year, even though demand for oil is about flat in the USA. Exxon’s profits were the second highest in the history for any company in the world. The first highest was Exxon in the fourth quarter of 2005. Joining us now from Chicago to make excuses for Exxon is Jonathan Hoenig, Fox News Business Contributor.

JOHN: And that’s how it went, Jim, this week after the profits were announced by the oil companies. And I think we’re calling this segment The Full Spin Zone, simply because of the fact any time O’Reilly has done anything on this subject, the one thing that doesn’t seem to come out are facts. There’s an agenda underway and “don’t confuse me my mind is made up.” Really, when you look at it everywhere, I’ve been listening to the talk radio channels around the country, we’re not getting a lot of facts. It’s not being put into perspective. Most of the talk people are uninformed about the whole situation. So what we’re going to try to do in this segment is to lay it all out for people in a way that is understandable. And something that you can come back with at cocktail parties too.

JIM: Ok, as Joe Friday said, “Just the facts, Ma’am.” Let’s start out with a few simple facts. And one thing that people have to understand is in the last 3 years, where we’ve seen oil prices go up from the mid-20s to today’s price somewhere in the 73 to $74 range, demand worldwide has grown unabated for the last 3 years, unaffected in any way by rising prices. If we look at the United States, in the first half of 2006, we reached a 20 year high in US drilling activity. So it’s not like the oil companies are standing by saying, “look, we’re making lots of money, but, you know, hey, tough, that’s the way it is.” No, with their drilling activity, their amount of capital expenditures is at near records.

But here’s the thing that I think these news people do not put in perspective. This is it in a nutshell. In 1985, the world consumed 60 million barrels a day of production; we also had 70 million barrels of capacity for production. In other words, John, we had a spare capacity of 10 million barrels a day between what we could produce and what was demanded by the world. Also, in 1985, capacity at our nation’s refineries was running at 78%, so if there was more demand our refineries could crank up and produce more gasoline; if there was a problem in the Middle East, if a refinery went down, we had 10 million barrels of spare capacity. They could handle anything like a war in Lebanon, rebels in Nigeria, a refinery catching fire in Venezuela. Today, oil demand is running at 85 million barrels a day; refinery capacity is at over 92% today; and spare capacity has dwindled to somewhere between 1 and 2 million barrels a day. And that is the main picture in a nutshell. [3:41]

JOHN: What it means is you’re hanging on the ragged edge of a stall. In other words, there’s no wiggle room in there whatsoever. One more thing goes wrong, then you’re in trouble.

JIM: Sure. We don’t have the excess spare capacity to make up for, for example, if they blow up the pipelines in Iraq, or if they shutdown 50% of Nigeria’s production; or if we have another hurricane season in August that hits the Gulf coast. We simply don’t have it, either in refinery capacity, in production capacity at a time when the world – it’s not just the United States anymore that is of relevance, it’s also what happens in Asia and other parts of the world. [4:24]

JOHN: Let’s go back to Gulf War I, if there was suddenly a crisis, OPEC, or Saudi Arabia, somebody would have a press conference and they would say, “we understand the crisis and we’re going to maximize production,” and suddenly they’re going to flood the world with more oil in this time of crisis. And then you would see the prices go down. The global nervousness index would go down with that. But that doesn’t seem to be happening anymore, what’s gone phooey with OPEC?

JIM: Number one, they don’t have the spare capacity right now. Once again, going back to what I said earlier, that spare capacity that we once had at 10 million barrels a day has shrunk to only one or two million barrels, and that’s with Saudi Arabia going full bore at what they’re doing now. They’re scrambling to get as many of the world’s drilling rigs as they can to start going after their heavier oil, because they have depletion declines going on with their major producing fields, such as Ghawar, Safaniyah, and some of their larger oil fields. So, once again, our spare capacity, at the production level and at the refinery level, has disappeared. So any time you turn on the news this nervousness level that you talk about heightens because people know we just don’t have any slack in the system right now to make up for any short falls. [5:51]

JOHN: Ok, if we have to take that and project that forward where is that going to be given the rising demand? If it’s bad now where will we be 24 months, 48 months out?

JIM: Oh, I think we could be at even much higher prices – 85 to $100 oil. As many, like Matt Simmons and T. Boone Pickens recently said: we’re only a few headlines away from $100 oil. According to the International Energy Agency, for example, in 2007 world oil demand is expected to rise by another 1.3 million barrels a day, so we’re up in the 86 million barrels a day, and it is expected to grow by 2% a year. And here’s the thing that people like O’Reilly just totally miss out completely: the bulk of that demand is coming from Asia. So, the IEA, which is the International Energy Agency, is projecting by the year 2011 Asia surpasses North America in oil consumption. I don’t think people realize how significant that is. [6:54]

JOHN: Yes, because now we’re on an equal demand market. At one time there was only one big boy on the block, that was the United States, and now that’s all changed which affects everything else.

JIM: Sure, I can remember one of O’Reilly’s past programs and he had Donald Trump on, and he asked Donald what he would do with the oil crisis and he said, “well, we’re the biggest consumer, I’d just go to Saudi Arabia and say, look it’s $70, we’re only going to pay you $50. Take it or leave it. We’re the largest customer, that’s it.” Well, I hate to tell Donald…

JOHN: I can hear, they’re going to say, “you know, I don’t know how we’re going to get along without you but we’ll manage, we’re going to China.”

JIM: Yes, which is exactly what they’re doing. Venezuela’s doing this; Nigeria is doing this; Iran’s doing this; Kuwait’s doing this; Saudi Arabia is doing this. We’re not the only shoppers in the mall now. There are quite a few other big shoppers and by the year 2011 there’s going to be a shopper even bigger than North America. [7:51]

JOHN: So basically, if we look at what O’Reilly was bagging on this whole week, the price is the core issue and I think he maintains that the oil companies are gouging or setting inordinately high prices. But if you look at the very simple fundamentals of the market, we have growing demand globally, at rather breathtaking rates as a matter of fact. Supply that has not kept up with that demand, and the spare capacity that we have to buy for that is shrinking as the demand increases faster than the supply. So sooner or later we’re going to be in a real negative situation here.

JIM: Sure, and the other thing I think O’Reilly bashing on Exxon –that Exxon is setting world market prices – really shows his ignorance. He kept saying, “I don’t want to hear that, I don’t want to hear that.” It’s like –I hate to tell Bill – in 1960 the international oil companies like the Exxons, or the Seven Sisters as they were once referred to, controlled 85% of the access to oil and almost 85% of the world’s oil production. Today, the major oil companies only produce about 15 to 16% of the world’s oil production. Today, the price of oil is determined in the world wide market. This is something that O’Reilly didn’t even want to hear.

The largest producers in the world today are the national oil companies like Saudi Aramco, the Kuwaiti oil company, the Iranian oil company, the Venezuelan oil company, the Nigerian oil company, the Chinese oil companies. And he bags on these companies, but here’s a simple fact, June 1st of last year oil prices were at $37 a barrel; at the end of the second quarter oil prices went from $47 a barrel to $75 a barrel – an increase of 58 ½%.

And this is something that I’ve been talking about on this show with Joe Duarte, we’ve been telling people, I said you’re going to see some blowout earnings because from March 31st of this year the price of oil was at $69 a barrel, the entire second quarter oil prices spent above $70 a barrel with prices spikes as high as almost $79 a barrel. So the entire second quarter was spent for the first time in oil history at above $70, and rising oil prices, rising global demand, consumers outside the United States. O’Reilly is saying basically 15% of the people that produce the oil dictate the price to the other 85% of the people that produce the oil. This just stands logic on its head.

O’REILLY: Joining us now from Chicago to make excuses for Exxon is Jonathan Hoenig, Fox News Business Contributor. Alright, now look, as I told our guests at the top of the program, I am a simple man. I think everybody would admit I am a simple guy. I have only one question for you, Jonathan, only one. Demand for oil – gasoline – in 2006 is flat over 2005, correct? It’s flat.
HOENIG: In the US it is.
O’REILLY: In the US, it’s flat.
HOENIG: But oil is the world market
O’REILLY: I understand that other people have oil. In the USA it’s flat. That means it’s the same now as it was 12 months ago in 2005. Yet, Exxon’s profits – all the other oil companies’ profits – are up. Exxon’s are up 36%. So, you do the math, Exxon’s profits about 40% derived from the USA, maybe more. Ok. And you see that not only are they passing the increased costs of a barrel of oil onto me and you and everyone else, but they’re jacking it up to make even more money, which they have done…
HOENIG: That’s not true.
O’REILLY: …every step of the way.
HOENIG: Bill, they didn’t jack it up early 1990s when oil was at $15 a barrel. I know it’s impossible for you to believe but Exxon-Mobil doesn’t set the price of oil. The price of oil is set by any number of factors, one of which is demand, as you pointed out. Maybe demand is flat in the United States, but it’s huge in China. [12:07]

JOHN: Ok, let’s see if we can dissect this, so people understand it. As I understand it, O’Reilly’s argument here is demand is up only 0.6%, but the profits are up 36%. He sees the disparity, that’s where he sees the hammering. But what he hasn’t factored in, and this is what Jonathan Hoenig was trying to get him to face – it got a little wild later on in the conversation – there’s no factoring in for supply considerations here. He’s simply looking at demand versus profit.

