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IN 2010: DON’T CONFUSE MINI-BUBBLES WITH REALITY (article by BERT DOHMEN, EDITOR of Bert Dohmen’s WELLINGTON LETTER  (12-28-09)

..............As a result, the financial system is flush with cash which is not being used for economic activity. Therefore, the capital is used for speculation, similar to what produced the financial crisis in the first place. The carry-trade is a favorite speculation once again: cheap US dollars are borrowed at 0.25% and reinvested in governmental bonds of higher-yielding countries at perhaps 5-8% with great leverage, perhaps as much as 100:1. This is a great way to make money, until the currency trends change. If the dollar rate increases by just 1%, with that leverage all the equity would be wiped out. If the bank has those losses, the taxpayers will probably get the losses, while the banks’ trading operations got the prior profits.

With the declining US dollar in 2009, it was more attractive to buy shares in companies which at least have a chance to grow profits, even if sales don’t grow, then just buy money market funds. In effect, stocks became a hedge against the depreciating value of the currency. In 2010, investors may turn out to be wrong when profits follow sales downward and the dollar rises in value. A rising dollar would turn the tide for many currently most popular investments, such as commodities, emerging markets, etc.

Although a steep yield curve traditionally has meant a good economic recovery was ahead, this time there are many obstacles to a recovery. Higher taxes, and promises of even more taxes in the years ahead, make business creation a game of “hope over experience.” A flight away from the questionable policies of a U.S. Congress, which threaten to destroy the U.S. economic system, is already occurring. U.S. companies are moving abroad because the writing is on the wall. Success will be punished in the U.S.

The “trader tax” proposal, thought to be dead earlier this year, is gaining traction again as Washington desperately looks for new sources of revenues. It would impose a tax on every stock market transaction. It would destroy the U.S. financial markets. Trading would move off-shore. But politicians are usually oblivious to the reality of the market place.

BOTTOMLINE: The excess liquidity spilling over into the investment markets has produced the illusion of a new bull market. But it’s just plain speculation. Once the Fed starts reducing the stimulus, or the perception is that the Fed will act, reality will return.

The markets in 2010 will bounce between disillusionment about economic reality and liquidity injections by the Fed. Another crisis will be averted, but significant parts of the economy will be totally under the control of Washington. This suggests that there will be no economic recovery, just long-term stagnation, shrinkage of business enterprises, insufficient job creation, and continued loan contractions.

The Dubai and Greek financial crises are the “canaries in the mine” confirming that all the rescue efforts of major central banks around the world have been insufficient to stop the crumbling of the global debt pyramid. It will be important not to confuse new mini-bubbles created by the central banks with genuine, sustainable economic growth

Traders will have great opportunities, will the “buy and hold” investors will continue to face the same difficulties as the have over the past 10 years during which the major indices actually lost money. It has been the lost decade.

GOLD                                                                                                                                                                        September 14, 2009

..........  Below is a chart of the seasonal behavior of gold (courtesy of Moore Research Center.) This chart basically adds the change of gold for each specific time period during the year over a number of years. The dotted graph is for the last 15 years, and the solid line is the last 34 years. Note that the seasonal tendencies are pretty similar for both.

 

The chart shows that starting with September, there is typically a very strong rise in the yellow metal. This is due to several factors: European gold manufacturers, primarily Italian, go back to work after a summer vacation. Yes, they get multi-months of vacation. Obviously they are much smarter than we Americans.

The Christmas holiday season in western countries produces demand for jewelry. And then we have the wedding season starting in India. Gold and silver are the traditional gifts. In other words, the demand increases. That usually leads to higher prices.

GOLD HEDGES ARE ABANDONED:   Barrick Gold Corporation (ABX) just made a public offering of stock for approximately $3.0 billion representing 81.2 million common shares of Barrick at a price of $36.95 per share.

 About $2.9 billion will be used to eliminate its gold hedges. Here is the real reason: the company announced that a $5.6 billion charge to earnings will be recorded in the third quarter as a result of a change in accounting treatment for the contracts. This is apparently the loss the firm had on its hedges. No wonder they decided to liquidate them. They couldn't stand the pain any longer.

You can bet that as the price of gold continues to march upward, more and more hedges will be abandoned. That creates more demand for gold. One major source could be an unwinding of the "gold leasing" programs. This is huge. For several decades, central banks would "lease" gold to the so-called bullion banks at very low rates, such as 1%. The bullion banks would sell the gold and invest the proceeds in government bonds at a higher rate of interest. It was a very profitable game.

