The "Second Round of Pain"
By Dan Denning
Melbourne, Australia

If you've been thinking about reducing exposure to stocks, now might be a good time. And if you've been thinking about increasing your exposure to precious metals, now might be a good time.

According to Morgan Stanley economist Gerard Minack, the stock market is in for a correction after its 9-month "relief rally." In a note to clients Minack wrote, "We see the rise from March 2009 as a typical relief rally that follows major bear markets. Those relief rallies can occur regardless of underlying macro conditions, regardless of liquidity conditions and - most importantly - regardless of what happens next... We think risk assets have swung to pricing a better outlook than is likely."

Minack says that a 25% correction is now in order. To be fair though, he doesn't think the market will make new lows after that, only that it's gotten way ahead of itself at these levels. The Grand Old Man of Dow Theory, Richard Russell, is even more direct. He's predicting a "second round of pain" for stock markets. "I note that most analysts are now bullish," he observes, "and that they are recommending stocks for the 'continuing advance.' At the same time, most economists are optimistic, arguing that the 'longest recession since World War II has ended.'

"Typical," Russell gripes, "last March everyone was bearish and the market was establishing a temporary bottom. Now that everyone is optimistic, the stock market is topping out and the public (the amateurs) are about to receive their second round of pain."

What to do?

Last time the world's financial markets panicked, something strange happened: the US dollar and US bonds rallied while stocks, commodities, and emerging markets sold off. The same thing could be happening now. It's not so much a flight to quality as it is a flight to liquidity and a massive case of global risk aversion. During the dollar's big rally late 2008 and early 2009, stocks and commodities fell. Yet once low interest rates and government stimuli found their way into stock markets, leveraged traders again bet on equities and higher-yielding risk assets around the global. The dollar fell and the stock market rally got pretty carried away with itself.

This time around, we wouldn't expect the dollar rally to go as high or last as long. We don't think the monetary authorities would be inclined to let a deleveraging positive feedback loop set in again. That is, the powers that be don't want to see falling asset values trigger forced liquidations by leveraged players, leading to more asset sales and further liquidations in property, commodities, and equities.

Now just because Ben Bernanke and the global cabal of counterfeiters don't want something to happen doesn't mean it won't happen anyway. The deflating of the world's asset bubbles is going to happen sooner or later. The world's massive inverse pyramid of debt is supported by a very small asset base. When the underlying assets (often commercial and residential real estate) fall, the whole structure becomes unstable (this is what happened in 2008).

That means that this time around, you wouldn't expect the monetary authorities to let liquidity to dry up again. A ten percent fall in stock prices is just the thing to get policy makers in an accommodative mood again. The US employment figures still stink. And markets are increasingly confused and worried about whether certain sovereign nation states (like Greece and Portugal) can finance their deficits and/or reduce public spending without increasing civil unrest.

Mind you, we don't think more money, credit, or liquidity is the answer. It is, in fact, the problem. The modern world economy is built on a foundation of unsound money.

When central bankers change the cost of capital willy nilly, they corrupt all sorts of incentives in the real economy. And they alter the economics of tens of thousands of investment decisions. If they make money too cheap (always the preference of governments), they create asset bubbles (in stocks, real estate, and commodities).

In fact there's a pretty persuasive argument that the commodity super cycle is itself a symptom of the de-facto dollar devaluation engineered by Richard Nixon in 1971. Once the world moved to free floating exchange rates and fiat currencies not backed by any metal, a tsunami of paper, credit, and debt has lifted (inflated) prices for everything (houses, stocks, commodities, and bonds).

Some people call this wealth.

But if the super cycle of paper money is ending (a big claim for sure), wouldn't it mean a dramatic contraction in global economic activity? Not just a severe recession like in 2008 but really, a long depression in which debts are worked off and paid down, or in which debtors simply default and their creditors must take capital-destroying losses?

Well, yes. All that would happen if the super cycle in paper money is ending. We've argued that it IS ending and that one symptom is a series of escalating sovereign debt crises. The funding model for the welfare state is broken because it's base on unsound money.