JIM: Yes, the fact that oil prices went up 58%, he’s not taking a look at market prices, and he’s almost like Swiss Family Robinson here, that the United States is the only island in the world that was is going on in China and Asia, what is going on with production declines in the United States despite record drilling, depletion decline curves in the United States and the North Sea and elsewhere, it’s like he’s saying supply and demand…see, his idea is demand only went up 0.6%. Yeah, it only went up 0.6%, but it went up another 1, or 2, or 7 or 8% up in Asia; and the fact is we’re not producing the supply side. It’s not growing as fast as the demand side. And so what he’s doing here, John, is mixing apples with oranges, and avocadoes and bananas. It’s the most bizarre analysis I have ever seen and this from a guy who was supposed to be Harvard educated. [13:49]

HOENIG: You know, I can’t believe you didn’t learn anything about economics, with all due respect, Bill, at Harvard.
O’REILLY: Who me? I’m just going by what Rudy said.
HOENIG: Ask Rudy what his profit margin is.
O’REILLY: I don’t care what Rudy’s profit margin is.
HOENIG: But that’s just the point. [14:02]

JOHN: You know, it’s funny, you said the same thing off the air, Jonathan Hoenig said on the air. “I can’t believe you graduated from Harvard.” You don’t understand this.

JIM: I don’t think he took economics.

JOHN: I don’t know. Basically what he’s saying here is, number one, the oil price should not be affected by the world market, alright. There’s no competition. He said that during this thing. Ok, so there’s no competition for oil, which is not true, you and I both know that. Number two, the oil market in the United States is supposed to be different from the rest of the world.

JIM: And it’s like, “I don’t care, I don’t want to hear about that.”

JOHN: And number three –Jim sit down and prepare yourself for a shock – the oil companies are passing their costs of production onto us. Isn’t that criminal?

JIM: Imagine that. For example, if News Corporation which makes the same profit margin, by the way, as Exxon does. And, by the way, News Corporation’s sales have gone from 15 billion to 24 billion on their way to 30 billion, and they’re raising their costs to their locals by almost 2 and 3 fold, because of their ratings. So, they’re raising prices. And throughout it all, when they were making 17 billion in sales their profit margins have remained somewhere in the neighborhood of 9 to 10%.

So, let’s put that aside for a moment, but if for example, Fox News had to pay anchors like Bill O’Reilly higher pay because of the ratings of his show, if they had to pay more for labor costs, for the studio people, for the reporters, the news team that they had out in the field, what do you think they would be doing to their customers? Would they be raising costs or would they be absorbing costs? In most cases, when you have a demand for your product, you’re going to raise the prices, you’re going to pass those on. And for some reason, in O’Reilly’s thinking, that’s Ok for companies like Newscorp, or other companies in different industries to do that, but it’s not Ok for Exxon if they have to import a good majority of oil for their refineries and pay world market prices, it’s not Ok for them to pass those costs on. [16:19]

JOHN: Yeah, but his argument would be you don’t have to turn your television on, but you do have to buy gasoline to get to work. That’s the argument.

JIM: The reality is he’s basically saying we in the United States should be special, we should not be subject to world market prices. Never mind, as you notice as he brushes these people off, that world market prices are $74: “I don’t want to hear about that, all I want to hear about is demand isn’t up that much hear in the United States.” Forget the fact that we have to compete with China, India, Latin America and other parts of the world for the world’s remaining oil reserves. And the most ridiculous thing is Rudy, he’s basically saying, they’re shipping oil to Rudy at his gas station, yes, the price is going to change every month depending on what Exxon had to buy in the spot market.

Let’s say a tanker from the Middle East leaves the Persian Gulf, goes all the way across the Atlantic, or the Pacific, whichever route they’re taking, or where they’re unloading their oil, they unload that oil at a refinery, the shipping company’s going to make a profit, because it costs them money to ship that oil to us. And then the refinery is going to take that oil whatever month they get it in, if they’re running gasoline now, and they’re taking all the oil they’re getting and turning it into gasoline finished product to meet Summer driving demand. They’re paying $74, what do you think they’re going to [do]? Pass it on to the local station. Are they going to say, “well, prices were lower a year ago, we’ll give you last year’s prices.” I hate to tell Bill O’Reilly but that’s not the way the world’s oil markets work, or the way the marketplace itself works. [17:59]

JOHN: The problem we have right now is that’s what everybody believes though, in other words that’s what the media’s thumping. We’ve heard it in testimony before Congress this week. It came pouring out. And as long as we do, my general assessment of everything right now is the US is a country in the process of committing economic suicide, just not only this factor but other things, we’ve talked about here on the show. We’re going in exactly the opposite direction of where we need to go.

JIM: Yes, every place else they’re building wind terminals. We heard earlier in the first hour from Joe Duarte, Texas is building windmills right off their shores where most of the wind comes. You can’t do that in California by the way, which is one of the reasons we’re having rolling blackouts. Our local utility had to build their natural gas power plant down in Ensenada, Mexico; and they had to build an LNG terminal there because they couldn’t get environmental permits to build it here in California.

And the most surprising thing, and this goes back to something BusinessWeek talked about in a cover issue about 3 or 4 weeks ago, is the international oil companies only account for 15 to 16% of the worlds oil production. According to O’Reilly –in his thinking he’s going back 50 to 60 years, which just goes to show you how ignorant this man is – but he’s basically saying the companies that produce only 15% of the world’s oil production are dictating prices to the countries that produce 85% of the world’s oil; and that somehow, the fact that the United States has to import 62% of its oil from Kuwait, Venezuela, Mexico, Canada, Nigeria, Saudi Arabia and other parts of the world has no relevance to what we pay in prices today. You know, I always thought you had to have high IQ to get into Harvard. [19:46]

JOHN: Maybe it tells us about the state of the educational system today.

I will tell you what happens though to be honest with you, Jim. Interestingly enough what I have discovered, especially watching my own kids’ careers is that the general education that you have in college now is not what it used to be. And so it is possible to have passed through college and avoided a whole series of types of courses, whereas before a well-rounded education was the goal. Now, it’s much more specialized and specific. So, maybe what you’re saying is more an indictment of our college situation here, than it is of anything else.

Ok, profits are the whole issue O’Reilly hammers on. Let’s give people some ammo, Jim, that they can deal with. Some facts on how this whole thing works.

JIM: Well, let’s take a look at Exxon’s earnings. First of all, revenues were up 12% in the quarter to $99 billion. Now remember, oil prices are up 58%. If the world market price of what it is you sell has gone up 58%, one would expect that the revenues that you get from selling that product are going to go up, and that’s what happened, revenues were up 12% to 99 [billion]. Exxon’s profit is the same. It’s the 10% profit margin, 9%...Exxon’s profits if you take a look – go to Value Line and you can take a look at 16 years of profit margins for Exxon, they’ve always been 9 or 10% of whatever their sales are. Yes, the price of oil is up 58%, but Exxon’s cost of finding that oil have tripled, and that’s not just for Exxon, that’s happening for other oil companies around the globe but their profit margin was 10% of sales. And that’s consistent with historical norms for what’s going on in the oil industry.

The fact that their profits weren’t up 58% tells me that Exxon’s costs are going up substantially just like other companies; just as we talked about in the Morgan segment – the price of gold is up but the profit margins for gold companies aren’t up as much as the price of gold because the cost of extracting gold out of the ground costs a lot more today; just as today, it costs a lot more for oil companies to get oil out of the ground. So, sales are up. Exxon is making a 10% profit margin. Now, if Exxon’s profit margins went from their historical norms – of 9 to 10% - to let’s say 20%, then you could say, yeah, their profit margins have doubled here, they’re doing something here in terms of marking up their product, and then I think O’Reilly may have a case – he doesn’t have a case.

And the other thing, each one of these companies whether it was Exxon – Exxon-Mobil is stepping up their exploration, they’re going to spend $20 billion this year in exploration – a record amount; Conoco-Phillips is going to spend $18 billion in exploration. And one reason that Exxon’s revenues are up, and profits were up, is they increased their production in the second quarter, as a result of investments that they made in West Africa, around Nigeria and other places. So, these investments, these tens, twenties, if not hundreds of billions of dollars, that they’re spending to try to maintain production and increase it, that’s the result of all these investments that they’re making. They’re doing exactly what they should be doing as revenues go up, and profits go up, they’re investing more of that to bring on more supply. Something that O’Reilly doesn’t recognize. [23:29]

JOHN: One of the other things I’ve noticed is that at the end he always gives his guest the last word but whenever it comes up to the subject – I’ll show you what happened here, Jim.