But it also created a virtual, huge short position in gold. No one knows the exact amount, but it’s in the billions. The bullion banks still owe the gold to the central banks and will either have to buy it back, or use options as hedges. The latter is too expensive in a bull market. Once the bullion banks can no longer keep the price of gold down through manipulations, they will have to buy it back.

Many people think that a rise in the price of gold is synonymous with inflation. Actually, there is very little correlation. Our work suggests that gold reacts bullishly to fears of governments monetizing the debt even if the inflationary impact doesn't show up for many years.  And there you have the real bullish story on gold. 

IS IT STILL A BEAR MARKET RALLY?

August 24, 2009

............... But "distribution" processes can last for several months. In 2007, the first top occurred in July, which we called perfectly. The market corrected. Then there was a rally off of the bottom in August. The indices made slightly higher highs in October 2007. We caught that top within two days. As it turned out, it was the 5 year bull market top. But at that point, the majority of stocks did not make new highs, meaning they had been under "distribution."

In past issues we have enumerated all the terrible fundamentals for the global economies, the $50-$60 trillion Mt. Everest of debt denominated in dollars, the fact that the banking system currently has a much higher leverage than at the peak in 2007, the fact that corporate earnings and sales have plunged, etc. But the stock market keeps rising. So, we have to think, what could be the reason. Here are several possible reasons:

1.  In a low volume, summer trading market, it's easy to squeeze the early short sellers who are using good analysis and realize that stocks are much too expensive. This is the game of the big trading operations.

2.  It behooves trading firms like Goldman to lure people back into the markets, as that enables companies to issue more stock (secondary offerings), which Goldman underwrites. It also enables mergers & acquisitions, and all types of money raising efforts. Therefore, more risk taking helps their business.

4. The government wants to encourage a strong stock market. The "President's Working Group on the Financial Markets," (use google.com) established after the 1987 market crash, has the power to intervene whenever there is a strong decline. However, currently it may have expanded that authority to actually produce a market rally, all in the interests of "preserving orderly markets."

BOTTOMLINE:  If you agree with us that the greatest financial crisis and wealth destruction, at least since the Great Depression, and possibly in the history of the nation, cannot be resolved with an 8 month recession, than you will not be convince by the Wall Street hype that this is a new bull market.

By Bert Dohmen August 4, 2009

Expect:  Big Rebound in GDP to be followed by "Double-dip"

.......... However, investors must recognize that this period of "green shoots" and "rosy scenario" will be followed by another decline into recession in 2010.

What are the reasons for a relapse into recession next year? A multitude! But here are some of the important ones:

1.      Tax hikes on the producers of society, the people who start companies and create jobs. With the current policies coming out of Washington, an entrepreneur has to be extremely bored and dimwitted to start a new firm.

2.      If nationalized health care becomes a reality, the above is amplified.

3.      The "Cap and Trade" is a multi-trillion dollar tax on everyone for the benefit of a few. It's a result of the greatest hoax in the history of mankind, "global warming produced by man."

4.      The global crisis was caused by excessive debt. The bailouts have not reduced debt, but only shifted it, from the private sector to the public sector.

5.      The only deleveraging has been in the hedge fund sector. In many other sectors, including banks, leverage is now greater than before the near meltdown of 2008.

6.      There is no credit expansion, the type of credit that produces economic growth, such as Commercial & Industrial Loans. Without credit expansion, there is no sustainable recovery.

7.      Jobs, jobs, jobs. Without job creation, how long can any recovery last?

The most important thing for investors is to differentiate between the short-to-intermediate term and the long term. This is critical. Over the intermediate term, psychology, false perceptions, market manipulations, and talk in Washington determine the markets. Over the long term, reality prevails.

It takes two quarters of positive GDP growth to mark the "end of a recession." We may have that early next year. The surprise however may be that similar to the Japanese experience, the economy will drop right back into recession thereafter.  The tax hikes and the expiration of the Bush tax cuts will virtually assure that.  

In the meantime, the average person will be led to believe that the greatest global financial crisis in history is over, after only 18 months. The investor is being convinced that the crisis that almost caused a meltdown of the global financial system, destroyed well over $60 TRILLION in wealth, produced real estate crashes globally, reduced trade by 30-45%, virtually shut down the credit markets, is still curtailing credit for businesses, caused 30 million people in the U.S. to be unemployed or underemployed, and caused the demise of financial institutions which had survived every depression and crisis of the last 150 years, is now over.

