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Financial Sense Newshour

The BIG Picture Transcription

January 5, 2008

Part 1

A Recession With No Name

JOHN: This is probably one of my more favorite-er shows of the year. Don't you love to use bad grammar? I like to do that.

JIM: Your grammar has been improving over the years. ‘Gooder’ and ‘favoritist’.

JOHN: Don't you say nothing about my grammar or my grandpa! I'll let you know about it. There! Well, here we go.

Now, remember, you're going to have to eat crow at the end of the year when we come to it, just like you did at the end of 2007. But here we go. We're going to do a couple of things in this segment for the Big Picture.

Welcome to the Big Picture, the first one for 2008. And I've only written “2007” once on checks. So I'm ahead of the game there.

And what we would like to do first of all is look, number one, at what the consensus is out there as to what the mainliners think we are facing; and then number two, we will make our own predictions for the year as the great Karnack puts on his crystal ball. (I don't know how you're going to put that on your head, but I'm waiting to see this one.)

All right. What we really need to do first of all is frame what we are going to say in the light of what the current consensus is. So Jim, let's look at that first.

JIM: Okay. Well, the first thing is if we take a look at what most economic forecasters, the Wall Street firms, are thinking, BusinessWeek publishes every year in their annual forecast issue a summary of the top economists on the Street. The consensus is – now, this is an average: some people think recession; some people think strong economic growth – the consensus for 2008 is the economy will grow at an average rate of 2.1%. And what you find in most consensus forecasts is there tends to be this linear extrapolation of the previous year. In other words, we know, for example, in 2007, the economy probably grew in the 2 to 2.5% range. So this is an extension of that. If you look at inflation, they do expect inflation to rise to 3.9% this year, so the headline inflation number is pretty much tracking what it did in 2007. The core rate of inflation is expected to be 2.4%. So that's already above the Fed's forecasted comfort range of that 1.5 to 2% range.

Now here is something that I find rather exciting. They are expecting that the unemployment rate will average or rise to about 5.1%. John, here we are on this Friday with the unemployment numbers for the month of December and we're seeing a very disturbing trend. The jobless rate already jumped to 5% and we haven't even got into this year yet. So they are seeing the unemployment rate at 5.1% and then they are also seeing that home prices will drop about 7% on average.

So that's the consensus of a whole spectrum including everything from private investment banks (which includes the big banking firms like Lehman brothers, JP Morgan, Citigroup), the big forecasting firms and the big economic firms. So nobody is seeing a recession this year. They are just seeing simply the economy will grow below average, the normal growth rate for an economy would be 3%. They are saying that the economy will grow at 2%. So that's BusinessWeek.

Then if we go to let's say the folks at Bank Credit Analyst, their theme for the year for 2008 is: Waiting For Reflation. And last year, Bank Credit Analyst, their theme was Riding The Liquidity Wave anticipating that central banks would be cutting interest rates –which they did – with the Fed beginning in the month of August. And basically, what Bank Credit Analyst feel right now is that the central banks of the globe have gotten behind the liquidity curve. They aren't cutting aggressively enough, and especially when you take a look at, for example, interest rates: The yield on the two year Treasury note or a yield on the 10 year Treasury bond in comparison to the federal funds rate at 4 ¼. [4:25]

JOHN: Yeah. You need to explain the difference between the federal funds rate and I would say the Treasury markets.

JIM: Okay. Well, the bond market, which operates separately and draws its own conclusions which may be different from Fed policy. I mean you're looking at the two year Treasury note, which is at 2.7%, and you compare that to a federal funds rate at 4 ¼%. If you take a look at the 10 year Treasury note at 3.84% and compare that to a federal funds rate at 4 ¼. The federal funds rate is the rate that banks charge each other when they come up short or they need to borrow. Now why that's a very important statistic to look at is if you take a look at credit expansion in this country right now, bank deposits have been shrinking which is one thing that you're seeing that the monetary base is shrinking in this country. And it will be one of the issues I take up with our special guest this week, Paul Kasriel, because that's part of his recession forecasting gauge. So that means the deposit base is shrinking at banks, how are they able to extend credit. Well, the banks are borrowing from each other and that's why the federal funds rate is very important.

So with the federal funds rate at 4 ¼ and the bond market much lower than that, the bond market is drawing a separate conclusion from what the Fed is drawing. The Fed is mixed right now and this is the gang that can't shoot straight. So the bond market is saying, “look, we're heading for a recession and a significant slow down.” And there is a disparity between this, too. So the Bank Credit Analyst are saying, “you know what, the Fed needs to kick this thing into high gear.” So if we take a look at what Bank Credit Analyst are forecasting for the year, they are forecasting slower economic growth and credit market strains. So what they are saying is that is not going to lead us to a recession. The debt Supercycle is now at an inflection point with the pendulum likely to swing towards conservative lending and borrowing behavior on behalf of credit institutions; but they are saying this will not last. And they are saying that the authorities –meaning the government, the central banks – will ultimately be successful in pumping up the system again and new financial excesses will occur as a result of that.

They also believe the US economy should avoid a recession; and they also believe just as everybody is kind of focusing on inflation right now, the Bank Credit Analysts believe that this fear of central banks focusing on inflation is misplaced, that they believe inflation is a lagging indicator and that with credit market strains and slowing global growth, they expect a bit of deflation coming in here. They also believe from an investment perspective government bonds are overvalued given the low interest rates. They also believe, as I do, that equity markets are likely to churn until this credit market pressure eases. They also believe that equity evaluations are reasonable and they expect higher stock prices. And I do too.

I expect that we will see a new record in the Dow this year. We will see a new record in the S&P this year, and they also believe that large cap international growth companies are going to be the preferred investment because they will participate more in an international economy where you can see stronger growth overseas. They also believe that the resource sector is going to be a prime mania candidate this year; something also that I agree with. And basically their view is the predominant risk is deflationary.

So that pretty much sums up Bank Credit Analyst. They were fairly accurate last year in predicting that there would be no recession, there would be plenty of liquidity. The only thing in terms of their forecast for last year that they sort of underestimated was the fall out from the credit market that we saw develop, not only in February of last year with the intermediate bank lenders but also with the fall out with subprime lending that we saw unfold in August. [8:44]

JOHN: You know, another gentleman who is known for his forecast is Byron Wien and he is head investment strategist at Pequot Capital, so what is he saying about the coming year?

JIM: Well, Byron Wien is known probably for the last quarter of a century of coming out with his 10 predictions at the beginning of the year. And he did it again this January. And his number one prediction is the US economy will fall into a recession in 2008. That is one that I happen to agree with.

The second part is the stock market will post a 10% drop during the year; probably in the first half of the year [when] there is a correction. Something else that I agree with.

Here is one that is quite controversial. He believes that Democrat Barack Obama will beat Republican Mitt Romney in a landslide election to take the presidency. So that's his third prediction.

Fourth, he believes the Federal Reserve will cut benchmark interest rates to less than 3% from today’s 4 ¼. And that would go in line with a recession. There are a lot of people like Bill Gross that feel that the Fed needs to cut interest rates down to 3%, but if we go into a recession, we could get it down to the 2% level.

Another forecast is that the unemployment rate will rise above 5%. And here we are on the first week of the New Year. We just got the December unemployment numbers and we're already at a 5% unemployment rate.

He goes on to say that a couple of the other forecasts that he's making is the 10 year Treasury note yield will rise to 5%. (And I'll explain that our forecast this year is going to be to think of an Oreo cookie – we'll explain that in the second hour of the Big Picture today.

He also believes that gold will surge to $1000 an ounce. Oil will drop to $80 a barrel before rebounding to $115 at year end.

And then number 10, agricultural commodities will climb to new record levels with corn rising to $6 a bushel. I could see that easily especially with the energy bill just passed where they are going to call for, I think, 35 or 36 billion barrels of ethanol by the year 2020. So that's Byron Wien. [11:21]

JOHN: I was thinking of that as creating incredible pressure on the agricultural sector and other sectors because the competition for ethanol is now squeezing farmers that need that for feed corn and driving those prices up, which is driving other things up like the price of milk etc. So that's going to be an ongoing trend that we're going to see as we go through the New Year.

JIM: Sure, because roughly about 25% of our corn crop is now going towards ethanol, so you can imagine the fallout that this is having with ranchers, with farmers, with dairy people. Grain is a very important food commodity globally, not only as a staple of diets, but it's also a staple of diets in terms of animals, so you can look for a higher food inflation in the stores. [12:07]

JOHN: Byron Wien has his 10 item forecast, but he's got five sure things that he puts in as well and that's a separate list. So what is he saying there?

JIM: Well, basically he's saying, “I'm getting a little older” and he said, “you know what, I'm looking more for sure things as I get older.” He's got what he calls five sure things. And one is oil prices are going to $100 a barrel and higher. That's part of his 10 forecast. Two, his sure thing is gold will reach $1000 an ounce. Three, cotton prices are moving higher and four, the dollar will continue to weaken. And five, the S&P will hit a new record by the end of the year. So those are things that he's seeing in his five sure things.

And I relate to a couple of things in his forecast that I agree with. Number one, I believe we will hit a recession. Number two, I do believe that interest rates at the end of the year will be higher. I do believe in oil going to over $100 a barrel. We talked about that in our last show of the year in 2007. I also believe that gold is going over $1000 an ounce, as we referred to in our Experts series with James Turk’s forecast in the first hour.

And some of the other things that he's seeing in terms of higher stock prices, I believe in that too. And we'll get into why stock prices will head higher – as much as that may surprise people at the present time with both the Dow, the S&P and the NASDAQ in negative territory the first week of the year. But we'll talk more about that later on in the second hour. [13:40]

JOHN: And before we get into our own predictions for the year, there is a Denmark-based bank that is known for making annual outrageous predictions. That's the best way to put it. What are they saying and by the way, do we have any evidence on their track record?

JIM: They've made some pretty good calls. This is Denmark-based Saxo Bank and each year they make what they call their outrageous predictions. They have ten of them and here is their outrageous predictions for 2008. Number one, world oil prices could hit $175 even if growth slows. And we'll get into our forecast why I think that could be a good possibility. They are also forecasting the British economy will go into a nosedive this year. 3) The S&P will drop by 25% down to 1182. And let me see, on this Friday as we speak, the S&P 500 is at 1413, so that's quite a drop. 4) Grain prices will double this year. 5) many of the US home builders will go bankrupt this year. 6) Chinese equities will see a significant correction this year.

Now here is one. And this one is out of the blue. Ron Paul elected president of the United States. I’d love to see that one but I don't think he has a chance. I mean, he would be my pick. [15:13]

JOHN: We're going to talk about in this next segment here on our own predictions. I think if we go through this crisis window, [Ron Paul] would gain even more traction than he has this election, to be honest with you, if he jumps back into the race.

JIM: Sure.

JOHN: Soon as people begin to find more pain, we're going to start that cycle of throwing the rascals out and putting new rascals in.

JIM: And we'll get into this in terms of the political cycle of the implications because when we get into our forecast segment, our own forecast, we're going to go beyond 2008. We're going to go to the year 2010. Let me go back to these outrageous forecasts. Number 7 was Ron Paul elected president of the United States. 8) A stellar year ahead for the Swedish Krona. 9) The Singapore dollar to fall further before rising against the US dollar. And number ten, the Hungarian forint rises to 275 against the Euro. So those are just the top ten outrageous forecasts.

A couple of those, I don't know if oil will get to 175 – that would be a real crisis mode. That would almost imply some kind of either war in the Middle East, a significant disruption, something major in terms of a geopolitical event. Maybe a terrorist attack on the Saudi oil terminal that accounts for a significant portion of the world's oil. So it would take something like that to drive it to 175. [16:36]

Oreo

JOHN: Well, now that we have heard from the Street and some of the more recognized personages who make forecasts each year, it is time to make our own forecast here on Financial Sense and see how well we agree or disagree. And we'll keep notes and at the end of the year, we'll check it out. And the way we'd like to have you do this here, Jim, is first of all, summarize up at the front; and then later on here in the Big Picture we'll get into the details. Ultimately, we need to predict whether this is going to be a one, two, three or four bottle of wine year.

JIM: This will probably end up being a two or three bottle of wine, the five and ten bottle of wine begins in 2009.

And the best way to describe what we see happening this year – and I was trying to think of an analogy, and here it is: An Oreo cookie. Dark on the outside and a creamy filling in the inside. And what I mean by that is the first quarter is we're going to see a lot of volatility, we're going to see a lot of roughness in the market, kind of what we're seeing right now with the major average is down anywhere from 3 to 5%. We may see a 10% to 15% correction in the markets. And then we're going to see monetary reflation kick in with a vengeance.

We're probably going to see fiscal stimulus. So by the second and third quarter I call that the filling. You're going to see the positive sides of monetary reflation and that's going to be higher asset prices. And then, however, by the time we get to the fourth quarter of the year, you're going to see inflation come back with a vengeance and you're going to see higher bond yields, higher inflation rates so that, John, when we get into the year 2009, central banks will be back into the rate-raising mode. And by 2010 – and hold onto your seat, get your Maalox, by 2010, if things unfold the way we think, the US will experience a depression. [18:56]

JOHN: Not just a recession? A depression?

JIM: A depression.

JOHN: Okay.

JIM: However, that Oreo analogy sort of describes a rough patch in the first quarter, a rough patch in the fourth quarter. We expect a recession. I'm going to call this “the recession with no name” because we could get some magical statistics, John, very much like we saw in the second and third quarter of 2007 where the economy went from a 1% growth rate to a 3- and almost 5% growth rate because the GDP deflator fell to the lowest level since Eisenhower was president. So maybe mathematically we could see the GDP deflator get down to the lowest level since Calvin Coolidge was president of the United States or something ridiculous like that.

But I do expect a recession and I do expect a record on the Dow and a record on the S&P. I expect the NASDAQ will be going north of 3000. That's going to surprise a lot of people. And the degree in terms of how high stock market goes will depend on the rate of decrease in interest rates. In other words, if the Fed cuts the federal funds rates to 3%, we could see 15,000 on the Dow. If the Fed cuts the federal funds rate in the 2% range, we could see the mid 15,000 to 16,000 on the Dow – as crazy as that sounds. But just think what happens if interest rates get down to 2 or 2.5, if they have to fight this recession which I think is going to unfold.

The other thing I expect this year is oil prices will hit at least $125 a barrel. It may even go higher if we get into a crisis. Gold will also hit over a thousand. Silver is going to go over $20 to 25. And I do predict as the gold market heats up and especially as we hit over 1000 we could see a spike in gold prices. Once it passes the $1000 mark, in other words you could see momentum come in. And I do believe this will be the year that juniors outperform the majors. That has not been the case in the last two years in the gold market.

So that in a nut shell, John, is the summary.

And one other aspect is –and this gets back to the dark side of the Oreo in the fourth quarter –bond yields go to 5% and inflation comes back. You're going to start seeing headline inflation numbers in the 4 to 6% range by the time it gets to the end of the year. [21:28]

JOHN: You just go on talking, Jim. I'm going to run over to Costco and get their 10 gallon version of Maalox, stock up on a couple in the pantry and we'll keep them online for the show. So we'll do that. But anyway.

I think we need to encourage people, though, because what we're doing here is we're providing sort of an early warning service and telling people how to get through the rocks. And it's going to be a pretty rocky time.