O’REILLY: I’ll give you the last word, but I’m not buying, I’m not buying it at all. Go.
HOENIG: Well, amazingly, Bill, most people wouldn’t agree with you. They’re griping about oil, but they’re still buying it, Bill. And you know what…
O’REILLY: They have to buy it, Jonathan! They have to!
HOENIG: Why don’t they carpool. Why don’t they take public transportation. Why don’t they get a smaller car. You can’t b***h about the price of oil after you’ve bought that Hummer, Bill. I just don’t buy that…
O’REILLY: I don’t have a Hummer, and I agree with you – conservation. We should all… [24:01]

JOHN: Notice that he didn’t give him the last word.

JIM: No, when it comes to this particular issue with oil, when anybody challenges his faulty thinking he interrupts them. He does exactly for example what Chris Matthews does on Hardball. Whenever Chris asks a leading question and he doesn’t get the answer he’s looking for, what he does is he talks over, and he out shouts his guest, which is what O’Reilly is doing here. So, I’m sorry, Bill, the ‘no spin zone’ doesn’t stop here, you are spinning the oil issue. The profit margins on Exxon at around 10% are the same when oil was selling at 20, when oil was selling at 30, when oil was selling at 40, 50, as oil is selling today at over 70. Those are facts, and you don’t have to take my word for it, just go to the local library, pick up a copy of Value Line, look in ‘international oils;’ look at the profit margins for Exxon, look at them for Chevron, look at them for Conoco-Phillips. It’s like his standard response is it doesn’t matter what demand for oil is outside the United States. He never addresses the supply issue. He never addresses the fact that we are importing more of the stuff from the rest of the world. [25:22]

JOHN: Alright, Jim, if we had to describe the world of oil according to O’Reilly, how does it work? Sum it up.

JIM: Ok. Bill O’Reilly’s arguments demand and supply doesn’t matter. Secondly, oil company profit margins should be different and lower than other companies. Thirdly, oil companies should sell us their oil below market prices. Fourthly, the United States should be treated differently than other countries in the world. In other words, we should not have to pay market prices, and it doesn’t matter that if demand is rising faster elsewhere in the world, since demand is not rising as fast in the United States, we should pay a lower oil price. And that’s economics 101, according to Bill O’Reilly, supposedly a Harvard educated man. [26:09]

JOHN: Well, Jim, I hate to say this now, but you should have heard what went on the floor of the US Senate this week in terms of …

JIM: Don’t tell me. It’s worse.

JOHN: Well, I won’t tell you that, just listen for yourself here.

Stuck on Stupid (SOS)Award

Well, Senator Richard Durbin of Illinois wants to have an energy policy because, my Gosh, we’re dependent on these foreign oil sources.

SEN. DURBIN: Looking at the national energy picture, and moving us toward breaking our dependence on foreign sources of energy. We’re doing business with countries around the world, buying their oil, and gas, and these countries are virtually our sworn enemies. There are many countries in the world that we send billions of dollars to as we buy their oil and gas that turn around and use the money that we send against us in the war on terrorism. That is as horrifying as I could think of at the moment.

You know, you’re right, Senator. So what say we start drilling here on our own property?

SEN. DURBIN: Whether or not the United States should now start drilling for oil and gas in the Arctic National Wildlife Refuge. The House and the Senate have rejected that idea on a bipartisan basis. Their belief, which I share, is that we have reached a rather desperate moment in American history if the only way we can look forward in terms of energy self-sufficiency is to start drilling in some of the most environmentally sensitive places in America. And that’s why I have opposed drilling in ANWR in Alaska. [27:57]

Let me see if I understand this. We’re desperate because we’re reliant on foreign sources, but we’re not that desperate because we don’t want to develop it any where we have it to develop – off any shores, any where, any how.

I don’t think this energy policy is going to work. Why don’t you call us when you think of something better?

You’re stuck on stupid.

By the time he got done speaking you went, “what did he just say, he contradicted himself.” Hey, I will say one thing thought that really came out during the course of this whole thing, and that is one of the arguments that we constantly hear – this is Senator John Cornyn again on cutting back. You hear this touted a lot that we need to cut back on our use of energy and there’s nothing wrong with being prudent about that, but it’s always touted as being the solution to our energy problem.

SEN. CORNYN: My colleague from Illinois, the distinguished Democratic Whip, also said, “well, the answer is not to open up places like ANWR, it’s to pass mandates from Washington on more fuel efficient vehicles.

See basically, that’s the argument right now, we’re not drilling, we’re not exploring, we’re not allowing LNG terminals – we’re not, we’re not, we’re not…Oh, by the way, cut back on what you’re using. And that’s only a part of it anyway, besides that. So that’s very unrealistic. Even the alternative sources, Jim, as you well know, you can’t run your car on a windmill, can you? [29:18]

JIM: No, if you take simple economics 101, there’s two sides to that debate. There’s the supply side and the demand side. So what they’re saying is, “we’re going to concentrate on the demand side, and we’re going to do everything to stop the increase of supply.” It doesn’t make sense. [29:34]

JOHN: It doesn’t make any sense. Basically, you can’t cut back like that, it’s not going to happen. You can’t, over night, suddenly say, “stop using all the oil.” It will not work. This transition time is going to take 10, 20, 30, 40 years and it will not happen instantly. So we have to do something in the meanwhile.

JIM: And the thing that we’re not doing is doing anything to increase the supply. I mean we’re experiencing rolling blackouts in California, but we’re doing nothing to put – let’s say, with all the wind that we get as a result of our long coastline – windmills out along the coast; we’re not building nuclear power plants; we’re not building pipelines to get more natural gas into the State to supply our existing peak generators, or power plants to run on natural gas. And anybody that wants to build anything like that can’t do so.

There are 6 proposals to bring LNG terminals here to California. Every one of them has been stopped as a result of environmental lawsuits. And as I say, tragically, our own utility locally here had to go to Mexico to get power permits. And here’s the thing that we talk about, that we’re committing economic suicide – as other countries, whether it’s France, it’s Europe, it’s China, it’s India, it’s Latin America, it’s Canada, they’re talking about building nuclear power plants, building windmills to generate electricity.

But here’s the problem, transportation runs on oil. Period. And yes it might some sense to start putting in mass transit systems to relieve freeway congestion; yes it might make sense to build more fuel efficient cars. But you know what is going to cause that, John? It’s going to be the marketplace; it’s going to be when gasoline prices go from – they’ve gone from 2.50 now, to 3.50, wait till they go to 4.50, or $5, or $6, then what you’re going to see consumers do is react to the mechanism of the marketplace. And I guarantee you the next time the lease comes due for the Hummer, they’re not going to be getting another Hummer; they’re going to be getting a more fuel efficient car. But, once again, 3 years worth of price increases and demand still goes on unabated. It did not decline in the United States, and yet we’re doing nothing to handle the supply, so – we’ve got a problem here, Houston. [31:54]

Soft Landing or Has the car gone off the cliff?

SEN. CLINTON: A lot of Americans can’t work any harder, borrow any more, or save any less. And those same costs of health care, retirement, transportation, energy are impacting our businesses as well. It’s time for a new direction: 5 years we have lived with deficits, this agenda will help bring back fiscal responsibility.

JOHN: That was Senator Hillary Clinton from New York, Jim, speaking this week at a private speech, and she’s keyed the first part correctly – I’m not sure the second part is a realistic appraisal given how bad the deficit is, but she does reflect the problem that the Fed has. We seem to be stuck between – well, an old sailing term, Scylla and Charybdis. Remember that? The Straits of Messina between Sicily and Italy. They can’t go one way, they can’t go the other, and everyone is beginning to feel the pinch as the Fed has been tightening everything up. So the real big question, right now, are we experiencing a soft landing or have we just yelled, “Geronimo,” and gone off the cliff.

JIM: You know, John, it is amazing what a difference a quarter makes. I mean if you take a look at the GDP numbers reported on Friday, growth has gone from 5.6% in the first quarter to just barely below 2 ½%. And one of the reasons for that slowdown is a dramatic shift in consumer spending. The downturn in consumer spending is accelerating. And why is that? Number one, the savings rate has been negative, so there is no cushion for consumers to offset what it is they’re receiving in income; wages have not kept pace with inflation. And that was Ok, as long as the price of the family castle was going up, and you can extract equity out of the family castle, and then refinance at a lower payment. So, that was the fuel that was sort of feeding this consumption, or increase in consumption, that we’ve seen in the last 3 years. That’s because one of the unusual characteristics about this economic recovery from the 2001 recession is that the consumer accounted for 80% of GDP growth the last 3 years.

Today’s dramatic slowdown is showing the accelerating impact of all those 17 rate hikes, meaning that anybody that got an adjustable rate mortgage in 2003 is seeing their mortgage probably adjust this year; there’ll be even more mortgages adjusted according to the National Association of Mortgage Brokers. The average family has seen their house payment go up by $400. And John, you know we’re dealing with $3.50 gasoline. So gasoline costs have gone up, interest rate costs have gone up, the cost of food, inflation rates are up, so the cost of living is going up for consumers while labor wages are falling further behind the rate of inflation. [36:08]

JOHN: But I’m taking great consolation in the fact that the core rate is very low, Jim. I did a ‘Puplava’ this week. I was at the supermarket, and she’s ringing it up, and I said, “could I have the core rate please?”

JIM: And did she look at you cross-eyed?