How easy the recession was! Many people I know felt no pain at all. So now, I guess we can start borrowing, spending, and speculating again. After all, even a newsmagazine told us that the recession is over. But life is not that easy.

As investors, we must take it one step at a time. You must look at the charts in order to differentiate between hype in the media and reality. Currently, with the S&P 500 at 1000, the index is only 4.4% above the high of almost two months earlier. But looking at all euphoria in the media, one would think that this is a rip-roaring bull market.

Although the long term looks poor, the intermediate term looks more promising. The next years will be the years for traders, not the "buy and hold" investor. Visit our website.

STOCK MARKET: BEAR MARKET RALLY PHASE II

.........  The bulls tell you that banks have raised billions of dollars to shore up their capital. However, the money raised by banks was by way of "secondary" offerings, i.e. companies selling more of their stock. Most of these stock offerings were below market price, meaning that existing shareholders were diluted. Apparently, they didn't complain too much as survival was at stake. In other words, the firms had to offer a great bargain to attract the money. To me, that's like car dealers offering big discounts: they lose money on each car sold, but they hope to make it up later with the "servicing."

Most of the rally since early March, when we gave our "buy" signal on the exact day of the low, has been caused by expectations that the economy will recover this year. We said the strength of the rally would even surprise some of the bulls and could go into August of the year. It was simple: the compression in prices had gone to an extreme. It was like a spring compressed to the maximum. The rebound is mechanical, not fundamental.

The bulls now tell you that the markets are forecasting a recovery. But markets act on "expectations" which are often totally wrong. Take the bull market top in October of 2007. Were the expectations that the "subprime mortgage crisis" would not infect the markets correct? Did that last rally "predict" a great economy in 2008? The fact is that the markets are wrong about half of the time.

In June, we wrote that our indicators were signaling a market correction, we also wrote:  "we don't expect a big plunge in the market during the summer, but rather a lot of back and forth. The summer market is being driven by the "black boxes," i.e. computer trading."

These "black box programs" trade against the emotions of the average traders. They may change positions several or many times in a day. They don't care about economic statistics or fundamentals, except as a way to benefit by going against the traditional emotional response of the average trader. When traders buy based on some positive news item, these programs go against that response by shorting against the initial response. It's a fact that the emotional response fades out quickly and then the markets, sectors, indices, or stocks go back to the trendline.

We have been talking about 60% of the daily stock volume coming from these operations. Our respected colleague, John Mauldin, and his Wall Street contacts say it's closer to 70-80%. Wow! That's incredible. In other words, actual investment buying of stocks has virtually dried up. And so has liquidity. This doesn't happen in normal bear markets.

Much of the trading now is "high frequency." The "black boxes" try to make as little as 50 cents per share on a trade, but they do it a thousand times a day. I see it in my own trading every day and I am trying to exploit that to my advantage.

Read this again so that it sinks in. This market rally has nothing to do with fundamentals. In fact, our view is that it is once again an engineered rally which eventually will end in a big trap for all the bulls. On July 31 the S&P 500 index was only 4.3% above the May 7 level, almost 3 months prior. Yes, the euphoria in the financial media makes it seem as if this were a rip-roaring bull market. Enthusiasm is getting too frothy. Whenever that happens, it's good to take some chips off of the table.

THE "REFLATION TRADE" HAS REPLACED THE "ARMAGEDDON TRADE"

By Bert Dohmen, June 25, 2006 

.............  Since early March this year, the Armageddon Trade has been replaced by the "Reflation Trade." The financial markets have begun to function again to a certain degree. Credit spreads have shrunk, some bank lending is taking place, the Fed is buying or guaranteeing commercial paper, supporting that important market, banks are able to issue debt with governmental guarantees, and the Fed is willing to accept everything but the proverbial kitchen sink as collateral for loans. In other words, the world has retreated from the abyss.

THE REFLATION TRADE:  The massive liquidity injections have produced a new trade, the "Reflation Trade," based on expectations of high future inflation. There is now a flight toward commodities, away from defensive investments, and away from T-bonds. Now the investment world is prepared for a new bull market in stocks, a period of high inflation, and a commodity boom. We believe some of these trades will work, such as gold, silver, and short selling long-term T-bonds. But a general commodity boom will take a long time.