JIM: Yeah, and I would say in the first quarter and probably towards the end of the year, fasten your seatbelt and hold on because it's going to be a very volatile first quarter – especially with the economic news coming out. We've got the ISM numbers that came out this week showing that the ISM index fell greater than expected. It fell below 50, which is telling us that the manufacturing economy is contracting and that just blew a door out of the idea that exports will save us and keep us from going into a recession. We've got the unemployment numbers for December, which went up to 5%. And usually, you don't see that in December because you see a little bit of strengthening in the employment numbers because of all of the hiring that is done for the Christmas season. It's going to be interesting to see what the unemployment numbers are going to be for January. [22:49]

JOHN: So we're going to summarize what we're saying here on the show. First of all, the first quarter is going to be rough. There is no doubt about that one. Second of all, there will be a recession in the US. Now we're distinguishing that from the following year depression, right? So we're sliding downward but not all of the way down. Third thing, there will be a drop in interest rates. And then we will also see at the same time new stock market highs as a matter of fact.

But by the end of the year, interest rates are going to go back up –high interest rates – and we will see inflation resume.

And what's ironic, Jim, is as we look at this, what is really haunting about this whole thing, this almost reminds you of where we were right around 1929, because the actions of government officials and others turned what was a recession into a depression. And if you listen to the politicians talking right now in the campaign speeches, they want to do those things when they get into office as were done back then.

JIM: And we're going to get into that in the second hour as I layout the three year forecast and why, by 2010, I think we're going to be heading into a depression. And a lot of that, John, is a result of the debt Supercycle coming to an end. And also, exactly what you just made reference to, and that's exactly what politicians are going to do. They are going to do everything that's wrong and take a bad economy and turn it into a depression. [24:13]

JOHN: We'll have to talk about it in the second hour. I always wonder why they wind up there. But like you said, we'll save it for the next part of the Big Picture.

It seems like every time we get to these cycles it's a different group of people but the pressures are always the same and it seems to follow the same path. Like Mark Twain said, history doesn't repeat itself, but it does rhyme.

JIM: That's true. And it's like every generation has to learn from its own mistakes and make those same mistakes that the previous generation made. And that's because, number one, I don't know if it's experience or what it is. Or we think: “You know what, we're smarter than the previous generation. We know more than they do. We've got more technology and we can better manage the economy than they did.” And that's what people in government think. [24:55]

JOHN: Yeah. And then you come out of the back side of it and it seems to go in cycles. Like you said, these cycles tend to be metacycles. They last more than one life time or over the course of a life time, so new generations forget the lessons the last generation learned.

Well, so far we have now given our general summary. Now let's look at details of exactly why we're making these predictions.

JIM: Let's take a look at – this will make reference to Bank Credit Analyst’s Waiting For Reflation. And I think one of the things that you have to understand here is this is probably the least experienced Federal Reserve boards that we've had, at a time of one of the biggest financial crises that we've experienced in this country for, John, almost the last two decades. And if you take a look at this, when you have a debt-prone and debt-ridden economy as we have today, there are three kinds of financial crisis.

The first type of crisis is a fear of panic. Something happens kind of like what we had in 1994 with the Peso crisis, what we had in 1997 with Asian crisis and then also what we had in 1998 with the Long Term Capital Management and the Russian debt default. What happens is there is a fear that grips the market. Something happens out of the blue and everything freezes up because everybody is worried about more selling and losses. And usually what happens with this type of crisis, the response is the central banks come in and they inject a large amount of liquidity, drive down interest rates to a penalty rate and basically inject money back into the system. Once they do that, the market responds. And once that happens, the market is assured that there is no more dumping of assets, the panic subsides and then we go on and up and away. And you saw that in 1994 with the Peso crisis, you saw it in 1997 with the Asian crisis and you saw it again in 1998 with the Long Term Capital Management hedge fund and Russian debt default. We had a crisis that appeared out of the blue, took the markets by surprise. The markets freeze up, the central bank comes in, slashes interest rates, injects a lot of money, and all of a sudden the panic and the fear subside and it's up and away and they sort of reinflate.

And I think that is where the Fed was assessing where we were for 2007. Remember, in February when we got the first disruption when the intermediate lenders started going under and then they told us the crisis is over and then out of the blue there it was in August, it erupts again and the Fed was sort of treating this as sort of a mechanical problem: “Oh, they are not lending. We'll just create some money or create some vehicles for this lending to take place.”

The problem that they are dealing with –and this is the second type of financial crisis – and I think eventually they are going to realize this is the kind of crisis that they face. In the second crisis assets fall because investors recognize the value of these assets were way out of proportion to where they should be – whether it's technology stocks in the year 2000 or real estate prices in 2006 and 2007.

And the danger of the second type of crisis is that this impacts the banking system. And if you look at the banking system, it is leveraged 20, 30 to 1. So the banks have a small capital base. And the real danger here is as that capital base erodes, because of defaults of the assets of the losses that they experience on their loans, what happens is the financial system becomes technically insolvent. And they are insolvent because of the prevailing interest rates. And the only way that you can get out of this situation is the central bank lowers interest rates and they keep them low in the future much in the same way that Greenspan did between 2001 and 2004. And what happens is the collateral, which backs up the banking system in those loans, asset prices eventually begin to rise as a result of this reflationary effort and low interest rates, and it makes the problem go away.

Now, the side effect of that is it causes inflation and it creates a moral hazard, which is exactly what we saw between 2001 and 2006. They lowered interest rates. They kept the markets liquid. Assets were reflated. In this case bonds reflated, real estate reflated. And then the moral hazard – look at stupid things that lenders did during this period of time: No money down; no doc loans; 125% financing; interest only; negative amortization loans. I mean you name it, we've written about this. This is the second crisis and this is the crisis that the Fed is facing today. The only trouble is inflation is much higher today than it was in 2001. [30:15]

JOHN: Okay. And there is a third type of crisis.

JIM: And that's where we are heading between 2009 and 2010. In the third crisis, you have bursting asset bubbles that drive insolvency in the system. Asset values fall and they fall so much it's too large of a fall to be solved by lower interest rates. It's not going to cut it. So what you have is wide spread insolvency very much like you did in the Savings and Loan crisis in 1991 where the government came in, took over these failed S&Ls, took the assets, rolled them over into the RTC and liquidated.

So when you get to this third stage, you can have various alternatives in terms of which way the government goes. Lowering interest rates isn't going to cut it. Number one, you can nationalize assets or liquidate them like they did in the S&L crisis. Or two, you inflate away massively and the consequences are a severe inflation. And that's where I think we're heading between 2009 and 2010.

And I think at around 2010, I think that is the end game for the debt Supercycle. And also I think you're going to see what I call the Perfect Financial Storm, which will be three perfect storms: One perfect storm in politics; one perfect storm in economics – meaning the economy and financial markets; and another perfect storm in the area of energy. And that, I think, is going to unfold in the year 2010. It's not going to happen overnight. It's going to be a result of a series of events, one event compounding the previous event. And it will start to build and build and build much like, let’s say, the force of a hurricane or a major storm. And that's where we're heading. So by 2010 we are going to be in a full-scale depression. [32:38]

JOHN: All right. So for this year we expect –based on your prediction – a recession, and then later on we're going to have to have some kind of reflation going on out there. But let's lay the picture out so people can understand it.

JIM: Well, let's take a look at –as I just described – the three kinds of crises. I think the Fed has been acting as if we were in crisis number one. In other words, it was a temporary lock up in the financial system. “We'll inject some income, the crisis will go away.”

What they are really facing is crisis level Number Two. We've got a deflating real estate market. They expect that by the time this is done we could see real estate prices deflate another 7 to 10%, so by the time the crisis is over in real estate we may have 15 to 20% price declines nationally across the country. And of course that's an average. In certain places it's going to be obviously much higher than that in places like, for example, Las Vegas, Phoenix, California, Florida – the hot real estate markets that we've seen during this real estate cycle.

So somewhere between now and at the end of the first quarter, the Fed is going to wake up to the fact that they are facing a full scale financial crisis. And the problem that they are going to have here is if you look at the writeoff of losses, if you went back to September last year, the experts were estimating we were going to see probably about $200 billion of losses in the financial system (between 200 and 300 billion). But as the crisis began to unfold, it was underestimated by most experts so that by the time you got towards the end of the year, the experts were saying by the time we're done with this, that the losses from the financial system were going to be between 400 and $500 billion.

Now, here is the problem that the Fed has: If the US economy goes into a recession as we expect, it's not only the subprime borrowers and the Alt A borrowers that now start getting into financial problems. With the unemployment rate growing you now have people that were making their house payments, they were not in trouble, now they lose their job and now that $500 billion loss could quickly go to 750 billion or a trillion if they don't start nipping this thing in the bud. So the worse the economy gets, the worse the financial crisis gets. And that's what the Fed is now facing. [35:21]

JOHN: You know, there was a talk given by Donald Kohn who is Fed vice-chairman here and he spoke on Friday. And one of the things that I think was salient in hearing what he had to say was that the Fed itself, inside the FOMC and trying to arrive at their forecast, they are not sure necessarily, a) what's happening, and b) what to do about it. And that's really important because this has gone critical right now and if they don't get it right, things are going to be in trouble.

JIM: Yeah. I mean if you take a look at it they [aren’t getting] this right. Number one, they are fighting the wrong war, John. Yes, they have some inflation problems, but if they don't get a handle on this crisis, they are looking at a full-scale depression. I think that's eventually what's going to happen anyway. But they can't deal with the underlying fear that a lot of firms are going bankrupt. In other words, they are still dealing with this thing as if we're still in just the first type of crisis, not the second or maybe even the third.

And they don't even understand: It's not just the banking system here. We've got two elements here that also we're not even dealing with and that is this whole area of credit default swaps. If that unwinds – I mean everybody is focusing on the subprime. We've got another crisis out there that can hit here and that's the credit default swap based on all of these people that wrote this credit default swap insurance on the corporate bond market thinking that we're in good times. If we go into a recession, then you're going to see a lot of these junk bonds default, and that's going to create a whole ‘nother crisis with the hedge fund community and credit default swaps. Not to mention a second area which is credit cards which have been securitized as well. So we're talking about another crisis here. These central bankers, whether you're taking a look at the Fed, the Bank of England or the ECB, if they don't get a handle on this and start working together to coordinate this, they will eventually lose control and the markets will take over and then at that point, they can lose control completely. [37:32]

JOHN: So let's chase that thought just a bit. If they do lose control on this thing, there’s a huge amount of debt sitting out there. This could really make 1929 pale in comparison. Then that's, of course, predicated on the “if” part of the equation.

JIM: At some point when I suspect they are going to finally wake up to the fact that they are facing the second stage crisis that I referred to, and at that point, John, it's going to be pure panic with these guys. The problem is these guys at a time when you are in this type of crisis, these guys...the difference I guess with the Greenspan Fed, Greenspan was a decision maker, where Bernanke is sort of a bureaucrat, he's more of a consensus [builder], “well, let's all agree.” And you've only got one guy out of the FMOC committee that has actually ever had to go through a financial crisis and that's Donald Kohn. And he just basically said Friday, “look, within the FMOC, we can't even agree in terms of where we're going.” That is not a good place to be when you have a Category 3 storm going that the financial forecasters are saying could go to a Category 4 or a Category 5 storm. [38:47]

JOHN: Now contrast that, Jim, to what we're hearing. Let's go back to October when we were being told that the economy is strong and there were rate cuts and Bernanke in November was forecasting strong growth. So what we're talking about here is a radical discrepancy from all of the warm fuzzy talk we're hearing coming out of the Fed – which I assume at this stage of the game, even if they don't really know what they are doing, it's similarly to keep the public assuaged at this stage.

JIM: I think part of the problem, John, is there is a discrepancy between the members of the FOMC and the Fed's own research staff. On Friday the day you and I are talking, there are two Berkeley economists Christina and David Romer who have written a paper that's going to be presented at a conference. And for the most part, and the Romers are key because they are members of the seven member business cycle dating committee – what we referred to as the National Bureau of Economic Research. These are the guys that pronounce whether we're in a recession or not. And the couple's paper that they are going to present calls into question the usefulness of the Fed's policy projections or economic projections. They are basically saying, according to this paper, the FOMC policy maker’s economic projections are basically useless and worthless. And they also warn that they are possibly misleading when given greater weight than the Fed's staff members’ forecast. In other words, probably what's more accurate and more useful is the Fed's staff and that is kept internally and that's kept private. They never release that. So what the FMOC people are are cheerleaders. And that's why when you hear all of these Fed governors making speeches, you should take it with a grain of salt because according to this paper by the Romers, they actually even go as far as saying that the Open Market Committee members’ views and staff outlook may be in conflict or there could be a conflict of interest here. The Romers conclude that the FOMC’s inflation forecasts doesn't contribute any useful information. [40:58]

JOHN: Yeah. But remember when Ben Bernanke was talking about the fact the Fed was going to have all of this transparency and they were going to be doing the forecast four times a year instead of two times a year, because that was one of the complaints. Remember this? We just heard this in the last 24 months.

JIM: We saw this in 2001: Alan Greenspan and the Fed talking strong economy, strong markets and meanwhile we were going into a recession. The Romers paper found whether you were looking at the Fed’s economic or GDP forecast, for example, or you're looking at their unemployment rate, all of them were highly inaccurate. You know, it's funny because you see the markets react to this: The Fed governor makes a speech and the market reacts, “oh, they said this, the economy is strong, our inflation is going down.” According to the Romer paper: Ignore it because what Fed FMOC tells you is worthless.

What is probably more important –and that's something that we do not get for five years – is the Fed's own internal staff forecast (known internally as the Green book) which is kept confidential for five years, and that's what they really think because that's the research done by the Fed's own internal staff. But what you see when these Fed governors give these speeches based on whatever is happening to the economy or anything else, they are highly inaccurate. And the best thing you can do according to the Romers is ignore them because it's very misleading. So the fact that they are going to give us four forecasts a year instead of two doesn't make any difference because it's, like, what is the old saying, garbage in and garbage out; and that's what we're getting.

The frightening thing that I see right now is that a key period of a major crisis and we're talking about a guy that wrote his PhD thesis on the Great Depression, meaning Ben Bernanke, that the Great Depression was caused because the Fed not printing enough money. Here is a guy who studied the Great Depression and he is looking at another great depression and these guys can't even agree among themselves what they need to do. I mean that's a very frightening thought in itself. [43:37]

JOHN: I think the great experiment though was set by Alan Greenspan. Wasn't it his theory that if he had been in charge of the Fed at the time of the Great Depression he probably could have avoided it simply by manipulating the money supply, by inflating more etc.? But Greenspan went over the side of the ship, because I think he may be recognizing the failure of that grand experiment of his and leaving it to his successor Ben Bernanke which...you've been left with a big pile of stuff to deal with.

JIM: That's one of the reasons why in a fiat world where nothing backs any currency and there is no limitation to the amount of paper that can be created, we are going to see a hyperinflationary depression. But I don't expect that to occur until probably the end of 2009 and 2010. [43:54]

JOHN: You know, we keep talking about that this coming depression –recession this year, depression next year. If we look back over the history there are – there were some really critical presidential elections. And for the first time in eighty years by the way, in this election, no incumbent president or vice-president from either party is seeking the White House, which is a first. But if we go back to previous presidential elections and look at where we stand now, both politically and economically, again, history seems to be rhyming. So let's set the framework here for: why a depression?

JIM: Let's take a look, you know, there have been three major philosophical changes in government if you go back the last hundred years. In 1894, the election of William McKinley ushered in a period of time where basically the Republicans held the House for 30 out of the next 36 years and White House for 28 out of the next 36 years. That was a culminating event and it set in a philosophical chain of events in this country, and that determined economic outcomes, market outcomes.