JOHN: Yes, she did. I said, “do you know what that is?”

“No, I don’t.”

But, as my wife and I were walking through the supermarket, it’s real obvious that prices are just skyrocketing.

JIM: Yeah, you hear this constantly referred to when the financial media, the political media, the core rate. It’s a rate that doesn’t apply to anybody that lives within the United States. And yet it’s used so widely in the financial press that any kind of number they always refer to the core rate. So let’s refer to a number on inflation that doesn’t apply to anybody who lives in the country.

JOHN: Doesn’t apply to this planet.

JIM: I mean, yeah, it’s just ridiculous.

JOHN: But getting back to some numbers that maybe should be attracting our attention, the GDP data that came out on Friday, boy, that would seem like a real red flag to the Fed to me.

JIM: Yeah, I think the GDP numbers that came out to the Fed, number one it was far below what the Fed is forecasting, because remember, well, you’ve got to take the Fed’s forecast in two parts. There’s the public pronouncements that the Fed officials give, and they always talk strong GDP growth, 3% plus, 3.2, 3.3 for the balance of the year. We’re already at 2 ½, so the number’s much lower than what the Fed is saying publicly.

Secondarily, internally the Fed forecasters are forecasting much, much lower numbers than what the Fed is saying publicly. So, these are numbers are confirming that. And this is the first time since the recession of 1991, that we’ve seen home construction, consumer spending on durable goods, corporate purchases of equipment, have all declined in the same quarter. In addition, there are huge inventories that are rising at the same time, so what we’re seeing, what the markets are telling us now, is that the bond futures pit is signaling a pause after today’s GDP report; and also, following an anemic beige book report that was published by the Fed earlier in the week. Just to give you an idea how dramatically things have changed in one week –and that’s really what a difference a week makes – the Fed futures have taken the probability from a 90% increase that the Fed will raise interest rates in August, down to a 28% probability that they will go in August. Already, the two year note, and the 10 year Treasury note is below 5%.

And on top of that, we have to also go in to one of the accompanying minutes of today’s release, is that the government went back and revised all the GDP numbers going back to the first quarter of 2003. And GDP growth was only 3.2% instead of the reported 3 ½%. So they took it down by 0.3%. [39:17]

JOHN: Last week when Benjamin Bernanke was busy sitting and squirming in the seat there, and he was asked about this very same issue, he said we had offsets in the area of business spending. So, how do you react to that?

JIM: That’s not what the numbers are showing. Business spending rose at an annual rate of 2.7%, in the second quarter. That’s down from almost a 14% rate of increase in the first quarter. And spending on equipment and software actually fell 1% during the quarter. So if there’s any offsets it isn’t there, because business spending has fallen off the cliff. About the only area that you’re seeing real strong capital spending is in the energy sector where you have, for example, this week, Exxon and Conoco-Phillips between them, announcing that they’re going to increase capital spending by almost $40 billion. And that’s just with two oil companies alone. [40:18]

JOHN: Ok, here we have the numbers and they’re warning. What do you think’s up next on the horizon?

JIM: Unless interest rates can dramatically turn around, and I’m talking about like the 10 year note get down to 4 ½, 4 ¼, and the Fed begins to lower sometime by the time we get into the fourth quarter, the problems are going to get worse. That’s because we still have oil prices at over $73 a barrel; we still have $2 trillion in adjustable rate mortgages that are due to reset in the next 12 to 18 months. So even if the Fed pauses, and they pause in August, and they don’t raise interest rates for the balance of the year, the economy will continue to slow down. Interest rate costs for most consumers are going to go up as their mortgages are reset. The fact of higher energy prices are working its way through the economy; it’s cutting into profit margins for companies involved in the transportation industry; it’s cutting into mining company profits; it’s cutting into industrial profits. And companies either absorb that, or they have to pass on the cost of you and I the consumer. So a lot of the damage the Fed has done with 17 rate hikes, we are still going to feel that, and we’re going to get to the point of the beginning of the pain that we’ve been talking about. Remember, first the gain, then the pain. And the pain is on its way, and we’re seeing the first signs of that. [41:40]

JOHN: Very much echoing the terms that Senator Clinton did very much at the beginning of this segment here, the consumer is obviously running out of ammo, they’re beginning to circle the wagons, and conserve as the costs are going up. Businesses are not spending. And considering this is what all drives a normal healthy economy, if that’s not happening, why are we not pouring down into a recession?

JIM: Well, John, we’re getting all the classic signs of an approaching recession. First of all, prior to 2001, all prior recessions in the United States over the last century were led by a downturn in housing. So that is what we are seeing right now. And housing is leading this downturn and it’s going to continue to worsen. So we’ve got further to go and there’s going to be more damage done to the housing sector.

Secondly, consumers are cutting back on spending due to higher interest rates, and higher oil prices. The only sector that is in good shape at this point is the business sector. Businesses, corporations are sitting on plenty of cash, they’ve refinanced their debt, so they’ve brought down their interest rate costs. However, John, as we’ve seen in this second quarter, I don’t think that businesses are unlikely to embark on a new capital spending spree. What I think you are going to see is a recovery in the financial markets and that will be the end part of the gain. In other words, with increased cash flow, with the maintenance of current profit margins, you’re going to see companies increase their share of buybacks as we’ve seen. We’re almost at record levels of share buybacks; you’re seeing record buying by corporate insiders of their own stock; you’re seeing increases in dividends. And about the only sector that is expanding robustly, and we’ve been hammering this point on this show, is the healthcare sector and the energy sector.

So, the bottom line is this is looking more like a recession – more and more. And it’s probably back to stagflation. So, in essence, you need to be defensive, you need to change your investment strategy, and we’re going to get to that in the final third segment of the Big Picture. But it’s time next to go to one of our favorite economists, John Williams at www.shadowstats.com.

Other Voices: John Williams, Editor of Shadow Government Statistics

JIM: Well, second quarter retail sales contract by 1.3%; the employment indicators plunge as inflation soars, the Fed President suspects the CPI is understated. Also, there’s very little real deficit improvement. It’s the worst of times, according to many, unfolding for the US equity and credit markets.

Joining me on Other Voices this week is John Williams, he’s editor of Shadow Government Statistics. And John, I want to begin with the Beige Book which came out on Wednesday, the day you and I are talking. Economic growth slowed across the US in the past month, consumer price and wage increases according to the Fed were modest; real estate was slowing down in most all areas. In your newsletter, you’ve been talking about sort of a recession that isn’t being reported, and let’s begin with that.

JOHN WILLIAMS: Well, we started getting signals on the recession –very reliable signals – a little over a year ago. Key leading areas such as the money supply, real weekly earnings, we’re seeing sharp declines there, that though they’ve been in place some time they’ve started to deteriorate sharply coming into what is now an inflationary recession. New orders as a component of the Purchasing Managers Survey plunged a year ago, and it’s a very reliable indicator to what’s happening to the broad economy.

JIM: How about the Help Wanted Index plunging, too.

JOHN WILLIAMS: The Help Wanted Index just recently, the second monthly 2 point plunge, down to 33 which is the lowest level since 1961; that is signaling a recession and just in this last month you’ve had retail sales, which is one of the more widely followed indicators, actually contract on a quarterly basis. If you look at the June numbers adjusted for inflation – and the government understates inflation (I know we’ve talked about that before, and I suspect we’re going to get into that again) but – using the government’s CPI number, deflating the retail sales, which is the way the St. Louis Fed looks at it, the second quarter contracted versus the first quarter. Now, where that’s significant and that’s seasonally adjusted retail sales account for half of personal consumption expenditure in the Gross Domestic Product; personal consumption accounts for 70% of the Gross Domestic Product. So we’re talking about something here which is 35% of the GDP contracting quarter to quarter. Now the first quarter GDP had up around 5.6% annualized growth, that’s an economic boom. Expectations for the second quarter are around 3%, that’ll be reported on Friday, following where we’re talking now on Wednesday. It should be very difficult in reality for the government to come up with 3% growth. It would be very difficult under normal circumstances to come up with positive growth, yet somehow they’re going to come up with growth that’ll be close to if not above consensus.

At the same time, if you take out all the bias factors that have been built into the GDP over the years, what you’d find is indeed not only is the economy contracting on a quarterly basis but also on an annual basis year to year. And it would be classified as a recession under old definitions of two back to back quarterly contractions in the GDP. The problem is the government doesn’t get to name a recession, that’s done by the National Bureau of Economic Research. And they used to use the old definitions of two quarterly contractions in the GDP, so long as there wasn’t anything unusual in the economy like a truckers strike. The problem is the reporting of the GDP got so political that the National Bureau of Economic [Research] backed away from it’s traditional definition, and now looks at subsidiary series like payrolls and industrial production. And when they turn down, then they call a recession. So I still think they’re going to call a recession, but you’re not going to see anything official here until after the elections. [48:19]

JIM: John, one of the things that we’re getting a lot of news in the press, and you’ve talked about it in your July newsletter, is you see the set constantly repeated in the press: conflicting data. In other words, the soft economic numbers and the high inflation numbers are being spun. This is conflicting. I wonder if you might just spend a moment and explain that.