But paper money has always been a con game based on belief. Neither the emperors of Rome, the Kings of France and England, or the chairmen of the Federal Reserve have been able to resist debasing the currency. It makes both warfare and welfare possible. Guns and butter are the health of the state and the death of sound money.

The counterfeiters always get first use of the bogus money before its purchasing power is diminished by the increased supply. This is a pretty dodgy way to run a world economy. But the assumption - encouraged by the powers that be - is that the an economy can be controlled with the right tweaks to the right dials by the right people wearing the right suits in the right government offices with the right university degrees.

This is also absurd.

But enough of the theory. What now? If the correction becomes a rout, expect more quantitative easing or policy measures designed to mask the pain (more stimuli). In other words, expect measures that will rekindle inflationary forces. Gold is correcting at the moment. But the risk of inflation remains as real and as potent as ever. So we'd say this is a chance to "buy the dip" on gold and other precious metals.

Regards,

Dan Denning

And now to Bill who has today's reckoning from TK...

Trichet to Greece: Drop Dead!

Obama to California: Uh...

Yesterday, stocks lost 103 points on the Dow. This looked like a confirmation to us. The stock market appears to have begun its next and final phase...

AP seemed to think so too:

"Stock investors see threats from all directions," said the headline.

We didn't bother to read the article. We already know the directions.

From the north, investors worry about falling consumer demand. Consumers are in a funk - they have more debt, less income, fewer jobs, and less access to credit. The only news on that front we have today is that even jumbo housing loans are going bad...delinquencies are up to 9.6%.

From the east, investors worry about the continued invasion of cheap consumer goods and cheap services. China's economy is said to be growing at double-digit rates. How can US firms compete? And what if China is a bubble, as Jim Chanos believes? When it blows up, US stocks will come down too.

From the south comes the threat of higher interest rates. The poor dopes think the recovery might be for real. If so, inflation will rise and the feds will increase interest rates...possibly cutting off the new boom.

And from the west what do they have to fear? Well, there's that business in Europe. You know, Greece and all. The PIIGS - Portugal, Italy, Ireland, Greece and Spain... Europe's peripheral countries are in trouble. Lenders fret that they might be forced to default on their debt.

So, they want higher interest rates. This, of course, just makes state finances worse...pushing the PIIGS closer to default.

The PIIGS owe $2 trillion, which might need to be restructured. Yes, dear reader, the sovereign debt problem is a big one - much bigger than Bear Stearns, Lehman Bros. and AIG. But the biggest porker of all - the USA - has fives times as much sovereign debt as all the PIIGS put together.

It won't take investors long to figure out that there isn't a whole lot of difference between Greece's finances and those of the US. Each has about the same amount of debt and the same size deficit, relative to GDP. The big difference is that the US ultimately controls the currency in which its debt is calibrated. Greece does not. Neither does California.

Both California and Greece borrow long-term at about the same rate...around 6%. Lenders know that when their backs are to the wall, both governments will have only two choices, not three. They can cut spending. Or, they can default. What they can't do is wiggle out of their obligations by inflating their currencies.

Jean Claude Trichet has already made that clear:

"...belonging to the euro area, you...have an easy means of financing your current account deficit. You share a currency that is credible, so that you have a quality of financing that corresponds to that of a credible currency."

He went on to say that Greece contributes only about 3% to the total output of the euro-zone. If push comes to shove, Greece will be pushed out rather than allowed to weaken the euro.

Then, Mr. Trichet made an odious comparison. California is a much bigger part of the US economy than Greece is of the euro economy. In fact, it is more than four times as large. Will the US come to California's aid? Mr. Trichet didn't say.

It is possible, of course, that Mr. Obama will say to the Golden State what Gerald Ford said to the Big Apple. In 1975, New York City's back was to the wall. It appealed to Washington for help. "Ford to City: Drop Dead," was the famous headline in the New York Daily News, reporting the president's response.

New Yorkers were incensed. Later, they realized that by vowing to veto a bailout President Ford had done them a great favor; he forced New York to clean up its act. The city went on to its greatest years. Likewise, the feds would be doing all of us a favor by letting failure fail with dignity.

Will Obama help California mend its ways? Or will he turn it into a zombie state?