Then we made a series of mistakes. We had Wilson come in. Wilson created the income tax and then he also created the Federal Reserve. And that sort of changed the course that would eventually lead to the Great Depression. But Franklin Roosevelt, the 1932 election was very critical because number one, Roosevelt won four terms as president and the Democrats held the house for 28 of the next 36 years, and controlled the house for 60 out of the next 62 years. And that pretty much remained in place until 1980 when Ronald Reagan came in. And if you take a look at that 1980 election, remember what we were facing? We were facing stagflation, interest rates on Treasuries were at 16%, money market fund interest rates, prime rate was close to 21%, inflation rate was 14%, gold prices were at 850, silver was at 50, the stock market had been in a bear market. Reagan comes in and what happens is Republicans then control the white house for 20 out of the next 28 years. They controlled the Senate for 16 of those years and they won control of the House in 1994 for the first time in almost half a century.

Now if you take a look at what's happening, John, this is very, very similar to what happened historically in this country, for example, with the Johnson administration, the Great Society program. We had Medicare. You had a series of big government involvement starting with Johnson carried on by Nixon and carried on by Carter. And we got to the point where we started running huge budget deficits, we began to monetize those deficits. We could no longer hold the gold peg to the dollar. We went off the gold backing of the dollar. And from that point forward, the government began to run perpetual budget deficits and then eventually trade deficits in the 90s. And what happened is we changed the course of this country. And through that period, from about 1966 all of the way to about 1982, we began a period where the financial markets did not do as well. We ran into a period of stagflation where inflationary assets –commodities – did well and we entered an era of what we call larger government involvement, higher taxes, higher inflation.

People sometimes forget the fact that, you know, if we go back to the Great Depression where the stock market fell, the first thing that Hoover did was cut interest rates. But then the budget deficit increased. And he began to spend more money in the following year. Hoover raised income tax rates to 60% and then when Roosevelt was elected in 1932, Roosevelt raised the tax rates to 90% and it basically killed the investment in the economy. That's one of the reasons we went into a great depression. I mean who wants to work at a 90% tax rate. It's one of the reasons Ronald Reagan had learned, Ronald Reagan was an economics major, but basically, if you were a movie star back in those days, you made about $100,000 for a picture, but John, over $100,000, the government took 90% of your income, so the movie stars only made one picture a year. It didn't make any sense to work. The wealthy people just put their money in Treasuries and municipal bonds instead of investing in the economy because it didn't pay. [49:09]

JOHN: Is that a part of what we call the linear thinking mentality that taxes don't affect the economic environment out there, so if you impose this much, then you get that much.

JIM: Yeah. It's basically static accounting. It's based – well, if there is a million dollars worth of revenues and if we increase tax rates from, let's say, I don't know, 35% to 65%, we capture more of that revenue. But what happens is entrepreneurs in businesses actually take evasive action. In other words, why would you expand your business if the government is going to take two-thirds or 75% of what it is you make.

JOHN: You just might as well go fishing. There is no purpose in doing it. But now why is it politicians don't understand this. This is the one that...I know I keep expecting that like Professor Pangloss in Candide, “this is the best of all possible words,” but I keep trying to say, theoretically somebody should have some brains over there.

JIM: It's not, because first of all, you start with a flawed premise and the flawed premise is Keynesian thinking. And under Keynesian thinking, the problem with the economy when it weakens or goes down, the government doesn't like deflation. But what happens in a deflation, when the money supply contracts, it's by virtue of lower prices that you are allowing a lesser amount of money to buy the same goods and services. But government tries to counteract that. They don't like lower prices or a drop in wages in a deflation and they try to counteract that. So you've got a flawed method of thinking in terms of how to correct something when the market is trying to correct itself through a natural healing process. A second idea, which is extremely flawed is the idea that it’s consumption that brings prosperity in an economy rather than savings and investments. So the idea is resurrected, John, if we can take, let's say, Ritchie Rich who is a wealthy person and let's say that wealthy person makes a million dollars a year. And because that person doesn't need all of that income to live on, a wealthy person takes that money and either reinvests in their own business, because most of the wealthy people in this country are entrepreneurs. They are business people, small business people that create business. So what they don't need and consume, they save and invest.

So either they buy a building, they build a new factory or order more equipment for that factory and modernize that factory. And it's the creation of jobs that comes from wealth creation by creating production. And it is production of goods and services in an economy that creates wealth, not consumption. And we've got the whole thing whopper jawed and turned around from the first role. And the idea is that if people consume more, we get more wealth. So the idea is in this flawed way of thinking, we will raise tax rates to be punitive. In other words, the rich guy that makes a million dollars doesn't need that money, so we'll take 80, 90% of what he makes, leave him with a hundred thousand because that's all he needs and we'll redistribute it to other people so they can consume. And so the idea is people consuming, borrowing, spending is what creates wealth instead of productive investment and savings. And so if you look at this pivotal point that we're now in politics, if you look at the populism of a Mike Huckabee, if you look at the populism of a Barack Obama, or let's say John Edwards, what are they taking about? Obama wants to get rid of the cap on Social Security, so you would pay 15.3% Social Security and Medicare tax on all of your earned income. They are talking about repealing the Bush tax cuts, so the income tax, the 10% tax rates would go up to 15. We'd go back up to 39.6. We're talking about the Rangel plan that would add a 5% surtax on income over 150. So just think, if they do nothing else but just repeal the Bush tax cuts, you're talking about a trillion income tax increase coming to the economy at a time the economy is weakening, which is the same thing that Hoover and Roosevelt did when the economy weakened and the markets fell. So picture next year rising inflation, rising interest rates and rising taxes. Those are all of the prescriptions for a depression.

And also, picture the point, John, where you come to the debt Supercycle coming to an end, where you no longer can monetize and that's why I think this is going to be a very key point as we go forward here in terms of what creates prosperity. Is prosperity created when we overtax a producer and take an entrepreneur or a business man, take away that person's wealth and redistribute it to somebody else. So the idea is if we can just all redistribute the wealth in the economy, sort of like communism. It doesn't work. It didn't work in Russia, it didn't work in China. And it's amazing, as the West moves further and further towards socialism, take a look at Russia and China whose economies are prospering, not only from manufacturing and resources, but Russia and China have some of the lowest tax rates in the world. So it's absolutely amazing that we don't learn from this, but this is the direction that we're heading in. [54:55]

JOHN: Well, these ideas were brought to the United States by a bunch of Gramscian communists who came over in the thirties and began to set up shop at teachers colleges and elsewhere. Gramscian communism based on the philosophy of Antonio Gramsci made their Long March through the culture rather than...you know, the difference between a communist and a socialist, a communist is a socialist in a hurry with a Kalashnikov. That's the only difference. Okay? And Gramsci has been proven correct, but they are Marxist ideas that came over. But Larry Lots ‘o Bucks however resents the fact that people are taking money from him. In other words, he probably wouldn't mind donating it somewhere, but he really resents when it’s forced from him, so he finds other places to put his money. Meanwhile, Wally Wannabe who wants to be the up and coming middle class business man discovers the harder he works, the behinder he gets because the more money he makes, the more they take from him. So it's a law of declining returns as well. So Wally Wannabe just gives up at some point. Why try? because they are just going to take more and more. You're not rich enough to say I have a lot of surplus. And if you're trying to struggle through that crisis period...you can see small businesses do this as well with a Social Security payments. You know, small business people pay twice what the W-2 check earner owes. So the system actually wars against any kind of wealth production, but I don't know why it keeps selling year after year after year. [56:22]

JIM: Well, there is two ways in which it impacts its economy. The higher tax rates aren't going to affect the wealthy class on the investment and saving side; and then the government fiscal spending and deficit spending is going to impact the lower and middle classes through the rise of inflation. So all elements of society get hit. The wealthy get hit on the saving and investment side. There is no money for savings, there is less reinvestment because the more you make, the higher you pay. And then the lower and middle classes get hit with fiscal and monetization of government debt, so they get hit with inflation. So the whole thing impacts all elements of society.

But, you know, what I think the route we're going to go and I disagree with...there is somebody else, a couple of other people see the same depression forecast that we see in the year 2010, the only difference is they see it as a deflationary depression where I see it as an inflationary depression. But we are going to make the same mistakes. Think about it. We're going to repeal the Bush tax cuts, so that immediately is a major tax increase. Secondly, they lift the caps off Social Security. And three, they add an extra 4 and 5% income tax or surtax on income over a certain level, so that's going to hit the savings and investment class. At the same time, the inflation rates, which are going to go much higher, are going to hit the poor and middle class. [57:56]

JOHN: So basically, Jim, your perfect storm scenario there as I call it, is coming about. Not to mention, we haven't talked about the effect of the energy crisis, which is going to happen in the very same window of time, which will drive prices up, because look at the cost; as the cost of petroleum goes up, the cost of delivering goods goes up, the cost of producing goods goes up and this is in parallel to all of the other issues we're talking about that. This really is a perfect storm.

I'm predicting, and this is my prediction for the year is that whoever gets elected in this election will be a one term president because the people will be so upset by the end of his four years, whether it's his fault or not, that they are just going to throw him out.

JIM: Yeah. Probably the best thing for any political party would be to actually lose this next election because whatever party is in charge of the White House or Congress is going to get the full scale blame for this much as, let's say, the Republicans got the blame for the Depression of the 30s, even though we know that Roosevelt actually made the Depression much worse with the New Deal policies that came in with government involvement and 90% taxation. I mean it just makes common sense.

There are people out there that feel there should be no rich people. You shouldn't have a Warren Buffett or Bill Gates or Steve Jobs. But when you think about what made this country great, the thing that made it great was entrepreneurs. It was Henry Ford inventing the model T. It was Steve Jobs inventing the Apple computer. Bill Gates coming up with Microsoft. This is what creates wealth. And if you penalize these people. Let's look at it this way. If they repeal the Bush tax cuts, tax rates go up to 39.6, add on top of that taking the cap off Social Security, which if you're self-employed you would pay 15.3% on top of that, so now you're in a 55% tax rate; add to that if they add a 5% surtax as the Rangel plan calls for, you could be up to 60%; and then on top of that, John, add tax rates like California where it's 10.3%. At that point, the government is taking three quarters of what it is you make. At that point, I think you're going to see what Charles Adams wrote about in his book Fight, Flight Or Fraud where there is absolutely no incentive. So unfortunately that's the way history shows us. And the outcome of debtor nations has always been inflationary. And that's why I think as we get into this, it's going to happen that way, John, until finally central banks and Keynesian economics are totally discredited because of the aftermath of what comes afterwards. Remember Keynes saying “in the end we’re all dead” because he realized this whole system falls apart?

You can postpone, postpone, which is what the debt Supercycle has been. It means that you postpone the inevitable day of reckoning. But in each postponement, it takes an ever increasing amount of leverage and credit to keep the system going. And when in the 70s, with inflation, mom went to work, in the 80s and 90s, the savings rate disappeared and then in the 21st Century, we added debt on top of that. And you know, what's left to monetize. And that's why I think this debt Supercycle that Bank Credit Analyst talks about comes to an end. The other thing too is if you look at the one bright spot in the economy right now, it is manufacturing. Indeed, it may be in its nascent stage right now, but a renaissance in American manufacturing [nonetheless]. But if you look at the election campaigns, both parties are talking about protectionism. And right now, if that's the way we go as the unemployment rate increases, protectionism gets us a beggar-thy-neighbor policy, which basically have been in with the currency depreciations that we've seen globally.

JOHN: So basically what we're saying here is that we are going to have to go through this pain and it should be pointed out that if we look at where we're headed energy-wise economically, the politicians, I would say, on all sides of the aisle, except for maybe Ron Paul are all running in 180 degrees the wrong direction. They are actually doing the opposite of what would be required to pull us out of this.

JIM: Absolutely.

JOHN: You're listening to the Financial Sense Newshour at www.financialsense.com. Next hour we'll continue the Big Picture, talk about the assets, markets.

JIM: And investment themes and risk.

Part 2

Risks

JOHN: I know when we were getting ready to do this program earlier in the week (we do a number of conference calls during the week to try to pin point what we're going to discuss on the show and who we're going to interview et cetera) and the first time I heard you say, “I think in 2009 we're going to have a depression,” that was one of those telephone tap moments. You know, where somebody says – you said depression and you go you know what, tap, tap, tap, I could swear I just heard you say depression instead of a recession, you know.

JIM: Actually, it's 2010 that I see it. But we are going to be heading in that direction towards the end of the year and into 2009.

JOHN: So basically it's inside of that crisis that we're always talking about which is really 2009, 2012 when we were saying last year that is the crisis window and the run up to it would be in 2008. We would see the first rumbles of the earthquake or the storm that's coming in 2008 as we move into it. So, okay, depression is a big thing, but of course if there is a depression and the price of oil is going up, there is also the potential for global conflict as well because especially by the way governments historically start trouble when they are in a depression.

JIM: Yeah. I do expect as the economies weaken, as the price of raw materials rise, especially energy that the tensions between governments around the world are going to increase and we'll probably be introducing another concept that I don't want to talk about now, next year. But one of the things that we've been talking about that here, John, probably for what, the last two or three years –this shouldn't come as a surprise to anybody listening to the program – is that crisis window period. In fact, as I recall, we talked quite a bit about it last year that crisis window that begins in 2009 and goes to 2012. [1:53]

JOHN: We're not alone, by the way, in that depression thing because people like Harry Dent and he's speaking from a demographic standpoint. He's talking about a depression in 2010. So we seem to be starting out from different trailheads but we're arriving at the same central point here.

JIM: Yeah. There are a number of people out there that have approached the depression that with the baby boomers heading into retirement, we get into a bear market. But I've arrived at this from two different perspectives. I'm approaching it more from an Austrian business cycle theory and sort of what has been labeled by Bank Credit Analyst as the debt Supercycle. The debt Supercycle comes to an end. And then another element that is also going to figure into this mix of perfect storm (or perfect storms) is going to be peak oil. So it's more from a peak oil, more from an Austrian business cycle theory that I'm arriving at the depression versus, let's say, the demographic concept that's been put forth by people like especially Harry Dent who has written a lot about this. [2:57]

JOHN: All right. So what do we have to explain now in terms of this?

JIM: Well, we are going to be covering this because it gets more complex as you get into the business cycle, the extension of credit. And remember we talked about this, remember we did a four part series of Dying of Money, and we addressed the issue that every time you get into one of these booms and then you go through a bust there is less of a tolerance for pain. So everybody wants government in the central bank to come in and do something about it. So what happens is instead of the day of reckoning, instead of the cleansing process that took place under the gold standard, what you have is a postponement of that day of reckoning by the extension of increasing greater amounts of credit. So every time that we go through this bust cycle, the credit cycle gets repeated and extended and it takes an ever increasing amount of credit to keep the whole system going. By the time we get to 2009 and probably 2010, we're simply getting to the end of that cycle. You're no longer able to extend that credit cycle any further. And the only thing that I would differ from people like Dent who believe that we'll be in a deflationary depression is I think we're going to be in a hyperdeflationary depression because that's always been the outcome of debtor nations. [4:26]

JOHN: Yeah.

JIM: And if you look at why we're going in that direction, the classic cure for a debt crisis is inflation.

JOHN: Why is Dent calling for a deflationary depression?