JOHN WILLIAMS: There’s nothing conflicting about it. There’s one set of economic circumstances. These are circumstances that have been seen a lot in past history where inflation and economy tend to run together, that if you have strong economic demand that will tend to push prices higher. And although that may be considered traditional, you do also have circumstances where the economy is strong and inflation is weak; or as we’re seeing now, the economy is weak and inflation is strong. And what we’re seeing is the inflation is not being driven by strong economic demand, but by commodity price distortions, particularly oil.

And I think very shortly we’re also going to see massive selling of the US dollar which will also put upside pressure on inflation, and you have an inflationary recession. Now, under those circumstances, the Fed cannot kill inflation by raising interest rates. It can kill the economy, or further damage the economy, but it can’t kill an inflation that’s not driven by strong economic demand. Again it’s driven by oil cartel policies, political tensions in the Middle East, and the government’s terrible excesses with the deficit that now are running $3 ½ trillion a year, but which are beyond containment, beyond the level where they can sustain any kind of stimulus in the economy because the foreign markets will not be accepting US Treasuries.

You have a problem with the housing market – you raise interest rates, it hurts housing. And that’s another indicator that in this last month has shown a very sharp decline, and is now formally signaling recession as we look at it. Housing starts is a good leading indicator to what’s happening there, and on a year to year basis it’s a very volatile series month to month, but if you use a 3 month moving average, and you look at year to year change that’s now down at a 10% annual rate. And that’s the biggest drop in that since before the last recession. So we have really a situation that is the worst of all worlds for the Fed, it’s the worst of all worlds for the Administration, and it’s the worst of all worlds for the financial markets. You’ve got inflation and recession, and there’s nothing anybody can do about it. [51:07]

JIM: One of the things that is commonly referred to is that liquidity has been drying up, the Fed has been removing liquidity, but the last time if you looked at the high-powered money as reported in M3, it was growing at over 8%, before they stopped reporting it.

JOHN WILLIAMS: Yes, I figured that’s up more in the 9 to 10% range – they haven’t tightened. I mean to say that the Fed is tightening is a misnomer, it’s a fraud. The Fed is playing the markets; they’re trying to prevent a financial crash. If they think they can keep the dollar strong by raising rates they’re going to continue to raise rates. They’re playing to the markets, there’s nothing they can do in policy that’s going to have long term impact. Nothing that’s eventually going to save the markets, but they can buy some time. So they talk up whatever the markets want to hear moment to moment – fighting inflation. Yeah, right. [52:02]

JIM: The one thing that concerns me, John, is a couple of years ago the Fed used to report in its semi-annual hearings before Congress their target rates for non-financial debt and financial debt – they no longer do that.

JOHN WILLIAMS: Right.

JIM: When it came to the hedonic adjustments that they would adjust the GDP figures they no longer report how they come up with those numbers, so you can’t validate that; they don’t report M3; there’s talk about the CFTC removing the Commitment of Traders Report. It seems like the information that you would want to get to tell you what is really going on in the economy, what is really going on with inflation, they’re removing more and more of the key information that analysts or investors rely on to tell them what’s really going on in the markets. Does that disturb you?

JOHN WILLIAMS: Very much so. And it’s very deliberate. And the reason they doing it is they don’t want people to know what’s going on! Because it’s really bad news, and it’s nothing they can do about it. When they’re in such a circumstance they have nothing to gain by having people understand, or have it reported. We’re on the brink on a national bankruptcy. There’s a fellow by the name of Kotlikoff who…

JIM: Laurence Kotlikoff.

JOHN WILLIAMS: …just in the last month had an article published in the St. Louis Fed Quarterly saying, “Gee, the United States government is bankrupt.” And the New York Times picked up on it this last weekend. We’ve been talking about this for some time the two of us back and forth; we publish on our website if anyone’s interested in looking at it – regular analysis – when the US Treasury publishes financial statements on the US government as though the US government were a corporation, and is prepared using Generally Accepted Accounting Principles it shows that the nation is bankrupt. It shows us with a negative net worth of over $50 trillion. It shows the deficit in terms of what our government is obligating us to pay, and not funding over time, all brought into today’s dollars, it shows the actual deficit of $3 ½ trillion per year. And putting that in perspective, if anyone wanted to let’s say correct that by raising taxes, they could raise taxes to 100% on everybody’s wages and salaries, and they’d still have a deficit. It’s beyond control. The nation’s bankrupt.

Now, foreign central banks know this. The only reason that interest rates and the markets have the liquidity that they have – long term interest rates in particular – are relatively so low, although they’re well above where they have been, they’re beginning to move a little higher, is that foreign investors who have been sitting on a lot of dollars that have been thrown into the markets by our trade deficits are buying US securities. And for the last two years, the amount of foreign buying of our US Treasuries has offset the net issuance by the Federal government. The foreigners have taken effectively all the net issuance. They’ve also absorbed half the new issuance of the corporate bond market, so that it has kept our system reasonably stable; we’ve been able to borrow beyond our means. But all of a sudden that’s going to stop and it has all of a sudden started to slow in terms of bank foreign participation. The reason the foreigners are not going to do is because they know they’re going to lose money on the dollar –the central banks do – and as they start to flee the dollar it’s a question of which one goes first. I’m betting on China. One starts to go you’re going to see a flood, a dumping of the dollar, a dumping of dollar assets. The result is you get a spike in US interest rates – no one wants to hold US Treasuries; you’ll see a massive decline in equity prices. Gold will be a good hedge under that type of environment.

But rather than let the system fail at least initially, and this is where the Fed is beginning to play its games. You’ll see the Fed come in and they’ll monetize the debt. They’ll buy up those US securities to keep the system liquid. That’s what they’ve been doing – they say they’re tightening but that M3 growth is still way up there. But they’re not tightening. They’re forcing short term rates high, but they’re still putting plenty of liquidity into the system. And as they monetize the debt, you’re going to see well beyond the oil inflation pressures and the dollar inflation pressures you’re going to see a monetization of the debt. And you’re going to have a very strong monetary inflation that likely –I don’t see how we can avoid it – is going to turn into a hyperinflation much as you had in Germany in the 1920s. A 100,000 Mark note was worth more as toilet paper than as currency. Where you could go into a restaurant one night and buy a very expensive bottle of wine, and the next morning that empty bottle would be worth more as scrap glass than it was the night before as a full bottle of wine. That’s the type of inflation that we’re heading for. It’s not immediate; this may be a couple of years down the road, but it’s the type of thing that will come quickly with very little warning. I mean it could be in the next month. I don’t think it’s going to be the next month, but I don’t think it’s going to be more than 5 years off. So in a circumstance like that, you want to be holding gold or other real assets. You don’t want to be holding onto dollars, you don’t want to be in US Treasuries. [57:48]

JIM: John, one of the points that are coming out now with the economy slowing down, people are talking in the financial community about deflation. And if we define deflation as a contracting supply of money, I haven’t seen it globally to date. I get the Economist every week, I look in the back section, and the money supply growth around the globe whether Europe, Japan, China or elsewhere – I don’t see any contraction of money supply.

JOHN WILLIAMS: That’s a canard that our good friend Mr. Greenspan started. If you’re afraid of deflation and you can start a scare there, guess what the cure is? The Fed starts monetizing debt. So here’s an excuse for monetizing debt: “oh my goodness, we’re preventing deflation. Hey, you don’t have to worry about inflation because it’s not showing up in the numbers.” Well, of course it’s not showing up in the numbers, they’re rigging the inflation reporting. And if you look at what the Fed does they go for absolutely the lowest common denominator for inflation that they can find: they go to core inflation without food and energy; and then they’ll take it out of the personal consumption expenditure component of the GDP where if people can’t afford to buy steak they’re going to buy hamburger, if they can’t afford to buy hamburger, they’re going to buy dog food. And when you start working your inflation based on that you don’t report any. It’s not an actual measure of anyone’s cost of living, but the financial market look at it the Fed has been trying to sell that as a concept: “look at how low inflation is, it’s contained.” I’m not hearing too much talk of deflation, but that does come up and people do cite that as a risk. The answer to deflation is you inflate, you monetize the debt. I wouldn’t be surprised if you see a lot more talk of deflation as they’re starting to do that, because it buys them a little time, but there’s no risk of deflation out there whatsoever. [59:40]

JIM: Well, John, unfortunately we’ve run out of time, but what would you tell somebody who is maybe somewhat confused, you know, they go to the gas station and they fill their car, and they’re spending $15 more a week on gas, they go to the grocery store they see almost every week their grocery bills going up, they go to their dentist, their doctor, they buy books or clothes for the kids to go back to school, tuition, and then they turn on the TV and then you hear talk of inflation rate of 2%? I think people are saying, “you know, something isn’t right here, I’m not sure what it is.”