JIM: Less consumption, less spending. And I think a lot of these people that are looking at a deflationary depression are looking at it from a world view of what happened in Japan and the United States in the 30s, and Japan in the 90s, not recognizing that, you know, the world is on a different system today. We were on a gold standard back then and both the US and both Japan were creditor nations. The outcome for creditor nations in a downturn is deflation. The outcome for debtor nations has been inflation, because the classic cure for politicians with a debt crisis is to inflate it away and that's what we're going to do. [5:17]

Asset Markets

JOHN: Now we have to look at one of the oddities of some of your predictions and that is for new records in the Dow. Especially considering the markets are going down. But this is nothing new. Remember on the show last year it was the same deal. It was like you were calling for new record highs and of course people were saying that's not going to happen. And then sure enough (I think it was early summer, wasn't it? I can't remember.) when everything went rocketing through and all of a sudden everybody was jumping up and down going “can you believe this, there is a Santa Claus” – that type of thing. So why do you think we'll have it again this year?

JIM: Well, if you take a look at – and I approach this from an Austrian perspective – the situation in 2001, the US economy was heading into a recession and the Fed was pushing money into the system massively, although nowhere near what they are doing today. When a central bank creates money in the system and they push them into the financial system, I mean all of this money, when you hear us talk on the program, of 18 out of the 20 central banks around the globe are seeing increasing double-digit money supply growth. You know, that money is not going in people's mattresses. They are not creating this money and then people are burying it their backyard.

So if you look at situation, for example, last time when the Fed did this when we were in a recession, 2001, where did the money go? It went to an area that wasn't inflated. What wasn't inflated at that time? Well, the bond market was a recipient. As the Fed lowered interest rates –remember, commodity prices were lower at that time – we had an influx of money going into the bond market driving down bond yields to record levels close to 3% on the 10 year Treasury note. It went into real estate because real estate was cheap relative to, let's say, what wasn't cheap. What wasn't cheap in 2001 was stocks. So money went into bonds. Money went into homes and money went into commodities. Where money did not go into in 2001, it didn't go into the stock market. The stock market was down in 2000. The stock market was down in 2001 and the stock market was down in 2002. So three years of a bear market in stocks where the NASDAQ, which was the big bubble of the 90s, the recipient of the last reflation of the 90s, you know, stock prices just got to ridiculous levels. Money went out of that sector, so it just found a new home. It went into bonds. As bond rates came down, as the Fed cut interest rates, mortgage rates came down. Money went into the real estate market. We got a real estate bubble, we got a mortgage bubble, we got a bond rate bubble, and money went into commodities.

So now you have to ask yourself a question. With the Fed creating money and central banks around the world creating money and central banks putting money into their sovereign funds –I think there is like over two trillion dollars in sovereign wealth funds and there is a projection by the year 2010 that figure rises to 7 or 8 trillion dollars – what are these sovereign wealth funds doing, John? They are buying stocks. So as the Fed pushes money into the system this year, where is it going to go. Is it going to go into the bond market? Maybe initially as a flight to quality. We saw a bit of that in the fourth quarter. We’re seeing a bit of it now, Especially with the rate on the bonds going down to, let's say, 3.8%. Maybe we get down to 3.5, 3.6. Will it go into real estate? Unlikely, because that's the area of the last bubble.

The two areas that I see it going into is commodities. And we're seeing it on the day you and I talking, even though the stock market is down, oil prices are down, base metals are up, agricultural and soft goods are up. If you take a look at the CRB Index on the day that you and I are talking about that, it was down a couple of points, but within the CRB Index we had nickel prices up, aluminum prices, natural gas prices up, sugar prices up, corn prices up. And I expect that same thing. And you're seeing it much today because as money dies (as we talked about last fall), and as central banks inflate, and currencies depreciate money starts going into tangible goods. And one of the areas that did not get over inflated in this bubble in this new decade was the stock market. I mean you've got a lot of companies. One of the things that did not happen in this decade, John, is stocks relatively speaking with a low interest rate environment, stocks aren't the extreme overvalued asset. Now, some would say “well, gee, it's no longer selling at six and seven times earnings,” but in a world where interest rates are at 3 and 4%, the earnings yield on stocks, stocks represent the better value and especially in the era of inflation.

And one thing that we saw, and we'll get into this in terms of investment themes in another part of the segment of this program today is you saw a lot of the classic growth stocks the must-own stocks kind of like the nifty-fifty stocks that everybody had to own, let's say, in the late 90s. You know, the General Electrics, the Ciscos, the drug stocks. If you look at General Electric, in the last five years, net sales have gone from 130 billion to almost 170 billion. If you take a look at net income, net income has gone from 14 million to almost 21 to 22 billion. And yet, John, for most of this decade, General Electric stock has been consolidating in a long consolidation pattern. General Electric stock reached a peak roughly at $60s a share back in August of the year 2000. Today, General Electric stock is at $36 a share. The PE ratio on General Electric stock used to be in the high 20s and today, General Electric is selling at 16 times past earnings and probably about 14 times this year's earnings.

And you can see this with a lot of the growth stocks and we'll get into investment themes for this year. Large cap growth stocks are going to be one of the places to be. But the point I'm making here is when central banks push this money into the system, it just doesn't stagnate, it goes somewhere. It can go into real goods creating inflation; you're seeing some of that now and that's playing catch up, that's why you're seeing higher commodity prices, higher energy prices all across the board, higher food prices. It doesn't matter. You're seeing the cost of living go up for all of the basic things that people need to live. Ignore the core rate of inflation for a moment. But what is not over inflated at this point is stocks. And that's why you're going to see with these sovereign wealth funds that are coming into existence that's going to probably be another catalyst for stocks. And as this money is created, I expect it to go into commodities and the stock market. And that's why in 2006, when the Fed was raising interest rates, particularly when Bernanke came into the Fed we were talking about why we would see higher stock prices in 2006. And we said the same thing in 2007; and it's why we think we'll see higher stock prices this year. The lower the federal funds rate goes, the higher the stock prices will ultimately go. [12:57]

JOHN: Let's see if we can reframe this now based on how we started the conversation. That is the year is going to look like an Oreo, real hard crust at the beginning, something that's rough to get through. How many months on that would you say?

JIM: I would probably say probably into the, maybe the end of the first quarter. By March we should get through most of the rough patch assuming certain things happen. And then by that time with the weakening economic numbers, with the weakening earnings, with the write-offs that are coming, by then, I think you're going to see all kinds of talk. Expect some kind of fiscal spending initiative that we'll get by summer and obviously monetary reflation coming from the Fed. [13:40]

JOHN: Okay. So basically we're going to have rough first quarter. Then we get to the creamy filling for two quarters approximately. Would that be a fair guess?

JIM: Sure.

JOHN: And then by the time we get to the end, you get to the other side of the cookie and unfortunately, unlike using milk, you can't lick the cream off first. So take it back to that in perspective here.

JIM: By the time we get to the end of the year and especially past the November elections, I think inflation is going to come back with a vengeance. In other words, all of the monetization by the Fed, the injections of liquidity, the lowering of interest rates...I mean look at it this way. We're already talking about oil prices near a hundred dollars a barrel. We're talking about that gold prices at close to, let's say, 870 an ounce. Silver prices over 15. And if you look at the commodity complex all of the way across the board, I mean even if you look at copper prices: copper’s over $3. You're looking at corn prices over 4 and we could very well see corn prices go to $6. That's one of Byron Wien’s projections this year. The whole ag sector –whether you're looking at soy beans, you're looking at wheat, sugar, even cotton – is on the rise. We can see higher cotton prices. All that is going to come back to haunt us towards the end of the year and what that's going to lead to is not only a major increase in headline inflation, we can see headline inflation numbers approaching four to six, maybe as high as seven percent. Core rate inflation numbers, who knows. Maybe they'll tinker with that. But at that point, you're going to see rising interest rates and you're going to see rising inflation levels. I think inflation really comes back to bite at the end of the year. And then I think as we get into 2009 depending on what happens with the election, then I think you're going to see a whole series of policy mistakes made by government and that will lead us into that 2010 window period where I expect us to be in a depression. [15:44]

JOHN: Okay. So basically we're calling here for higher stock prices. Very quickly, positives or negatives for stocks.

JIM: Okay. The negatives probably at the top of the list has been Fed policy mistakes. They are behind the yield curve. As we talked about in the first hour, they are still dealing with a crisis as if it's a stage one financial crisis instead of a stage two. Second on the negative side, credit crunch. If the Fed doesn't get behind the curve, we could move from a stage two crisis to a stage three crisis. Another negative is the peak in corporate profits, which I think peaked around 2006, around 2007. And also this return of inflation comes much sooner than I anticipate. And so those are some of the negatives. [16:40]

JOHN: And then what about the positives?

JIM: Well, the Fed is definitely in a easing mode. It's already lowered interest rates on the federal funds rate by a hundred basis points. We've got decent equity valuations in comparison to bond yields. Low bond yields right now in comparison historically. I mean when you're looking at bond yields I don't care anywhere across the globe, I mean you've got two year treasury note is at 2.7. You've got the 10 year note at 3.86. You've got the 30 year bond at 4.37, so we've got lower bond yields. And I think eventually, you're going to see a steepening yield curve. And banks need a steepening yield curve. In other words, they need a wide spread between the longer interest rate and shorter interest rate because shorter interest rate is what they pay for money coming in. That's what they pay depositors. And they need a higher curve and higher long term interest rates so there is a positive spread for banks to go out and lend. [17:39]

JOHN: Okay. So we're looking at higher asset prices and what would your predictions be based on that then?

JIM: If the federal funds rate gets down, to, let's say, 3, 3 ¼, we could see the Dow approaching the upper limit in the 14,000 range. Maybe on the outside as high as 15,000. If the federal funds rate goes down in the 2% level, then you can see the Dow in-between the 15 and 16,000 range. The S&P above 16,000; and NASDAQ above 3000, maybe as high as 3500. That would depend on the Fed taking the federal funds rate below 3% though. The lower the federal funds rate goes, the higher the stock market ultimately goes, so definitely higher stock prices. I do expect oil prices to approach somewhere in the $125 range, maybe even higher, as high as 150 if we have some kind of disruption or some kind of geopolitical event or something like a bad hurricane season during the summer that goes through the Gulf and takes out some of the oil platforms or some kind of geopolitical event in the Middle East or something like that – so oil prices are going to be higher.

I do believe gold is going over a thousand, and if it does go over a thousand, I think just on sheer momentum alone of the hedge funds, the institutions and even at that point Danny Day Traders coming in, you could see gold spike very high, very quickly and hit 1200, 1400 or maybe as high as 1500. So I expect higher gold prices, higher silver prices. I expect this is the year of the junior. I think once gold goes past 1000, you're going to see prices on juniors that are going to be unbelievable. And I also believe across the board you're going to see higher commodity prices, higher agricultural prices, higher base metals prices, higher energy, I mean the whole complex. [19:42]

FSN Humor: Andy Looney

I'm Andy Looney. Oh my. It's 2008 already. My wife Sandy says I should make a New Years resolution, like losing 20 pounds this year. Been there. Couldn't do that. Could you? I couldn't. Heck, last year's inflation looks modest compared to the gains from Aunt Fannie's Christmas fruit cake. It's a gold mine of calories, so even if I try to lose weight this year, Aunt Fannie's fruit cake will come back just like the IRS to haunt me next Christmas. It's a battle I just can't win.

You know, I'm thinking a better resolution is refusing to believe government figures, politicians’ promises or Bernanke babble this year. After all, here it’s the silly season before the elections. And you know that I know that you know that with a drooping economy and impending election, these guys will say anything to fool the public. So I'm resolving to not be fooled. Will you be fooled? I won't. Hope you won't either. When the government says the budget is balanced, I'll ask which part. They haven't balanced a budget since 19 – 1918 something. I don't remember. Anyway, it was before my time. Probably before your time too. When politicians promise to give me everything I need by soaking the rich, I'll ask, who is Rich, and how much money does he have and how wet can he get? When the Fed says inflation is contained, I'll ask what their definition of ‘is’ is. Actually, you and I both know that the Fed has an overinflated opinion of its control of inflation.

Anyway, I hope you have a happy New Year. Happy 2008. For Financial Sense, I'm Andy Looney.

Investment Themes

JOHN: Now we get to a very important part of any one of our conversations here, Jim, and that is the “so what are you going to do?” because we described the environment, we think everything is going to be in higher stock prices are going to be out there. Now our listeners need some investment ideas. And maybe we'll want to look at some of the track record of what happened with PFS Group over last year so we see how well the trends were followed.

JIM: We talked about, John, in the last hour, of this analogy that we were talking about of the Oreo, so let's talk about the first quarter. A lot of volatility coming in the first quarter. We're seeing it right now. You're going to see weaker economic numbers very much reminiscent of what we've just seen in the last week. The ISM numbers on Tuesday going below 50. The unemployment rate going up to 5% on Friday. So expect more weakening economic information on the fourth quarter. Expect more weakening economic information on the first quarter. Expect lower profit numbers, probably in the second or third week of January. Anybody that's missed their fourth quarter earnings are going to announce, so that could be some greater volatility. You're also going to see more write-offs. A lot of these big financial institutions are going to be writing off a lot more than what they’ve disclosed because when you get into assets that you don't know what their value are until you get down to selling them, a lot of these big financial institutions (whether you're talking about the money center banks or other financial institutions) don't know the extent of their losses. So expect more of that. Expect maybe some bankruptcies in the first quarter. So a lot of turbulence in the first quarter and if you just can't take the volatility, one of the best places to be is in cash.

Now, one recipient of the stock market going down is money just rotates in the bond market, and so if you look at a graph of bonds since the beginning of the year, the yield on the 10 year Treasury note has gotten a lot lower as we’ve seen this volatility in the bond market take place. So one recipient or one place to hide may be the bond market or simply cash. [23:50]

JOHN: Okay. When we talk about the stock market going higher, obviously we're talking about the stock market as a whole. But that doesn't mean every sector is going to perform equally, so what sectors are key here in the discussion?

JIM: Well, I think one theme that you're going to see continue from the last part of last year is that growth stocks are going to outperform value stocks. And that's simply, John, a lot of value stocks are in the financial sector, a lot of the value stocks are domestic smaller cap companies. And if you take a look at the US economy slowing down and you take a look at the emerging economies of India, Asia, Latin America, growth stocks tend to be international-oriented companies, they get a good portion of their sales overseas. So growth stocks, large cap international stocks, companies that have wide exposure to the fastest growing regions of the world, I think they are going to dominate the markets, which is one reason why I think you'll see the Dow outperform the S&P. Especially within the S&P where you have so many financial stocks, although that can change as we get towards the end of the year. So definitely companies that are exposed to the global growth story.

And also I think another sector and a theme that we sort of emphasized last year and that is the infrastructure boom, because when you talk about the Chinese building 100 airports, building new cities, building highways, building factories, building power plants, you know, that's infrastructure. And one thing I would not be surprised to see –just as we had the highway funding bill that we're going to spend 200 billion in the US is as the economy weakens – is some kind of fiscal stimulus coming out of the US where we start to build the infrastructure in this country, which is basically falling apart at this time. So companies that are exposed to global infrastructure whether it's energy, engineering companies, also on the defensive side as the economy weakens, I think consumer staples, they did well last year. I think they will do well this year. So those are sort of some broader themes. In other words, large cap growth, international companies, companies exposed to infrastructure. [26:09]

JOHN: If we're talking about large cap growth, any specific performance sectors you'd expect to see.