JOHN WILLIAMS: Most people know that there’s something wrong with the numbers. Believe your instincts, believe your common experience over what the government tells you. I’d be surprised if most people don’t already do that. Anyone I talk to at random on this, I say, “oh, you know, they’re fudging the inflation numbers.” The response I get back is, “of course they are.” Most people understand this. Don’t rely on what the government’s telling on inflation, particularly in an election year, particularly running counter to your personal experience. You know what’s going on. There are ways of protecting yourself. Jim, I know you help people in that area, and if you want to understand some of what’s going on with the numbers you’re most welcome to go to our website. We do have some articles which describe the background to the CPI reporting, the employment reporting, and the GDP reporting, as well as a number of publicly available earlier newsletters that go on in further detail on some of those issues. Our website is www.shadowstats.com. Again, we welcome anyone who wants to look at the material. [1:01:23]

JIM: You know, John, that’s the one thing I appreciate about your website. I know you have a newsletter that our listeners could get more information about as you report these real details each month, but you also have an education portion on your site which gets into how these numbers are manipulated, and you also cover the old CPI index, and they can see just a graph on your front page between the real CPI the way it used to be reported and what we’re getting currently in the press. You do a real great service my friend.

JOHN WILLIAMS: Thank you.

JIM: John, as always it’s a pleasure to have you on the program, and I hope you’ll come back and talk to us again and keep us posted.

JOHN WILLIAMS: I sure will, and thank you for having me, Jim. [1:02:03]

Should you be a bull or a bear? Three reasons to remain bullish

JOHN: Now we come to the very important question for everybody who’s an investor out there. Should you be a bull or a bear? Well, I guess there is no all of the above to this. Maybe 3 reason to be less bearish – we’ll look at that, anyway.

Bull or bear? Which way do we go?

JIM: I think this is going to sound surprising but as we’ve been talking about over the weeks, [there has been] the transformation of the US economy from a manufacturing economy to a service economy to the financial economy. And whenever the Fed creates money they flood the banking system or create more money and credit. Where is the first place that money goes? In a financial economy, it’s going to go into the financial markets. So when new money or new credit is added, it has a tendency to go into some market. It could be stocks, bonds, mortgages, real estate, and you get an asset bubble. And what I think you’re going to see here is as interest rates start to come down, and that’s what we’re seeing now, interest rates in this country whether you’re looking at two year treasury notes, 10 year Treasury notes, or the 30 year bond, peaked on June 28th. Since that time, the two year Treasury note has come down from almost 5.3%. it closed out Friday at around 4.98%. So interest rates have come below 5%.

You’ve seen the 10 year Treasury note come down to just slightly below 5% at 4.99. And that’s a real key interest rate to watch because a lot of home mortgages are tied to the rate on the 10 year Treasury note. So as Treasury notes start to come down, you should start to see some of the pressure taken off the mortgage markets and you should see fixed rate mortgages start to come down. And if the Fed goes on pause, perhaps you may see even some pullback on variable rate mortgages.

So, three reasons in my opinion right now to be less bearish on stocks is: interest rates are starting to come down; with a cutback on spending by consumers, and an increase in the buildup of inventories, not just here in the United States but also in Asia, you’re going to see price mark downs on goods. I don’t care if it’s camcorders, computers. We just bought, for example, three computers for the office as we’re going to have to upgrade our web servers here because the amount of traffic to the radio show and the internet site is causing break downs, so we’re going to have to upgrade servers. But we got three computers for the price of two. So basically we bought two computers at a lower price from Dell and they threw in the third one for free. [1:04:48]

JOHN: Obviously anxious to sell.

JIM: Yes, because they’ve got a lot of inventory. So that’s going to take some of the inflationary price pressure’s that you see in goods. That’s not going to stop an increase in inflation because the money supply is still growing; but the things we count as inflation, which is an increase in price, the markets will react to that. The third reason I think to be less bearish is corporate earnings are still doing very well. One of the sacred tenets in economics – whether you’re looking at the stock market, or you’re looking at the economy itself – is something we refer to as mean reversion. So everybody admits that profit levels have probably peaked. They can’t stay this high indefinitely because in order to stay at these levels that would imply the corporate sector gets more and more of the benefits of Gross Domestic Product, at the expense of let’s say employee share of income. And if that was to continue you would see more wage demands; you already here talk, for example, in Congress, here in the State of California and other states, to raise the minimum wage. And so there’s a backlash to this.

So the three main reasons right now are: interest rates are starting to come down, that’s going to relieve some of the pressure because the stock market is a discounting mechanism; second, with the build up of inventory and also the economy weakening you’re going to see price pressure on manufactured goods, so that should relieve some of the inflationary pressures in the pipeline; and third, even though corporate earnings have peaked, they’re still going to be at above normal rates because corporate profits as a percentage of the corporate world have not peaked yet. [1:06:42]

JOHN: What happens if profits mean revert? Wouldn’t that be negative though for stocks?

JIM: On the surface, logically that would seem to apply. In other words, if profits go down therefore stock prices go down. But John, that is not what has happened over the last half century. We’ve had about 9 recessions since 1950, and every one of these recessions we’ve seen profits peak and then they mean revert then they fall back to a normal level, but the average gain for stocks – now ,here’s the interesting part about this – has been about 10% gains in the market, that’s the average, but we’ve seen gains as high as 19%, and as high as 30% in profits following a peak in profits. And this all happens within a two to three year period.

One of the most interesting lessons, at least for me in this business, was to see this unfold, because in 1994, the Fed doubled the Federal Funds rate – they raised it from 3 to 6% in a single year. And corporate profits that year were up about 40%. However the stock market did terribly that year. It was only up a couple of percent, and it came in towards the end of the year, but you would have thought with the jump in profits that stock prices would have gone along with profits. The following year, in 1995, when the Fed went on pause and actually started to lower what you had is profits were up only 20%, but surprisingly the stock market did much better.

So what happens in these periods is that as interest rates come down liquidity comes back into the economy, because the economy starts to slow down, the Fed takes its foot off the brakes, and starts to inject money and liquidity into the economy. And as a result you see interest rates fall and in almost every one of these 9 periods I was talking about since 1950, all but 2 of these periods, the PE ratio expanded on stocks. Even though profits were lower, the PE multiple went up.

A good example is in 1984, the Fed went on pause in August of that year, they were raising earlier in the year and the stock market gains within the next six months were 10% gains for the stock market, and almost 14% gains in the next 12 months. In May 1989 the Fed stopped raising interest rates, the stock market was up 12% in 3 months and was up 12% within 12 months. Now, there was one negative period and that was in September of 1987 and stocks were down 21% – everybody remembers the October crash of 1987. But going back to this period I was telling you about, in 1995 after the Fed lasted raised interest rates in February of 1995 –remember they were raising it all through 1994 – within 3 months of them stopping raising interest rates in February the stock market was up 9%, within 6 months the stock market was up 19%; and within 12 months, the stock market was up 35%.

Now, we had a little bit of a different problem in May of the year 2000. The stock market was up in the first 3 month period, but it was down in 12 months and of course that was a little bit unusual because we had a recession, number one, and we also had the events of 9/11. [1:10:11]

JOHN: So I think what we’re saying here is that interest rates are playing a more primary role in what happens to stock prices as opposed to earnings.

JIM: Sure, because PE multiple expansions or contractions are very cyclical for the stock market. And interest rates are the main factor causing these expansions and contractions in price earnings multiples. Because what happens in the business, John, is whether you’re an analyst or you’re a company making a merger or taking over another company, you’re going to say, “OK, what is the business revenues or the cash flow of this business?” And then what you’re going to do is take that cash flow or earnings over a 5 or 10 year period, and then you’re going to discount them back to present value using some kind of discounting mechanism – meaning interest rates. And also, you’re going to take into [consideration] what we call risk premiums. In other words, well, Ok, if there’s three things that are going to go into the discount interest rate that you’re going to use on those cash flows: one is going to be the prevailing interest rates; two is going to be the risk premium that’s perceived in the market – are we in a period of high risk or low risk, the higher the risk the higher the discounting mechanism; and then also the higher the inflation rate. So today we’ve seen interest rates go up the last 2 ½ years. So the general level of interest rates used to discount is higher. Second, we’re getting more volatility in the markets so the perception is risk premiums are expanding again so you go for a higher discount rate. And thirdly, the level of inflation that has gone up. So you’re using overall a higher discounting mechanism on future earnings. And that obviously impacts the Price-Earnings multiple or what you’re willing to pay for earnings. [1:12:00]

JOHN: So basically what we’re saying here Jim, anyway, it’s obvious interest rates are more likely to go down as the economy weakens because the Fed is certainly not going to take them up – not if that’s happening.

JIM: Sure. And I would suspect, John, especially with the GDP numbers they announced here on Friday, that the emphasis and attention in the market is going to shift away from the inflationary hawkish fears of May, and where we were in June, and now they’re going to be focusing in on an economic slowdown. That’s going to be translating into the Fed going on pause; it’s going to translate into lower interest rates in the bond market – we’re starting to see that – already the futures market, futures traders are already taking down the probabilities of interest rate hikes. And I think the emphasis is going to be shifted to an economic slowdown and talk about lowering of interest rates. [1:12:55]

JOHN: And summing up, if you were an investor obviously what should we be doing.