JIM: I also think that this year like last year, the year before that and the year before that, I think energy is going to outperform again and especially as oil prices cross $100 a barrel. So I think the energy sector, the energy infrastructure sector, energy alternatives. Remember, as the price of energy moves up higher, especially with oil prices crossing over $100 a barrel, you're going to see alternative energy rise – whether it's solar, wind, coal. You're going to see the alternative sector also rise with that. And specifically, I think, consumer staples, we mentioned that earlier.

Along with that infrastructure theme are industrial stocks, because not only are the industrial stocks exposed to the global infrastructure theme that we see, but I also think that there is a nascent beginning renaissance in American manufacturing, in other words. And I think also this goes well with the peak oil theme, John. As energy gets more expensive, as the labor differentials change between the United States and the rest of the world, especially as the dollar goes lower, it's going to become more economical for companies to build factories here in the US where the labor rates are much more competitive. And also, as a lot of companies will find as the price of oil heads towards $125 a barrel, $150 a barrel and eventually over 200, maybe as high as $300 a barrel, it's just going to become too expensive to be just-in-time inventory and also buying raw materials in Latin America, shipping them to Korea or Singapore and then from Singapore and Korea shipping them to China and then from China across the ocean to Long Beach and then from Long Beach put on a rail to New York. So I think industrials are going to be another sector.

And here is what will probably shock a lot of people: Technology. The technology sector tends to be shorter term in its nature. You know, you take a look at a lot of the technology spending that we saw in the latter part of the 90s, a lot of that infrastructure is aging. It's going to be replaced. And also, technology will be on the forefront with peak oil in terms of solving the peak oil crisis. I think technology is under owned, underloved and undervalued, so I think technology stocks are going to do well.

And then two other sectors that we’ve talked about in my pieces that I've written both in my Perfect Storm series and The Next Big Thing and that is food and water. So I expect the agricultural sector to do very well. Actually, the level of inventory of grain, which is probably one of the most important food commodities in the world, is at some of the lowest record levels as we move more towards ethanol. The water levels are falling precipitously. Especially in our big water aquifers in this country, so I think water is a big issue. That's a theme that we've been emphasizing here on the program for quite some time now, both water, also the food sector and the energy sector and precious metals. Those were basically the four sectors that I said would outperform this decade when I wrote The Perfect Storm back in the year 2000.

So I expect those four themes to continue, but adding on to that theme, I think you would definitely have to go with the industrials because of the infrastructure boom and also technology. [29:42]

JOHN: When we talk about predictions, if there is one thing about predictions is that certain parts of them are not predictable and that means that life is full of non-linearities. You know, we go to work, come home, do whatever we do and life sort of repeats itself in cyclical patterns. However, into every life non-linearities do fall and that occurs to a country, to an economic market and they come out of places that's nobody really anticipated; you just can't expect every single thing. So what are the risk factors now as we talk about investments? Obviously, geopolitical is going to be a big one in that area.

JIM: You hit upon something and that's something that anybody listening to this program or listening to any other program or reading any forecast for the year, you hit upon something, John, that throws every forecast off course and that is these non-linear events. I mean a good example of that was in 2007. In February of 2007, we got the first break in the credit markets with the financial intermediaries starting to go under. In January of 2007, oil prices at 50 and look where we ended up the year. And once again in August out of the blue, the subprime crisis hit and threw everything off kilter. So if there was anything that could go wrong here, it is a policy mistake by the central bankers. In other words, if they don't get on the ball, then we go from what we described in the first hour, the stage one crisis to the stage two crisis and directly to the stage three crisis.

And that indeed is a big risk. Bernanke is not really a decision maker, he's probably the least experienced Federal Reserve board chairman that we’ve had at the helm here. He's more of a consensus builder, and when you're into crisis, John, you know, if the ship is sinking, you can't have a bunch of guys getting around the table and say, “what do you think. Do you think it sinks in an hour or do you think it sinks tomorrow?” You can't have that. You have to have a decision maker saying we just hit an iceberg, we've got to do something. And that doesn't seem to be – Bernanke is more an academic. He's a bureaucrat. He's a consensus builder, where Greenspan was more of a decision maker, had a better feeling for a market crisis and that is a big possibility here. I mean look at the ECB. But I take that with a grain of salt. The ECB is talking very tough. At the same time they are allowing their money supply growth to grow at three times the limit that they put in place when they formed the ECB. So there could be a policy mistake made both by politicians in Washington, in the central banks, but I would say probably at the top of the list, barring some large terrorist attack, a war or something or the break out of Ebola virus or some kind of plague or something like that, I would say probably top of the list is policy mistakes. Like I said, this is probably the least experienced Federal Reserve board that we've had at a time of probably one of the worse financial crisis that we've had and the Donald Kohn speech on Friday, basically saying we can't even agree among ourselves where we're going. So basically, what Donald Kohn said on Friday, we can't figure this out and have no idea where we are going. [33:13]

JOHN: Well, obviously, that's going to be a problem right then and there simply because of the fact that most of the markets, if you look at them and listen to the chatter out there, they are counting on this reflation theory. But it would seem like the central banks instead of taking action, they are sort of sitting around twiddling their thumbs. And so already you have a discrepancy here between expectations of what they will do and actual performance.

JIM: And I think one of the reasons why they are having a problem with this, John, is remember, take a look at where the inflation rates are right now. Look at commodity prices. And this is something that we talked about over the years here on the program is unlike 2001, when we went into a recession, the events of 9/11 hit, man, Greenspan was dropping interest rates 50 basis points in-between meetings and he took the federal funds rate from 6% down to 1% very quickly. But remember, we had 18, $20 oil prices, we had gold at 250. That's not what we're dealing with today. The headline inflation numbers themselves, even though we know they are somewhat jerry-rigged by the government, even the headline inflation numbers are much higher today than where they were in 2001. So that's the dilemma. They know the money supply is growing at double digits and they are saying, “well, we've got higher oil prices.” And they are looking at that, and I think that's the problem is that they know that they are painting themselves into a corner here and we're going back to what it was like in the 70s where there was no positive outcome to anything that they do.

I mean if they don't lower interest rates fast enough, we move to stage two and stage three crisis; and we can accelerate the depression timetable that we've been talking about that earlier in the program. On the other hand, if they really start cutting interest rates, I think you're going to see what we've been talking about is the Oreo analogy where at the end of the year we get a rough final months of the year where inflation comes back with a vengeance and we start seeing a rise in long term interest rates which begins to choke off what will be an anemic recovery coming out of a recession; or we could still be in a recession at that point despite the monetary and fiscal stimulus that I expect to unfold this year. [35:28]

JOHN: Yeah. If you look at some of the indicators right now, Core inflation is up, the Headline inflation is up, Producers is up. The dollar is going down. What if this keeps on this trend line? Things could burst a little earlier than we anticipate.

JIM: Well, one thing that I think you could see here in the first half of the year and boy, I've got a good dose of this during the Christmas holidays, in-between Christmas and New Years, we went to the outlet mall, John, and it reminds me, remember the Kevin Costner movie, “build it and they will come”? You know, put it on sale and they will come. We went to one of the outlet malls. We went to an outlet mall in Carlsbad, and I'll tell you, we went on a Thursday, it was in the middle of the week, two days after Christmas, figuring the traffic wouldn't be there. Had to have my car valet parked. Couldn't find a parking spot anywhere. And you walked into the Ralph Lauren store and as soon as you walked through the door, you had a guy giving you a coupon that for every $75 you spent, you got an additional $10 coupon off of the price. The store was a mob scene. I mean everything was slashed 40, 60%. You went to the coach store, they were they were giving out gift certificates or prices off stores. I was absolutely amazed at the traffic.

So let's define inflation as seen through the world of Keynesians and most of the people in this country. They would say that inflation is rising prices, and deflation is lower prices. Now, I come at this from an Austrian perspective in that inflation is an increase in the money supply, deflation is a decrease in the money supply. Let's go back to the Keynesian argument of what constitutes inflation. What you could see is from a price perspective both inflation and deflation from a Keynesian point of view. You could see deflation in the drop of manufactured goods prices. In other words, we know for example with the economic numbers that inventory levels are starting to build. And what happens when inventory levels build? Whether it's a retail store or business you start slashing prices just like the home builders to clear the inventory levels, so you could have falling prices, maybe in the first half of the year as manufacturers and retailers begin to clear merchandise and try to move it and put it on sale. I was just absolutely blown away at some of the sales I saw, not only during the Christmas season but also in the period after Christmas at some of the outlet stores where everything was just slashed. And of course, we know the White Sale that takes place at the beginning of the year. So you could see falling prices on one hand in manufactured goods which would get carried over in to the core rate of inflation; and on the other hand you can see rising prices in the things that people need, energy or food. And so on one hand you can see both of these things taking place in the economy at the same time.

However, one real risk is that the monetary inflation, instead of kicking in to, let's say, as an outlet for inflation, which is the asset markets, you could see more of it spillover into the real economy. But I would expect that you would see a disinflationary trend in the sense that we know real estate prices are continuing to fall, inventory levels are at a record level, they'll probably move even higher as the economy weakens, more people lose their jobs, we've got the unemployment rate on Friday, the unemployment rate is now up to 5%. So you could have people defaulting on their mortgages because they are losing their jobs even though up until that time they were making their mortgage payments.

I was talking to a friend of mine Thursday night and he's in a new housing development. There is, I think, 70 homes he was telling me. And two of his neighbors have got their homes for sale because both of them have recently been laid off. So you can see more of that taking place in the first six months of the year. But the inflation risk is definitely there, but I, in my personal opinion, I think it comes back to bite us at the end of the year as a result of fiscal and monetary stimulus. [39:39]

JOHN: Well, we know that China is trying to slow its economy, but what happens if they overdo it there. What effect is that going to have?

JIM: Well, obviously, Chinese economic growth was to drop from its 11 and 12% growth rate, I don't even know, down to 3 and 4% rate, you would have immediate impact on the commodity market, so you might see a declining trend in commodity prices very much similar to the growth scare we had on China in the spring of 2004 when everybody said “oh my goodness, the Chinese economy is slowing down.” The commodity market sold off. As it turned out, that was not the case. You might have some problems in the Chinese asset markets being overvalued, but I just don't see that. I think with the Olympics in the summer of 2008, there is no way they are going to want to throw their economy into a recession with civil unrest. I think that is a less threat to this scenario just simply I don't think the authorities are going to want to see that happen. [40:37]

JOHN: Probably the one that is most difficult to predict (I mean in addition to geopolitical events because some of those things come out of left field when you don't expect them), but everyone is talking about that populism right now. If populism begins to really catch on and we start to see this move to a sort of tax the rich, tax the corporations, regulate the corporations – in other words there will be another move to require another layer of regulations which releases another swarm of agencies on businesses etc. All of this has a chilling effect on the whole investment area, which is what starts to slow the economy down here. That could be a real serious issue. It's always interesting to me how those who make an appeal to populism pant heavily for the money that capitalism produces at the same time they’re condemning it. It seems to be a contradiction in their belief systems. [41:26]

JIM: One of the risks that you have here is the caucuses, I think the majority of the caucuses should end by the end of February, so we should have some kind of idea of who is going to be the Republican candidate, who is going to be the Democratic candidate. And then once we've got a front runner, then they are going to start espousing policies. And if we start seeing anti-economic, anti-investment, anti-corporate, and anti-market policies coming in with populism, that's a very big risk. That could throw the forecast of what we call that kind of creamy center in this Oreo analogy that we're talking about that. If you start hearing people like Edwards wanting to tax corporations, raise tax rates to unbelievable levels, get rid of the capital gains benefit, double the capital gains rate, get rid of the special lower tax on dividends and start that, that's not going to be good for the markets. The last thing the market wants to hear is “hey, we're going to raise taxes on capital gains, we're going to raise taxes on dividends, we're going to raise taxes on corporations, we're going to raise taxes on individuals.” If that starts to pick up momentum, then add that to a weakening economy, that's not going to bode well.

What I do suspect is if the economy begins to weaken and go into recession as we think, I think both parties are going to scramble. Remember, like Bill Clinton did in his 92 campaign, he said “it's the economy stupid.” And remember what was it? He promised a middle class tax cut. Well, he reversed that as soon as he took office and said, “well, I can't do it.” But politicians, remember, are going to tell everything they can if they think it brings in votes and gets them elected. So instead of talking about raising taxes, you could hear something like a middle class tax cut very much in the same way that Bill Clinton talked about in his first presidential campaign. So you could see that reverse itself.

But you're absolutely right. This is a presidential election year. It is also an election year. The entire House of Representatives is up for reelection and also one third of the Senate, so God knows what kind of crazy kind of schemes or ideas that we could see float. And especially if we start seeing bankruptcies increase and you start seeing like Bush did – remember in December when he came up with his mortgage proposal, which would basically alter property rights and contract law? That's the kind of stuff that's very scary for the markets. [43:59]

JOHN: Yeah. Because it's an effort to solve a sort term thing but not only has it got a long term impact, which sets a not necessarily good precedent, and we're already having trouble with a lot of law and I guess you would call it populism. You're seeing under Ron Paul, we've been making a wreckage of a lot of our legal system by constantly changing things for political expediency that really now needs to be repaired including assaults on the Constitution. And it's interesting that in the mainline crowd that are leading in the pack so to speak on both sides of the aisle as far as the campaign is going, that these do not seem to be traction issues. And yet judging from the quantity of traction that Ron Paul has been getting in terms of campaign contributions, there's really a large number of people out here who think that's an important issue. It's just that the media haven't picked up on that as being an important issue. So that's the discrepancy you're seeing.

JIM: Yeah. Because if you look at the Paul campaign, he's talking about running this country as our Founding Fathers originally intended with a Constitution, a Bill of Rights, less government interference in the marketplace, not allowing the Fed to inflate away the currency. And that is gaining a lot of traction, especially on the independent side. And I'm an independent and I'm for Ron Paul. And a lot of people like myself have become disenchanted with both parties where John it doesn't matter who is in office. I mean the Republicans took control of Congress in 1994 what did they do? They lowered taxes, increased spending, did a lot of things that were not in the Ronald Reagan conservative tradition of the Republican party, so a lot of people are disenchanted with Republicans, the Democrats regained control of Congress and look what they've been doing. Look at all of the pork barrel spending, the special spending programs that they've put through. So a lot of people have gravitated to Ron Paul because they are realizing it doesn't matter whether you have a Democrat in or Republican, nothing changes. They both do the same thing. They both feather their own nest and they hand out goodies to those who supported him and contributed to their campaign and rewarded them. It's all about rewarding contributions, and it doesn't matter if it's a Republican or Democrat. [46:17]

JOHN: Yeah. Socialist party D and socialist party R. So that's how it would seem to be. But that's why you're getting the movement. I think that will even get more traction as the crisis window unfolds. The crisis window develops inside the four years of the coming presidency and we'll have one turn over of Congress in 2010 as well. So you may already see some of it happen at that stage, but we'll have to see. Like Bette Davis says, “put on your seatbelt, it's going to be a bumpy ride.”