JIM: Same thing that we’ve been telling people since the beginning of the year. You still want to stay long energy, remember when we were going through the energy correction, I told everybody we were going to see record blow out profits as a result of where oil prices remained above $70 a barrel for the entire quarter. As the price of energy remains stubbornly high, or we’re just a couple of headlines away from maybe even $85 to $100 oil, you’re going to want to stay in alternative forms of energy. I think also as the economy slows down you’re going to want to be in consumer staples; and healthcare. And especially the international companies, because international companies do very well at times the dollar starts to decline. The international companies do not do as well in a period of rising US dollar. So a weakening US dollar is good for international companies, good for consumer staples.

Also, I think the healthcare industry is turning around – that’s where you’re seeing a lot of spending, you’re having increased demand from an aging population. It’s also in that consumer staple area that safety, defense area. I think you also have to be in the precious metals sector with everything that’s going on – supply and demand conditions – the fundamental demand, the increased investment demand coming in for the metals. And then finally if you want something to trade play the bond market and maybe be into intermediate term Treasuries. [1:14:21]

Emails and Q-Calls

JOHN: And indeed my favorite part of the program is to hear from the people who listen to us – although, Jim, I can’t imagine why anyone would be insane enough to do that, but nevertheless they do, and they actually phone in. Don’t forget, our phone in number for our Q-Line which we’re going to hear is 800 794-6480. It is toll-free in the US and Canada only, but it does work for the entire world. It’s just that if you call from somewhere else you have to pay for it. So, here we go.

Hi, this is Norman from the Barry Quarter. And my question is how far more on the down side do you see the dollar going. I think it’s going to get dropped down to where the Iraqi dinar is. What’s your opinion? No, no I think the Iraqi’s will be worth more. Thanks.

JIM: You know, Norman, you’ve got to stop thinking dollar you got to think amigo. You know, what’s the amigo going to look like. I think the key level is to watch a breakdown below the technical level of 80 on the dollar index. And I think you could see 60 in a breakdown and then I think there would be some kind of measure to hold it. God knows what happens when the whole system breaks down, but then hopefully it’s time for the amigo by then, because we’re going to need to rescue. We just have too much rising debt levels in the United States and everything is unbalanced. But look for it to break the 80 level and an intermediate term stop at 60. [1:15:50]

JOHN: Kanji is in Redondo Beach, CA:

Jim, in your recent interview with Jeffrey Christian, he stated 80% of Saudi Arabia has not been explored for oil. This statement does not pass my ‘smell’ test. Saudi Aramco expects an 8% production decline. Jeff Christian is in a position to influence people with large investment accounts. No wonder oil stocks are selling at low prices since experts like Mr. Christian are telling clients lower oil prices are around the corner. My question to you is do you know if his statement is true? Or is he just repeating his company’s disinformation. During the interview you didn’t ask for the source of his info.

I think Mr. Christian is incorrect in that. I would go more with what Matt Simmons has written about. You know, you take the last 30 years, they’ve been poking holes everywhere they can in Saudi Arabia. There’s only about maybe 10 to 15% of the world that hasn’t been explored for oil. And much of that is in regions of deep water and Antarctica. And so they’ve been poking holes all over Saudi Arabia. Probably one of the areas that is probably least unexplored I would say tends to be Iraq more than it would be Saudi Arabia. [1:17:00]

John, from Minnesota. There’s an old proverb that says you’re snared by the words of your mouth. Consequently I want to analyze Chairman Bernanke’s speech for the word inflation. Did you know 14 paragraphs contain the word inflation and only 6 didn’t, for an average inflation word count of only 3 per paragraph, for a total inflation word count of 41 times? Perhaps this is something we should keep up on going forward. You guys have a great show, keep it up.

JIM: Yeah, you know, John, it’s interesting he mentions inflation a lot but a lot of it is misleading because the Fed leads you to believe that inflation for example is higher oil prices. So it’s not Fed policy of creating a lot of money into the banking system and into the economy, it’s always some other means. It’s rising prices. So we tend to blame inflation on the symptoms rather than the cause. And all of this is obfuscation on part of the Fed. And I really believe that a lot of these guys believe their own BS so to speak. There’s been a redefinition of what inflation is today, it’s rising prices, it’s not an increase in the supply of money and credit which is what it’s always been throughout all of man’s history. [1:18:26]

JOHN: Is that a technical term, BS? I didn’t find that one in Black’s Economic Dictionary.

Robert is in Morris Plains, New Jersey.

First off, thank you for Financial Sense Online, and the Big Picture. I am in particular, as a devoted Austrian, it is extremely comforting to hear such logical analysis each week and not to feel alone in the world. I’m a small investor who believes in the power of gold to preserve savings, and I work very hard for that paper note I get paid in. My portfolio mainly consists of GLD, SED, USO, and ERF for the long term, with the understanding that commodities are in strong demand and central banks are continuing to inflate credit and the money supply. With the onset of an economic slowdown that may expand beyond the American coasts, is holding a gold, oil, energy position now a safe bet to get through the downturn? I’m not dreaming of hitting a jackpot. I just want to preserve my savings. I’ve worked my *** off, and refrain from spending on many things, to accumulate the amount of money that I have. How can I find safety?

JIM: You’re exactly where I’d be putting my own money. I’d be putting my money in energy and gold. [1:19:16]

JOHN: That was too easy an answer. I expected something really…

JIM: No, the guy had it right. What can I say?

Hi Jim, this is Robert from Vancouver. I love your show, been listening to it for several years. I’ve got my friends and family listening to it as well now. Marc Faber described liquidity as a lake, central banks pump liquidity into this lake, and the lake sloshes around in a manner which is out of their control. So the lake may overflow into internet stocks, forming an internet bubble, the lake my overflow into real estate and cause a real estate bubble. Now, you’ve said that the only reasonable way to deal with the current debt levels is to inflate. And that’s the equivalent in the analogy of turning on the pumps and pumping water into this lake.
And I agree with you, but I worry about another scenario, and that is what happens if the dam against the lake breaks, and very, very rapidly the liquidity in this lake flows out, such that no amount of central bank pumping can offset the deflationary spiral? Now, what may cause this event we don’t know, maybe it’s the resetting of the mortgages in the next year, maybe it’s a geopolitical event or some other event, but your belief that central banks will simply inflate our way out of this, seems to me to require some slower period where they have time to respond. So, again, what happens if a deflationary spiral occurs far too rapidly for central banks to respond. Love to hear your answer on this and again I really enjoy your show.

JIM: Robert, the scenario that you’re actually talking about with the dam breaking is not deflation. When the dam breaks it’s hyperinflation, that’s when the money just flows out of the dam and everywhere. And that’s where you get a hyperinflationary scenario where the currency collapses, and that’s where you burn the currency at that point. That’s what this liquidity has caused. [1:21:18]

JOHN: An interesting email from Laurie in Brisbane, Queensland Australia.

Hi Jim and John, you talk so much about peak oil and how it is going to get more expensive. How about something more uplifting, give us some hope. How about this battery-fueled car.

And she sent us a link on that.

Actually there is always hope because people make through every situation that has ever come upon the face of the planet, and the goal of doing the show is actually I would assume Jim to give people hope to point out where the rocks are so they can navigate cleanly through the times that are coming. And there is hope. There’s alternative energies and other things that people should be investigating. Not as I would say, just for investments but also what can you do in your own home. For example, Australia right now is having a very big water problem, so you can start thinking in those terms; or electricity like you’re talking about. Let’s face it, the majority of people in these different countries – the US, Canada, Australia – are not thinking about these things, Jim.

JIM: Yeah, you know, one of the things, Laurie, I would tell you is if you go back to when we first started putting this show on the internet back in late 2000, 2001. John, when did you and I start working, was it 2001?

JOHN: 2001 is when we came together. Right.

JIM: Yeah. And we were telling people, even though the economy was in a recession, we just got attacked by terrorists with the events of 9/11, the stock market ended up losing 75% of its value, we were talking about buying gold in 2001. If you were listening to the show or reading what I was writing about, we were talking about making investments in energy. So even though people were losing money in tech stocks and the market were making money in taking advantage that the market had changed. We were in a different operating environment. So no matter which way the markets go, whichever cycle, if we’re in a cycle for paper, or we’re in a cycle for things. I happen to think we’re in a cycle for things, and we’re going to be in that cycle for quite some time. I agree with Jim Rogers and Marc Faber that this cycle is going to be with us for quite some time – at least well into the next decade.

So there’s ways that you can make money as the price of energy continues to escalate and go up. You’re going to make money in alternative energy; you’re going to make money in nuclear energy – uranium; you’re going to make money in wind; you’re going to make money in ethanol; you’re going to make – any kind of alternative energy form, in coal. These are the things that we have right now that we know that works. And of course, there’s always something new on the horizon that could come about – fusion, or something like that as a result of research as energy becomes more scarce, and also its price goes up significantly that all of a sudden people start looking at alternatives. So alternative energies, gold markets in this gold and precious metals, commodities in general; I think food, water.