JIM: It's definitely going to be a volatile first quarter, could definitely get more volatile at the end of the year, and especially as we get closer to the November election, especially after the Democratic and Republican convention when they have their campaign platform saying, that hey, if I'm elected, this is what I intend to do. So you could have some nervousness around that and especially leading into the fall as we get into October, a month before the November elections as everybody will be following minute to minute every single poll that's issued. And God knows, we'll have a gazillion polls issued every week saying this or saying that. Let's put it this way, as you and I always comment, this is going to be a good year to be in the news business. [47:25]

JOHN: We'll do pretty well regardless. It's really true. It's one of the strange oddities of news and radios that when things go badly, for some reason news and media tend to do well. Remember that Hollywood was actually built on the backs of the Depression and that people were willing to plunk down money to escape, for a little while, a lot of their problems and issues that they were dealing with. And the same thing for news because –you quoted Field Of Dreams earlier – if you tell the truth, people will listen as well. There is always this suspicion of the mainline media now that we're just not getting the real story, so people are looking elsewhere. And that's something else that the gatekeepers have been very upset with, so I'm anticipating we'll hear new calls, both from the left and the right for the Fairness Doctrine. In other words, they are going to have to start making it a little hotter for the alternative media, much as under the Clinton administration, they use the Internal Revenue Service to go after much of the alternative media at that time. And the Democrats are not the only ones to have done that historically, but that's what happened during that time. So it's going to be a little turbulent, but like I said, it's a good time to be in talk radio.

As I mentioned earlier when we started out this segment, it's really important to keep in mind as we talk about these nonlinear events there, but as the global economy begins to slow down, commodity prices go up, inflation goes up, global tensions will go up with it for two different reasons. Number one, certain factions will discover they have a lot of leverage now in the energy area –and we don't have to mention who they are right now. And number two, if you remember the Falklands War, that began over a monetary crisis which was present in Argentina at the time. Remember they had a military government composed of a tribunal of three heads and they were not doing well, and so to distract the Argentine populous, they attacked the British-possessed Falkland Islands and that's what started the Falklands war. So historically, governments start wars to distract their people in rough times.

JIM: Absolutely, and that's been the history whether you look at the rough times in the 30s, which eventually led to World War Two. And that's something that I do expect. As we head into that depression that I expect by the year 2010, what do I expect to follow with that and along with peak oil is global conflict. But, you know, that's discussion for next year. [49:52]

JOHN: But folks, Jim Puplava is selling fallout shelters.

JIM: I'm looking for a cave somewhere in the mountains.

JOHN: PFS Group, meals ready to eat, MREs. Hurry, hurry, get your Cold War era fall out shelter, dig it today in your own backyard. There we go, so... Which by the way is a very real possibility, a possibility in terms of the threat has never gone away, believe it or not.

The hard part of all of this, here is the deal, if you're going to be some kind of early warning service and many times speaking the truth in an environment where dishonesty is prized, speaking the truth can be a revolutionary act, so to speak. And the biggest problem you have is if you're going to be ahead of the cutting edge, most people are not out there. Most people look at the situation of where they are now and they compare what you're saying, especially if you're giving a lot of advanced warning and they look at the two and they can't understand how there could be this disparity. So, because the main line crowd are saying one thing, you just have to be wrong. But remember we were talking, we started 2001, 2002 saying oil prices are going to be up, peak oil was going to be an issue, we predicted $50 a barrel oil. It did that. We predicted 100; it did that. And at each point, everyone said “it would never do that.” And then sure enough, it does. And that's the hard part of being in this business. If you notice, no one ever comes back and says, “you know, you guys were right.” And that's the whole trick is you have to prize truth in going after...

You're not always right. You can't be right 100 percent of the time, but if you put things together sort of seeing clearly, then you can do it. So I don't know how you phrase that in any other way, but that's the situation you run is that I've heard for as long as we've been doing this type of thing: “I would never do that. Why would they do that. That's just crazy. You don’t know what you're talking about.” They've never done any research. They don't know. They just don't like what they hear. That's the difference.

JIM: Well, we've been telling people about this and we've done it in a very subtle way. We talked about this crisis window. We talked about that in 2005, 2006. We probably elaborated more on that crisis window more last year as a topic here on the Big Picture and we're going to elaborate more on it in going forward this year because in terms of how people are going to better able to prepare themselves because, John, I expect this depression to take place, I do expect peak oil. Those things are coming about. And I do expect as they always do throughout history, you know, when you read history –and half of what I read is history – is you read these events in history and you look back and say how could the leaders of that time, the kings, the prime ministers, the pharaohs, how could they have not seen this? How could they have made these errors. But they do. Every generation does. And that's one of the reasons, you know, failure to learn from history condemns you to repeat it. And here we are much like the end of the 20s and the 30s we're talking about making the same policy mistakes that Hoover and Roosevelt made in the 30s, but, you know, here we are. And that's what they are doing. [53:29]

JOHN: You know it's interesting. I was listening yesterday to the audio track from the interview with Traudl Junge, and I bet you don't even remember who that was.

JIM: I have no idea but go ahead and tell me.

JOHN: Traudl Junge was Adolph Hitler’s, one of his four private secretaries. She was very young at the time. She had been recruited into the secretarial pool and they did a documentary filming of interviews with her a few months before she passed away just a couple of years ago. And listening to this, what was amazing is she describes the mindset of the people at the time – it's easy to say Hitler was a bad guy in retrospect after you see the damage that was caused and the debts and devastation. But at the time, they didn't catch on to that, the people of Germany. It was a whole different spirit.

The second thing was that even after everything had fallen apart, there were people in Germany trying to figure out what had happened. Do you know that? They couldn't understand. They still couldn't put the pieces together in their head and that's why I think I heard Michael Reagan one time say on his radio show, he said “some people make things happen, other people watch things happen, most people wonder what happened.” And that very same group of people always has the same difficulty in looking forward for the same reason.

JIM: Most people are absorbed with the aspects of daily living. You know, you get up, you go to work, you have a job, you come home, take care of the kids, get them to the soccer game, help them with their homework, on the weekends you're mowing the lawn, doing the honey-dos. And most people don't have time to think about it. And unfortunately in the sound bite world that we live in today, everything is synthesized.

I remember I did television news and between 1991 and 1992 and my producer when he was teaching me to write my...I was the financial anchor back then. And he said, “you know what, in television, every sentence is no longer than three to five words. You must synthesize it to three to five words. You know, it's see Dick run, see Bob jump. Don't go on these long run off sentences because, you know, television is sound bites.” Programs, when you see the evening news, even the financial news, what do you see? You see sound bites.

One of the things I enjoy doing here on the program is when you get an author, (most of our interviews are between 30 minutes and 50 minutes, every once in a while we go over an hour) who has taken a year, six months to write a book, is to get beyond the sound bites. Get into the meat of the research in the book. And one of the things that we do not do in our society is we do not read enough. Most of us will take cursory pieces of information off the internet or a newspaper or a magazine where you get maybe two or three pages to cover a topic versus reading a book where you may have three or four hundred pages that's covers a topic that tells you why this thing originated, why it's unfolding and the way it ends. And that's something you get with reading a book that you don't get work let's say, reading a short blurb on the internet or listening to a sound bite on television. [56:46]

JOHN: Let's see if we can verify some of what we've been talking about. The best proof of prediction is the past. The past is a good predictor of the future. The past tells you as well how well your predictions did. And ultimately, the proof is in the pudding, because last year we made a whole series of different predictions as to where things were going to go. We do that based on a lot of research and observation I think and PSF Group in all but on one account, the PSF Group, based on the research you were doing, beat all of the major indexes. So that's where we stand on it.

JIM: We manage six accounts and there was only one type of account that under performed and that was our gold account. And quite honestly, John, last year I would have been better off if I just bought the four largest gold stocks because that's what really led the HUI last year was a handful of stocks. We're more heavily invested in juniors. Even though we had double digit returns, it was not a good year for the juniors, so we under performed the major gold indexes. But, you know what? I expect that to be made up this year, so I’m a long term believer in gold, long term believer in the things that we talk about on this program. [57:59]

JOHN: Yeah. A good example of this is remember one of the last shows that we did during the year, we were talking about how gold and silver got hammered, but now look at where everything is looking up to as far as the first part of the year. It does not go where the mainline crowd expects it to go. That's all there is to it.

JIM: And what I think is more important is that's what we try to focus on, fundamentals here, is if you're in a long term bull market as we believe we are in commodities, then along the road there are going to be pullbacks, there are going to be corrections. But the way to make big money in a bull market is to get on early and stay with that trend until it is ending. And I wrote about this in a piece called The Next Big Thing in 2003. But what really struck me, John, in studying the investment markets is a lot of these bull markets tend to have multi-decade cycles, the 16 to 18 years in duration. And if you look at the stock market, bull market, that began in August of 1982, it continued until March of the year 2000. So, you know, that was a long trending market.

And just as, you know, we've been talking, gosh, every single year about gold, we've been talking about that water, we've been talking about food, we've been talking about energy, we've been doing that since you and I have be doing this show from 2001. And if you look at a chart of energy, if you look at a chart of gold, if you look at a chart of the CRB Index it's been going up every single year, so that's why I think you're much better off holding on, getting on and adding to your positions and holding those positions as this bull market unfolds because that's how I think you build real wealth, rather than trying to trade in and out. That’s because, remember, when you make a decision to sell, number one, you have to assume that you're at the top, number two, once you sell you've got another decision:: what do you do with the money. So then you've got to make another decision: what do I buy. And to me, there is too much buying and selling decisions that are made rather than saying, “you know what, I think energy is in a bull market, I'm going to stay with energy.” I think gold is in a bull market, I'm going to stay with gold. Or I think commodities are in a bull market, I'm going to stay with commodities and that's the problem that we run into here. [60:22]

JOHN: I think we were talking about this yesterday here in our office and we said the funniest thing we heard come out of CNBC a while back was someone had said “well no one ever made any money by investing in gold.” And if you looked at the growth of gold since 2001, if you put your money into it you could have doubled it by now. It's really like that. And they are saying nobody made any money investing in this. Really?

JIM: You kind of wonder what they are watching.

JOHN: Or what they're smoking.

Part 3

Q-Calls

JOHN: Welcome back into the Big Picture at www.financialsense.com. It’s time to go to the Q-Lines. The Q-Line is available 24 hours a day for you to call in on a toll free number in the US and Canada and to record your question that we may answer here on the program. Just leave your first name is fine and your location; we like to know where you're calling from. The toll free number from US and Canada 800-794-6480. That does work from the rest of the world, but you have to pay for the call. It is not toll free from anywhere but the US and Canada.

Please remember that the information we present on the Financial Sense Newshour is for informational and educational purposes only and you should not consider it as a solicitation or offer to purchase or sell any securities. And responses to listener inquiries on the Q-line, and on the rest of the program for that matter, are based on the personal opinions of Jim Puplava. We can't take into account your suitability, your objectives, your risk tolerance, because we don't know you and we don't have enough information. And as a result, Financial Sense is not liable to any persons from losses that result from investing in any company's profiled on Financial Sense Newshour or any such other thing. Please always consult a good financial advisor who knows your particular situation before you make a lot of decisions.

First call is from – by the way, these go back to about the middle of December, we've been collecting calls because you remember the last part of the last year we did not do Q-lines the last couple of weeks because we did the special year end programs, so we appreciate your patience.

Hi Jim and the rest of the team. This is Ken from Philly and this is my first time I'm calling, but I'm very concerned about the market. I'm reflecting on your show December 8th you weren't too concerned from what it sounded like. Watching the Russell 2000 intraday, the IWM, it was like watching two heavy weight football teams grinding it out on the ground, the Bulls and the Bears pushing the ball back and forth. And you know, it gapped down and the bulls pushed it all of the way back up to the previous day's top and then the bears pushed it back down to the previous day's bottom until the bottom finally broke. It wasn't a high volume day, but it was telling me something. I’m trying to read the market here a little bit and I need your help with this, but Citibank apparently is not going to be able to hide its

$40 billion in SIV losses. The dollar seems to be rallying with that news and I think it's related because there is now a shortage of available capital because there is a loss of confidence now in – I think in the Fed or all of the central banks. I'm convinced that the Federal Reserve will not be able to get us out of this squeeze. They can't create liquidity without adding fuel to the high CPI numbers that came out this week. I think it's really bad. What should we do, not just as investors but just as Americans who are going to be suffering through what's going to be happening over the next, I'd say, six to 12 months. I'm sorry for such a tough question, but I am scared. Extremely scared. Because I think Citibank may have to face bankruptcy and so will other financial institutions. Thank you.

JIM: Ken, one of the things that you're seeing right now is the market does not like uncertainty. There is a loss of confidence that is growing in the Bernanke Fed, especially with the flip-flops and especially with Fed governors saying different things on different days. But one of the things you've seen here is an increase in volatility. If you look at the VIX, at the beginning of the year it was around 10, or actually, below 10 in January and towards the end of the year it got into the 20s. So the VIX, meaning volatility, has doubled in the market and you've got this constant battle based on news of where the Fed keeps saying it's data dependent. Well, the markets have become data dependent. One day you get one economic report, the market goes ga ga and it's up a couple of hundred points. The next day you get something negative, it's down a couple of hundred points. That happens while you have this period of uncertainty. Listen to the first hour where I talk about crisis stage and I think the Fed has not realized the crisis that it's facing. In other words, it's facing a stage two crisis and it's dealing with what it thinks is only a stage one crisis, so I think that accounts for some of this.

But also remember the markets are much more institutional today. You not only have hedge funds. There's what? Nine thousand hedge funds and they are leveraged. You have eight or nine thousand mutual funds then you have institution funds like endowments, pension plans that are in the market and everybody thinks in group think. So one day something goes down, rather than focusing on fundamentals, people focus on price. If the price goes up, everybody jumps on board, you get a big move, the next day it goes down, everybody panics and they get on that panic band wagon and they sell. And the markets are more momentum and technically-oriented today, as well as institutionally oriented and that's why I think you're seeing this big swing back and forth that you're seeing –this tug of war that you're talking about – at a time when the markets are uncertain. And there isn't a lot of confidence in the Federal Reserve right now as let's say during Greenspan's day whether – whatever you think of Mr. Bubbles himself, at least he was decisive in his decision making. Bernanke is more of a flip-flopper. [5:52]

Hi, Jim. This is Mike from Oxnard, California. Did I hear you right? Were you citing the CPI as evidence that inflation is taking hold. I thought we in the Financial Sense cult decided long ago that the CPI was a completely manipulated number due to hedonic adjustments, seasonal adjustments, geometric weighting, substitutions and other nonsense. Instead of pointing to it as evidence, shouldn't we be asking what are the powers that be up to by reporting a higher CPI? Thanks and merry Christmas to you and the gang.

JIM: You know, Mike, even though that we know the CPI numbers are doctored through geometric weighting, hedonics and substitution and some of the other things, what I was simply pointing to is even the headline inflation numbers were rising as well. I mean I believe the inflation rate is probably twice or two and a half times what it's reported officially. I think it's closer to 8 to 10% than the 4% that the headline inflation number is. But even the headline inflation number has been going up, the headline PPI number has been going up, the headline core rate has also been going up and that's what I was referring to there. [7:00]

Hi Jim, hi John. [high pitched scream]That's me. Joanne from Southern California on the biggest roller coaster ever. Okay. I got into stock market three months ago, I had an exhilarating everything in the green top; and now everything is below my core investment. Red, red, red. But I'm going to hang on like you said because I believe in you guys, I believe in your gold bugs, I believe in you silver bugs. I hope you're not going to take me to bankruptcy. Okay, Hecla (HL), I have 200 shares at $11, 400 at $12. It's down 24% today Monday. They are coming out with a preferred stock at $100 something. I don't really understand all of that. Can you explain it? Should I get out of what I have even at a loss and buy the new share dollars or maybe this isn't a good company. I thought it was and it has gold and silver. Win win, I think. I'm not really understanding what the new share thing is. I know they want to do it to raise money. Can you explain more about this new offering and what would you recommend? Thank you very much. I love your show.