If you go back and read what I wrote about in the Perfect Storm in my last couple of scenarios I gave some alternatives, and then I also wrote a piece called The Next Big Thing which was back in I think March or April of 2003. All those things that I have talked about then you’re seeing unfold today. And just like the tech cycle that lasted from 91 all the way to the year 2000, and was with us for well over a decade, this cycle is likely to be with us well over a decade. That’s why we encouraged you to pick up the oil stocks when they were correcting; we encouraged you not to sell your oil stocks; we encouraged you to put more money in junior gold stocks. Now, I’m going to be recommending producers because I think the price of gold is going to 850, and then on to 1000. And as it heads past 850 you’re going to want to be in very late stage producers, and you’re going to want to be in junior producers as the price of gold goes up, because once it goes past 850 and 1000, that is a lot of money that goes to the bottom line of a producer. [1:25:17]

JOHN: Mike is writing from Vancouver, British Columbia, Canada.

On last weeks show I heard you refer to an email I sent in: “here’s an email that’s kind of cute.” Cute? You know how to hurt a guy, Loeffler. Those are fightin’ words. I’ll meet you behind the corral at high noon.

No you won’t. I’ve notified Homeland Security they’re going to intercept you at the border. And then he says:

If Jim was offended by my email I apologize. It wasn’t meant to be in any way hostile.

And I don’t think we took it that way anyway.

JIM: No. No offense taken.

Hey, Jim and John, it’s Robert from Sholo, Arizona. I wanted to mention there’s a movie called Syriana with George Clooney. I wonder if you guys have seen it. It’s kind of almost a documentary based on a book written by a former CIA guy, and talks about the politics of oil. And it would be interesting to see it, and then maybe comment on that sometime. Thanks.

JIM: Robert, seen the movie, was bored stiff with it, more Hollywood than it is truth. [1:26:26]

JOHN: Gary’s in Boca Raton, Florida.

I really enjoy your show, very thought provoking even when I’m on vacation. I look for Wifi hot spots on Saturday morning to download the broadcast.

I don’t miss the show either, Jim, except when I’m on vacation, that’s amazing.

JIM: I don’t either.

My question is: is it likely that spiraling energy costs would be the focus of increasing world expenses that would be paid for with newly minted money, especially as economies begin to slow? If that’s the case, then why would we expect any asset inflation in anything but oil, coal, uranium and to some extent gold as the commodity but not the stocks themselves.

JIM: Well, I think you’re going to see inflation manifest itself in the cost of real goods because when central banks create money that creates no wealth. It’s called artificial wealth. A central bank like the Fed printing money doesn’t bring new oil into the market. Just by printing a lot more money it just means you will end up spending and paying more for the same amount of oil. So when central banks artificially inflate an economy what they do is they simply raise the price of those goods and services. And that’s what you end up seeing. So that’s why in the things that they can’t create like commodities, real goods, you’re seeing those prices go up. And that’s what I expect you’re going to see continue. [1:27:47]

JOHN: Mark’s in Batavia, Illinois.

He says:

Gentlemen, as always, it’s a pleasure to listen to your show, my personal circumstances aside what I need to find out is that as the price of gold rises and the prices of basic necessities of life also rise, will the price of gold, not gold stocks, but gold itself, rise faster than the cost of goods, the CPI and inflation. Thank you for your time and attention to this matter, as well as the work you do on behalf of the little guy.

JIM: Usually when you get into a hyperinflation in the final stages as the currency collapses, you have the price of goods going up faster than the amount of money that is being created, and that’s what I usually call the final stage of a hyperinflation. And that’s what I would expect. We’re a few years off from that, we’re not there yet but ultimately that’s what I expect to unfold. [1:28:41]

JOHN: Alright, Jim, we’re coming up now upon August, this is our last broadcast for July. And in August we play a lot of hooky, but what are we going to do so our listeners know what to expect. And obviously, if anything major breaks during the month of August we will do a special report on it, if something is really critical that we have to follow.

JIM: Yes, one of the things that we’re going to be doing here, John, is you and I are going to be doing a couple of shows the first two weeks of August because we have two guests. The first week of August my guests will be George Orwel, he’s a noted reporter and journalist covering the energy sector. He’s been with Dow Jones, now he’s with Petroleum Review. He’s going to be my guest next week. And then on August 12th we’re going to be talking with Stephen Drobny Inside the House of Money. What Goes on in Wall Street with the Hedge Funds, and this guy comes from that sector. So that’s going to be our guest.

You and I, John, are going to be doing the Big Picture, but this is the month all of our experts, Frank Barbera wasn’t with us this Friday, he’s off to a wedding. We got Paul Nolte somewhere in wine country in Michigan on his cell phone, but he’s on vacation. [1:29:53]

JOHN: Boy, did we have to sober him up before we did the show?

JIM: Hey, Paul, hope you’re not listening to that. No but we got Paul…in fact I think we had to do about 10 outtakes because we had to get him to an area where we could actually talk to him on hiscell phone.

Joe Duarte’s going on vacation. I know Dave Morgan is doing traveling. And JP is finally heading out to sea. I am going to be sailing literally 5 or 6 days a week, testing out a new sailboat designed for going fast and on the ocean. And so I’m looking forward to that, and as I always say, John, all work and no sail make Jim’s forecasts fail. So it’s time to kind of clear the cobwebs. But we are going to be doing two regular, or sort of semi regular shows the first two weeks of August.

And then I’m going to play a couple of interviews that we did several years ago with some people and I think what you’re going to find fascinating about this is you’re going to hear what people said 2 or 3 years ago; and then you’re going to say, “my goodness, when did they say that?” And this has happened since then. And so we’re going to piece together a couple pieces, and we’ll play those for the last couple of weeks in August, and then we will return September 9th, with our experts, and of course some exciting guests that we’re lining up.

We’re going to try to get Matt Simmons back on this show. I may even try to get Bob Prechter on deflation. And so a lot of neat things that we’re going to be covering as we come back in the Fall. We’re going to be adding more news stories. And so we’re always looking at ways to improve the show based on our listener feedback, and we hope you’ll be enjoying that. But anyway, we’re still going to be doing this for another couple of weeks, we’re just not going to have our experts as this is Summer and people do take vacations.

So, in the meantime, [1:31:42]

JOHN: Wait, wait, wait. Before you go away, I know when you go away on your summer you always read and you have published on our website right now your Summer reading list for people who are interested in that.

JIM: Thanks for reminding me, John, because I wanted to put that up before I headed for vacation. We’ve got a couple of books – some of these people you’ve already heard on this show: Jeffrey Christian’s book, Commodities Rising, Marcel’s book Oil Titans, very important for understanding the oil issue. We’ve got Leonardo Maugeri’s book The Age of Oil which is a good combination of sort of Matt Simmons and Daniel Yergin. In one book, Black Gold, Orwel; we’ve had Peter Tertzakian. And then a couple of other books, one of them I’m going to complete on vacation, Money, Bank and Credit by Jesus Huerta de Soto. Then also Michael Mauboussin, More than You Know: Finding Financial Wisdom in Uncommon Places; Joel Greenblatt’s book: The little book that Beats the Market, great book. And then a couple of books on dividend investing which I think are very well written, and especially for a lot of you that are getting ready to retire, looking for a source of income. And then of course, When the Rivers Run Dry which is the situation in water. So good reading list.

And also, we updated our peak oil reading list because I think I’m beyond 70 books now on peak oil. So if you want to keep up on the debate of what’s going on with peak oil we’ve updated our peak oil list so, John, thanks again for reminding me on that. [1:33:11]

JOHN: I feel really humble, I’m actually reading Zorro by Isabel Allende. There just comes a point where I can’t look at another news story, Jim. It just seems like there’s a point where I don’t want to read another news dispatch, I don’t want to read anything financial, I’m going to read a novel. That’s just fun.

JIM: Well, I’ve got, outside a couple of heavy books that I’m taking that I’ve saved for Summer vacation where I can sit quietly on the beach where I can just focus on it, this is just one of the times where I’m going out and clearing the cobwebs. So I’m looking forward to actually doing that – vacationing. I’ve hired sort of a race team to help me during the Summer, and so I’m kind of excited and looking forward to that. And once again, just want to let you know, unless something happens. John, as Joe Duarte said, it could. I remember the last week on vacation last Summer I hadn’t paid attention to the news for 3 days, I was literally out on the ocean every single day, and I came back on Sunday night and turned on and there was Katrina. I said, “Oh my God, I can’t believe this happened.”

JOHN: And we did a special show, remember we came back in to do it.

JIM: Oh yeah, that’s right, we did. We did come back.

JOHN: So we kept our promise.

JIM: Alright.

JOHN: And as Jim sails slowly off into the sunset, he says, here’s your closing line Jim.

JIM: Alright. On behalf of John Loeffler – hey, almost forgot my key line here – it’s getting late folks.

JOHN: Would you just read the teleprompter, and get on with it!

JIM: Ok, on behalf of John Loeffler and myself we would like to thank you for joining us here on the Financial Sense Newshour, until you and I talk again, we hope you have a pleasant weekend.

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© 1997-2011 Financial Sense® All Rights Reserved.

The opinions of the contributors to Financial Sense® do not necessarily reflect those of Financial Sense, its staff, or its parent company.