JIM: Joanne, you know that scream that was you on a roller coaster, that pretty much describes the stock market and even the precious metals market. We saw a big run up from August if you bought Hecla. It was selling below 8 dollars. It was around 7.75 in August and it went all of the way up to about $12.43 cents. It's pulled back to the day that I'm answering your question to 9.69. That's just the nature of the metals market. But take a look at a long term chart on Hecla. I think silver is going to out perform gold, so you want to stay with this. What they’re talking about is a preferred stock with a sort of a coupon rate that might be – I'm trying to remember if it's going to be a convertible. It's just a method of financing for the company. Stay with what you have and just hold on and I think you'll be well rewarded. I don't know what else you bought, but it sounds like you bought in the high range after it took off. And if you have been listening to the program, remember us during the summer in the middle of August we were saying they are throwing away these stocks and giving them away but unfortunately, nobody wanted to buy back then. But, you know, look at a long term chart, stay with this long term. I think you'll be well rewarded. [9:37]

Hi, Jim and John. This is Brian from New Hampshire. I wanted to get your opinion on rental real estate and you know whether now is a good time to buy or not. My thoughts of it going forward, I think given the lowering value of the dollar, certainly it may be a good time to purchase real estate and wait for rents to increase. That may be a good way going forward of creating wealth. I wanted to get your opinion. Thank you.

JIM: Brian, I think real estate prices are going to get even weaker this year as you see more foreclosures probably going into the – probably won't see the real estate bottoming until the end of the year. We know that for example the peak and mortgage resets I think is in the month of August. I would hold off on rental real estate. I think there are better places. I'd be much more oriented towards energy, precious metals, food, water, the basics. I think you're going to make more money than that. And remember, the last bubble was real estate and there is a tendency when the Fed reinflates the money never goes as much into the old bubble, which was over priced. It goes and forms a new bubble. And I think the new bubble is going to be commodities. [10:48]

Hello, Jim. This is Mike. I'm calling you from Connecticut. I happen to be a mortgage guy, believe it or not, living through the mortgage credit crunch. It’s been very much fun. I just have a question for you. Basically, I noticed on US treasury.gov that the Brits had increased their holdings of US T-bills by 380% between October 2006 and October 2007. And it seems to me that that would have the dual impact of keeping our rates lower than they would have been and the dollar stronger than it otherwise would have been. And in addition, the Fed would have had to monetize shortfall T-bill purchases which the Brits had made, which would have brought inflation into hyper drive and we would have been sitting here with higher rates, weaker currency and higher inflation and it probably would have sent the ship to the bottom. I was wondering what you thought of that and if I'm correct in my thinking. Thank you.

JIM: Your thinking is correct, Mike. It's the recycling. You know, if you take a look at as foreign institutions and individuals have lowered their purchases of Treasuries; central banks (in this case you're referring to the Bank of England) have stepped up their purchases. If it wasn't for that recycling of our trade imbalance back into this country, interest rates would definitely be much higher. And you're absolutely correct, the Fed would be monetizing more of our deficit. [12:30]

Greetings Jim and John from Bangkok, Thailand, the land of smiles. I've been listening to your show over here for I guess close to two years and I've done real well. I’ve been in the best financial shape I've been in my whole life in good parts thanks to your sage advice. I’ve got a question regarding the naked shorts regarding the gold mining stocks. I recently have been told that if the shares are borrowed that you can place a sell order way above current price and if my broker had loaned out the shares my good-till-cancel order will require him to call those shares back causing the borrower to cover their shorts. I wanted to find out if you had any information on that. Obviously, this was a serious problem. And what say you? Thank you.

JIM: That's absolutely the case in fact. There is a company that we've invested in where on Thursday that very same thing happened in the final minutes of trading where there was a forced buy in. And usually when that forced buy in occurs, it's at a penalty. It's at 10% above the market price and that was indeed the case of one of the companies we’ve invested in where there was a naked short position that got covered between Christmas and New Years. But there is still a large outstanding short position. And if you do that and place a sell order if your shares have been loaned out, that forces a buy back in, you're absolutely correct. [14:14]

Good morning Jim and John. This is Warren from Omaha: “In 2002 in my report to shareholders, I talk about the danger derivative and I coined the term financial weapon of mass destruction.” I'm interested in hearing your view and if it’s possible could you please interview either Warren Buffet or Charlie Munger how they interpret the current derivative nail down into what they were saying way back in 2002 when nobody was decent. And what Warren Buffet said was: “in our view however, derivatives are financial weapons of mass destruction. They are in danger that while now later are potentially lethal. I'm interested in your view as to how bad the situation can get. Thank you. Bye bye.

JIM: I'd love to interview Warren Buffett and Charley Munger. I just don't think that's going to be possible. Warren Buffett does very few interviews and they are very select and they are usually to the larger media outlets. But what he was referring to as weapons of mass destruction, the derivative market has gotten so big and so huge in fact that is the one problem. You know everybody is talking about the subprime crisis. In the first hour we raised two additional crises that we could see unfold this year. One is problems in the credit card market that has been securitized and the other one big issue is the credit default swap, especially if we get into a recession and you start seeing some defaults on corporate bonds. But derivatives, gosh, we – that would take a series of programs to explain that. But in the end, with this crisis and what we think is going to be the end of the debt Supercycle, I think you're going to see the implosion of financial derivatives in a massive hyperinflation to cover up and mop up the damage. [16:20]

Hi, I'm Jim from Walnut Creek and I have noticed that the money supply in November actually decreased. M1 decreased 1.8% while M2 increased 4.7%. I also noticed that the increase is actually going down compared to earlier this year. So the rate of growth of the money supply appears to be slowing. How could this be when we hear of all of the increases in liquidity, but the money supply is actually decreasing? And what affect does this have on inflation and investment? I appreciate your response and thank you very much.

JIM: If you look at the different money supply rates whether you're looking at the monetary base (that's cash, checking), which has been decreasing, one reason that you might have seen that contract in the month of towards November and December is the Christmas holidays as people pull money out of the bank to do their Christmas shopping. So that might complain what's going on with M1. But if you look at M2, that's still increasing, part of that may be money going into cash, coming out of the market. If you look at MZM, which is money of zero maturity, which is high-powered money, that's also been increasing along with M3. The more high powered money when they create credit tends to show up in the M2 and M3 figures than it does the M1 figures, which is cash and checking accounts. [17:52]

Hi Jim and John. This is Karen calling from Northern California. I love your program. I keep hearing about the impending collapse of the financial system. And I have three questions. One, do you think that this is imminent? Two, if it did happen how do you think this would unfold? Would we all wake up one day and the banks would be closed and if so what would happen next? And number three, what do you think the length of time that it might be before a new system might be implemented? How long would we be trading our gold doubloons with one another until a new system could take place? Thank you very much.

JIM: Oh, boy. Let me see, Karen. Number one, do you think it's imminent? No. Do I think we're heading into a crisis state here? Yes, because the Fed doesn't know what it's doing at this point. In other words, it doesn't know how to assess this crisis whether it's a stage one, stage two. If they don't do anything, then yes, we could get into something. But I don't see that, especially in an election year.

Your second question, when the system does implode you'll have a bank holiday. How would it unfold? Probably something similar to what they did in Argentina with the corralito meaning you couldn't get money out of the bank or they would limit it out of the bank which means they would probably eventually go to a cashless system because in a cashless system with the world's central bank –which will be recommended – then there is less problem, they will argue for currency fluctuations and crises around the world and also with a cashless society with a fractional reserve system, then you would never have a run of the bank because we wouldn't use cash. It would just be digital money much as it is in the real world today anyway. [19:49]

JOHN: Jim, let me ask you a question. A lot of people talk about the whole money system is going to collapse and we're going to run around trading gold and silver and all of that stuff. I don't think we'd ever get to that point; that they would not allow that to happen – meaning some system would have to be put into place because the majority of people don't have gold and silver. I mean you can walk into a supermarket and sometimes I think you'd have to could worse a clerk to take gold and silver in payment for something. Do you see what I'm saying?

JIM: Yeah. I would suspect more what we would go to is some kind of debit card system. In other words cash and coins would no longer be usable. And I think at some point we're going to get to that stage, John because if you take a look at the content that goes into a penny, the copper content is worth more than the actual face value of the penny and that's one of the problems that they have with even our nickel coins, our dimes and our quarters. In fact, didn't they pass wasn't it last year they passed a law that you couldn't melt the coin because the change in your pocket is worth more as a base metal than the face value. So I suspect that we'll probably go to some kind of digital debit card system much as we're doing today any way. [21:00]

JIM: Yeah. That's why in some cities the lamp posts (and other circuits) are getting are getting ripped off for their copper now because of the value of it, you know, the scrap copper value. But I've always keep hearing this like it's all going to implode, we're all going to be back to bartering and this and that. I don't think it will ever go back to that point. Something will have to happen because of the large numbers of people who don't have gold and silver and they'd have to be kept in the system, so it would have to be supported.

JIM: You’d go to digital money and that gets around if you no longer have cash withdrawals. In other words, we go to a cashless society. It's one way of preserving the fractional reserve system because how can you have money on the bank when you can't take money out of the bank, it's just simply a debit system. [21:46]

Hi, Jim and John. This is George calling from Minnesota. Question for you on the CDO squared bonds, the ones that are leveraged. My understanding with the way those work, if I own a $1000 bond, if it's leveraged 10 times it's actually exposed to the risk of $10,000s of mortgages. So that means if there is a 10 percent default rate object mortgages, my bond is now worthless because there is a ten time leverage there. However, here is my real question I wanted to ask. Is there any way those bonds can actually become a liability? In the old days of finance, I would say there is no way a bond could become anything but worthless. It would never be a liability. But I keep hearing how complicated these products are and it occurred to me that maybe some of them were actually written up with you as the bond holder could actually not only be holding a worthless bond but one that has a liability attached to it. In case you guys don't know how to answer that question, could you ask around with your contacts, because I just want to kind of eliminate from the possibilities in my thinking how bad this mess really is the idea that maybe there is an actual liability associated with those bonds. Thanks a lot, guys. Great show.

JIM: You know, I can't say that I'm definitely assured of the answer that I give you. I don't think there is a liability associated. In other words, you loose all of the money that you have in the system. There might be a liability. In other words, you might own one tranche of the system that you may be liable for other tranches of the system. I think that's more what you're referring to. [23:15]

Hey, Jim and John, this is Al from Jersey City, Missouri. I'll make this quick. I’ve been reading over some of the message boards for a company that Puplava Securities is involved in and Jim that you're involved in, I just can't believe some of the stuff that I’m reading on there. I'm an emergency room physician. Let me tell you, sometimes even after I've been doing it for a while, people come in and they'll bad mouth me and it still kind of gets to me. And I just want you to know that I know you do the show every week and there are probably a lot of people out there that you helped a little bit, but there are some people out here that you have really, you've changed their lives. And let me tell you something, my kids, me, my family, you’ve changed the way I think about the markets, you’ve changed the way I think about money, you’ve changed everything for me. And I am just eternally, will be eternally grateful for that. And I'm going to find some way to pay you back some day. I'll figure out something I can do. But I appreciate everything that you guys have done and are doing. You just keep doing it. You just keep fighting the good fight and know that there are people here that you're not just making a little difference involving, you're making a big difference in involving. So keep up the good work guys. Thanks.

JIM: Al, appreciate the word of encouragement here. You know, one of the things that you have to be aware of when you're in the public arena as we are with our website and with this webcast, people are going to take pot shots and they love to do this anonymously. It says a lot about their own character, but that's just part of being in the public. It just comes with doing public programs as we do. People are going to take pot shots, maybe they don't like our calls on the market. Maybe they don't even like the program, who knows, but it's just part of being in the public eye. I did television and we would get positive responses, literally thousands of letters that would come into the studio on the segment we would do. But every once in a while we would get a nasty letter. And I don't know, they didn’t like my tie, they didn't like the segment that I did or the particular piece I covered. It just, you know, that's what happens when you're in the public eye. People take shots at you, but that's part of it. [25:25]

JOHN: By the way, we're not opposed to critical calls to the Q-line either. There's just a restriction: no body parts or calling people names. We like intelligence discourse here. Now, as far as helping Jim make your tax deductible check out to the Save the Puplavas Foundation...

JIM: No. We do. We do have a foundation that we run, that makes contributions to less fortunate people, that we have. So if somebody would like to make a contribution to the foundation, we'd love to have that. But, no, seriously, we don't mind criticism here. Sometimes they are quite amusing. If you think some of the things they say about us on the chat room, you've got to see some of the emails we get. And like I say, John and I have categorized them into three sections. Usually they start out with four letter words. Those are the mild ones. Body parts gets a little tougher and then the third one is the family members. And sometimes we get combos where they start out with four letter words, talk about body parts and family members. It's just the nature of people today. [26:32]

JOHN: You know what really hurts? What really hurts, Jim, is when they begin attacking Buddy and Lodo.

JIM: When they take on my dog, then it gets personal.

JOHN: What was that – I'm just trying to think –

JIM: Oh.

JOHN: It's a late show today. I can tell.

JIM: You know, it was funny. I was watching during the holidays a movie with Mark Wahlberg called The Shooter and he's going after, you know, it's kind of vigilante justice. He's been taken advantage of and set up and somebody asked him, I think. And he was getting very tough and he said, “it's personal, they killed my dog.” As long as they leave my dog alone, I'm okay. All right. Richard is in San Francisco Bay Area.

Hi. This is Gary in Madison, Wisconsin. I appreciate all of the work that your organization does for us out here. My question is about junior-mining-stocks financing. I often see that these companies, their stocks seem to get pushed down and then there is a financing that was either completed or announced and I notice often that the stock prices the financing goes off at a dollar a share let's say with a warrant for allowing the purchaser to buy an additional share for like a $1.25 for a period of a year or something. I just don't understand how all of this works. Could you shed some light on this process? Maybe it's a good time to buy these companies prior to a financing or after financing is announced. I just don't understand how the whole warrant thing works and how that affects the stock price and the potential for the upside. Thanks so much guys.

JIM: You know, Gary, we did a program towards the end of the year on naked short selling where I explain what goes on with the financing. It was an hour long program on naked short selling, how the financing cycle works for the junior mining sector. And if you have the chance, go back and listen to it. John, what was it? It was its show we played on the Christmas weekend I think it was when we get into great detail almost an hour long. So if Gary, you wouldn't mind listening to the program that we did on December 22nd, it's up on our website on the radio program. It's the third hour segment called Crime of the Century, it gets into naked short selling, why prices drop ahead of the financing, the machinations and the scams that go along with it. And there’s a whole hour segment on it and I recommend you listen to it. [29:05]

JOHN: Now, if I've got it right, Richard here in San Francisco Bay.

Hi, Jim, John, this is Richard from San Francisco, North Bay. On Christmas eve I'm reading you the Wall Street Journal that the anticipated spread between the 2 and 10 year Treasury notes to be auctioned will only be 1%. Billions of dollars of individual and corporate savings are being invested and the total dollar extra returns for tying up money for 10 years versus two years will only amount to about $11.50 for every $100 invested. That’s a heck of a sanguine view of the future. Are the bond buyers next or am I near neurotic about the future? I look forward to hearing your answer if you have a chance. Thank you then.

JIM: I think what you're seeing here is a flight to quality or safety with the stock market gyrations, worries about an economic downturn. The bond market is saying that we see a recession ahead, and so that's why you've seen this rotation into Treasury notes where, like on the day I'm answering this question, a 10 year Treasury note is 3.86% and a 2 year treasury note is 2.72%. And it's just – I don't know if it's sanguine, I think it's more anticipating tougher times, a weaker economy, a recession and therefore if the economy goes into a recession, the inflation rate will go down. And also I think it's a flight to quality as you get stock market volatility. On the day you and I talking about when the stock market was down 256 points, money rotated into the bond market and yields went down. [30:48]

Hi, my name is Steve from Los Altos, California. So far we haven't had much of a downturn in real estate prices here, but Jim mentioned that in the December 29th issue that by the end of the year he may expect asset prices across the board to recover or be going up. And I was wondering if that includes real estate? Is it a reasonable time to buy a house do you think? Thank you.

JIM: I expect real estate prices to weaken further. Remember, that was the last asset bubble. Just as when the NASDAQ bubble deflated from 2000 to 2002, you know, something else inflated in its place. As money was created, it went into the bond market, the mortgage market, went into the commodities market and went into the real estate market. Well, the last bubble was really the real estate market. So that's still in the process of deflating. Unless you can afford it and there is a personal reason, if you're looking at real estate prices, I expect it to be lower six months from now. [31:52]

Hello, guys. This is Tim. I'm calling from Denver, Colorado. Enjoy your show. I've been listening to you for about three years. You've opened my eyes to a lot of things. My question is about owning stock in a company that is getting a buy out offer from somebody else. I've never owned shares in a company that's been bought out. I wonder if you can speak to this as the best way to play this. Should you hang on until the buy out is made and how does it affect your share price? Does your share price go up to the buy out offer or should you sell your shares on a pop on the stock just on the news alone? What's your best advice for this situation? Thanks.

JIM: Tim, there is a number of issues that come into play. Even though there is a buy out offer, the deal could fall through based on a number of factors unfolding. The other thing is if, you know, you bought this company that's now being bought out, the question is do you like the company that is buying out your existing company and is it a stock you would want to stay with? In other words, sometimes the buying company is also a growth-oriented company, you might want to stay with it. And if they buy it out and I don't know what company you're talking about that, whether it's a stock buy out; in other words, they are simply going to exchange stock. If you hold onto shares and it's a stock buy out your shares are exchanged for the new stock and there are no capital gains so you can avoid paying taxes. So the real issue you have to understand is the buying company a company that you would want to stay with? In other words, do you like that company equally as well as the company you own now that's being bought out. And then another issue is usually in terms of a buy out, the – the arbitrageurs come into the market driving down the stock of the company being bought and there is a spread. And that spread doesn't narrow until the final day of the buy out. So you might want to hold on. But I think the real important question is the company buying your existing company is that the kind of company that you would want to hold on to? [34:09]

Hello, Jim and John. This is Richard calling from Changmai, Thailand. Jim, on your economic forecast for 2008, you predicted that starting 2009 the Fed will begin focusing more on inflation and thus begin raising interest rates. Jim, how is that shift in policy going to affect the price of gold. Que tenga buen dia, hasta luego.

JIM: Hey, Richard, what happened to Argentina? You must be on vacation.

JOHN: By the way, that Que tenga buen dia-stuff doesn't cut it in Thailand. Okay? It only does it in Buenos Aires.

JIM: Yeah, Richard, you've got to come back with something different.

Actually, initially if the Fed began raising interest rates, you might see a knee jerk reaction to rising interest rates. But the one thing I would point out, as inflation comes back, longer term gold prices will keep going up. There is a lot of people saying well, if interest rates are going up, it makes gold less attractive. That's short term noise. If you look at a graph of interest rates going back to the 70s, we went from 4% interest rates on Treasuries, all of the way up to almost 16%. Bonds rose, interest rates rose, all of the way across the board from the federal funds rate to the discount rate to corporate bond rates to Treasury rates to mortgage rates to the prime rate. And during that whole period of time, gold went up from $35 to 850 an ounce. And the reason: Inflation. [35:33]

Jim and John, this is Bob from New Jersey. First let me thank you for a terrific program. I think you perform a wonderful public service to your listeners. I'm calling because you’ve referred to the Bush tax cuts in a way that would suggest that they are good for the economy. If you believe the tax cuts stimulate the economy, you would support, I think, a broad based tax cut that benefits the middle class. The middle class is responsible for the vast majority of our nation's consumer spending and our economy is now completely dominated by consumer spending. I've learned that from your program. According to the Congressional Budget Office, 52% of the Bush tax cuts –amounting to about half a trillion dollars – will go to 1.4 million Americans who earn over 1.5 million a year. If economics stimulus was the real reason for the tax cuts, why wouldn't it be better to provide tax relief to the middle class who actually are responsible for most of our consumer spending, the average family making $75,000 dollars gets a tax break of $350 a year, which frankly is a joke. The Democrats have walked into this issue and frankly it resonates with most people. The Democratic plan is to take the Bush tax cuts and redirect them to the middle class. To me this sounds like very sound economic policy if the goal is to stimulate the economy. Let me know what you think about that. Thanks very much.

JIM: Okay, Bob, let me get into flawed economic theory. Because we got into this in the first hour. First flaw, let's take the Bush tax cuts. If you were in a 15% tax bracket, you might have dropped to a 0% tax bracket or you might have dropped to a 10% tax bracket. So on a percentage basis your tax drop was much greater. That's number one. Number two, if, and let me give you an example, let's see that you pay $10,000 a year in taxes and we cut tax rates 10%; and I pay a million dollars in taxes and they cut my tax rates 10%. Well, if I pay a million dollars in taxes and they cut my tax rates by 10%, I save 100,000 dollars. If you pay $10,000 in taxes and they cut your tax rate by 10% and you save a thousand, well, this is what they typically do: They go “well, gee, Jim saved $100,000 in taxes and Bob only saved $1000 in taxes.” But let me tell you where this thinking is flawed. They never tell you that the top 1% – John, what is it? It’s 1% pay 50% of the country's taxes. [38:22]

JOHN: Even by the IRS's own figures the wealthy are carrying the lion’s share.

JIM: And let's get to economic theory. What creates wealth in a society? If a wealthy person and let's say he's an entrepreneur which tends to be most of the wealth in this country is created in small businesses. If a small businessman creates a job, creates a company, let's say it's Steve Job's fooling around with a computer in his garage and he creates Apple Computer. By saving and investing and creating wealth and production, you create more economic well being. In other words, wealth is created in a society through savings and investment; not through consumption. And that is the flawed thinking behind this “well if we can just get people to consume more.” One of the problems and why the economic well being of the United States has been declining is we've gone from a society that saves and invests to a society that consumes and goes into debt. Consumption doesn't create wealth. It is building new factories, building new plants, starting new business. That's what creates wealth. And what we've done is we've substituted wealth creation for artificial wealth creation through money printing. And it doesn't work as we're starting to see now. [40:02]

Hello Jim and John. This is Ahmed from Toronto, Canada. I have been a listener for many, many years and thank you for the great show. It makes for my Friday night routine and Saturday morning workout. I wanted to inform you of something I'm not sure many of your listeners are aware of that you may find very useful. I read a lot of Arabic media and the Arabic media has been reporting that there is a huge amount of unrest and turbulence among their neighbors in the Gulf area. The Gulf area consists of Saudi Arabia mostly, Kuwait, Qatar, Arab Emirates etc. etc. There is almost four expats working in these countries for every citizen. So for every Saudi there are four people running around. I used to work there for sometime and you would get an Egyptian worker, Pakistani, cleaning the roads; Filipinos driving the car; some American consultants; some Korean engineers; and then there would be like two or three Saudi’s around. And that's how the work force is. The problem is with the diminution of the value of the US dollar and linking the Saudi dollar, Saudi dollar and Kuwaiti dinar and all these currencies to the US dollar, these workers have no more money to send home. They send the same amount of money home but the value of this money is deteriorating. The conditions are getting worse. And for the first time in the history of the region there was actually a labor strike in the United Arab Emirates. This is causing a huge amount of problems in that area and these governments are quite wary of this huge foreign population that is getting grumpier by the minute. And their choices are two things: Either print more money, give these people more money and import the inflation from the US; or actually disengaging their currency from the US dollar. I just wanted to bring this to your attention. Please feel free to make my phone call shorter as you play it to your listeners. I hope your new year will be blessed and happy for everybody. Thanks.

JIM: Ahmed, you bring up an interesting point with a lot of countries. You bring up the Gulf region that are linking their currency and you're seeing more and more, whether it's Kuwait or others, that are talking about delinking to get rid of this inflation problem. You've got the same thing occurring right now in Hong Kong where the Hong Kong authorities have not only been inflating their own economy, but because they need to keep the Hong Kong peg to the dollar they are inflating even more which explains why Hong Kong market was up so much. But you know, I do think you'll see more Gulf states delink because otherwise they are going to have too much social unrest because of the inflation cost that you were addressing. Thanks for bringing that to our attention. [42:57]

Hey, guys. It's Brian from New Orleans. Happy New Year. I was listening to the radio or TV, I don't recall, and one of the talking heads out there says that they were very skeptical about upcoming rate cuts by the Fed. And the reason they said was that the Fed is changing two voting members and one is coming in from Philly who is apparently a lot more hawkish. I didn't realize they rotated and I wonder if you would comment on that and what did you think of those comments. Is that feasible? Thanks a lot.

JIM: You know, Brian, one of the things that you have to be aware of is public pronouncements by the FMOC committee members –whether it's their forecast or what they say publicly and what they actually do. If you look at 2001, prior to heading into the recession or it was pronounced recession, Greenspan was talking that the economy was strong, the markets are okay, this is just a healthy correction. The European Central Bank was talking very tough in the first part of 2001, and the second half of 2001 they were slashing rates furiously. So if you start seeing these unemployment rates rise like they did this Friday with the unemployment rate jumping to 5%, if you start seeing the economic numbers coming, there is going to be great political pressure. But what he was referring to is every year they rotate a portion of the FOMC committee and there are two members coming on that are more hawkish. But watch for those hawkish members to change their tune as this crisis unfolds in what I think is going to be a rough first quarter. [44:41]

Hi, Jim and John. What would cause you to change your mind – turning the table on you, as you do on many of your analysts on the show – about the end of next year? You're expecting a bullish outcome. What would make you change your mind and make that stance more bearish, like Peter Schiff and Frank Barbera on the program. Thank you very much.

JIM: I think probably number one on the top of my list is policy mistakes by the Federal Reserve, like we have talked about over the last couple of months. And especially with the flip-flopping that we've seen with Bernanke is this is probably the least experienced Federal Reserve that we've seen, most of these guys are academics. Bernanke is not a strong character, he's not a decisive person, he tends to be a consensus[-builder], more in the bureaucratic [mold]. And if they allow this to get to stage two, which is the crisis they are facing and still take no action and allow it to go to stage three, at that point it's put all of your money in gold bullion, you know, head for the hills because we're in great trouble. [45:47]

Greetings, gentlemen, this is Dave in Milwaukee, Wisconsin. And I'm wondering about the exploration stocks in China, if the mining explanation stocks in China and the Canadian ones if they are something to be considered or if there is too much country risk in China? Thanks so much.

JIM: You know, depending on the company, you know, we own two companies in China that have done extremely well. They are run by very confident people. They are working with the government. They are in a rural area where they've created tremendous jobs for the rural population. That's a high priority for the Chinese. I would say right now I just don't see those risks there. I think China wants to develop its resources; and with this company there is a great incentive for the mining company to reach certain production levels. And once those production levels are reached then there is a greater revenue sharing with the government. But even then this company is extremely profitable, one of the most profitable silver companies in the world. [46:48]

Hi, Jim and John. This is Alvi from Spain. I would like to wish you a Happy New Year. Let me ask you this question. If you're waiting for the pain in the first part of this year 2008 before the gain in the last part of it, how much cash or bonds would a long term investor hold in his portfolio before that pain or correction arises. 70% in cash; 50%. Please let me know your point of view about it.

JIM: You know, Alvi, I take more of a long term view, but if you do not want to ride through some of the volatility that we're going to see here in the first quarter where you may see a 10 to 15% correction in the market, then simply just remain in cash. You sound to be more conservative with the amount of cash that you're talking about that. You know, whether you're 25%, 50%, it work very subjective at this point. I think it's more of a personal decision in terms of how much volatility you can withstand. But when they begin to massively reflate, which I think they are going to do as things get progressively worse, then I think you're going to have to basically make a decision if you keep your dollars in cash, which are going to be depreciating and losing purchasing power value as central banks deflate. You're calling from Spain and the European money supply growth rate is 12.3%. And that was just announced this week. So you've got tremendous monetary inflation that's occurring in your region of the world. So it becomes a personal question in terms of how much cash. [48:28]

Happy New Year, Jim and John. My name is Rick and I'm calling from Orangeville, Ontario, Canada. Inflation or deflation? I keep hearing both when I peruse the financials. While I am firmly in the inflation camp, I would like to hear from some credible deflationists that, although we may think they are wrong, can defend their views. Obviously if they are right, I and everyone that listens to your program may stand to lose a lot of money. Would it be possible to have a debate with some credible deflationists on your program that succinctly –and I repeat, succinctly – describe why they think deflation is going to happen by contrasting their views with your inflationary views, I believe this would make an excellent discussion. Thank you and keep up the fantastic work.

JIM: You know, Rick, if I was to have somebody that is a deflationist, probably the most prominent that would come to mind and credible would be Bob Prechter of Elliott Wave fame. And Bob and I agree on inflation. It's just a sequence. Bob thinks deflation first, hyperinflation second, where I think hyperinflation first, deflation follows. So that's a great idea. Maybe we need to get Bob on the program and have somebody else other than myself who believes in the inflation camp and have the two debate each other. You know, somebody who would come to mind I think would be somebody like a Dr. Marc Faber and Bob Prechter. That might make for an interesting conversation. [49:57]

JOHN: Jim, it was good to be back at the microphone. You always feel itchy without it and whenever we take vacation we're never sure if anything is it going to break while you're gone. But anyway, a good first show of the year. We do have some really exciting things coming up. I'm looking forward to some round tables. Dr. Marc Faber is going to be back with us. What does the purvey of the future look like?

JIM: Next week my special guest will be Dr. Marc Faber what's ahead for 2008. We've got a special show. Don't want to announce it yet for January 19th. Dick Davis will be with us on January 26th. He's written a new book called The Dick Davis Dividend. A roundtable on February 2^nd energy round table with Jeff Rubin from CIBC markets, Matt Simmons and one other individual that we're trying to get is Robert Hirsch. Matt is working on that. I hope that takes place. Vitaley N. Katsenelson will be my guest on February 9th. He's written a book called Active Value Investing. Steve McClellan on February 16^th Full Of Bull. Mike Stathis Cashing In On The Real Estate Bubble. Lila Rajiva, co-author with Bill Bonner, Mobs, Messiahs and Markets and March 8^th, Sy Harding Beating The Market The Easy Way. A lot of great stuff, some surprise roundtables. We're also going to be doing special round tables this year, but don't want to leak out the surprise. We've got a lot of things that we're working on here. But that's coming up in the weeks ahead, John. Meanwhile we've run out of time as usual.

On behalf of John Loeffler and myself, we'd like to thank you for joining us here on the Financial Sense Newshour. Until you and I take again, we hope you have a pleasant weekend.