Some analysts even talk about "hyperinflation." Well, I studied the hyperinflation that occurred in Germany’s Weimar Republic 90 years ago. It takes a long time to develop, if it ever does. It takes incredible distortions of the financial system to materialize. There are different steps in the process. The first part has the velocity of money plunging which means there is little demand for the money the Fed is injecting. That's happening now. Prices plunge as well as consumer spending plunges (see chart below).

 

 

Obviously, there is no sign of inflation here. So, anyone who bets on inflation may have to wait a few years, or longer.

The next phase in the process for very high inflation can occur if the value of the currency plunges because confidence in the government’s policies has plunged. That's when money velocity speeds up because consumers spend money as fast as received because they fear the loss of purchasing power. It also causes interest rates to soar, as lenders want to be compensated for the loss of purchasing power. This is when gold and silver skyrocket. But that takes a long time to develop. It doesn't occur while the
"great deleveraging" is still going on.

While this is happening, the central bank, in the U.S. it’s the Fed, will cause gigantic swings in the financial markets as it fights these ominous trends. It's a very hazardous time for investors.

The past three months analysts have been hyping the reflation trade, recommending commodity related assets. They are expecting a global economic recovery and rebound in the demand of basic materials.

We would take the opposite side of that trade. Our work strongly suggests that we are in long term, economic shrinking process. Demand for commodities will continue to erode, slowly but surely. Look at this chart of the CRB Commodity Index. It is heavily weighted towards agricultural commodities, but it shows that perhaps the commodity frenzy is over hyped.

The markets often act on "anticipation" of the future. However, these expectations are often wrong. When the market finally recognizes that, you have severe corrections.

MUSTARD SEEDS or TERMINAL VELOCITY? 

June 9, 2009

 ...........But just because acceleration declines, doesn't mean that the deterioration is over. Instead, I call it "terminal velocity." When someone jumps from the Empire State building, his acceleration stops at a "terminal velocity" of about 123 mph, i.e. the rate of descent no longer accelerates. But when he hits the sidewalk, he still going 123 mph and goes "splat."

All these green shoots will wither in the wind later this year for lack of water, i.e., credit and corporate profits. And the few profits that will be made will be taxed away.

But for now, the "REFLATION" trade is alive.  The game of money managers right now is to bet on a global economic recovery, which will increase demand for materials, energy, etc. However, money managers are very often wrong. They are often forced to get into positions in order not to miss a move, After all, they are being paid to invest. If they miss a meaningful move, they may get fired, or lose a lot of clients. So they plunge in, even if they don't trust the move.

We had a" reflation" rally in 2008. It ended in early September. The popular sentiment about reflation was wrong. In fact, that's when deflation really got going. The market doesn't tell you anything about the future, just about the lemming response of the participants.

With the global economies withering, there is cost cutting everywhere. No one needs large stockpiles of anything. Only China is buying, but their infrastructure is about 100 years behind most industrialized countries. They can now put all the stimulus money into catching up. But that won't be enough to pull the global economies out of recession. Remember, China's entire economy is only 25% of the size of the U.S. economy.

BOTTOMLINE:  Our view is that all the theories behind the current rallies are wrong and will be proven wrong by the fall of the year. The smoke and mirrors games played in Washington have for now calmed the fears of a global financial meltdown. That's what is really behind the rally: the "end of the world" fear is dissipating. But all the other problems remain, which will now get the attention again.

The next bear market phase is when poor economic conditions come to the forefront. It's one thing to rescue the banking system, but a totally different thing to engineer an economic recovery when credit creation has plunged by trillions of dollars and tax burdens are soaring. There is just "no gasoline in the tank" to fuel a recovery at this time. And Washington tax policies will assure that any little spark of recovery will quickly be extinguished by higher taxes.

Bert Dohmen

June 8, 2009... BEAR MARKET RALLY, NOT A NEW BULL MARKET

..........

The bulls say that we have already seen the equivalent of the 1932 bottom. To me, that seems improbable. At the 1932 bottom, the DJI had lost 89%. Therefore, the bottom this March doesn't qualify as "the bottom" at all. In fact, given that we had the greatest speculative bubble of modern times, using the highest degree of leverage, and creating $1.2 quadrillion of derivatives, the final bear market bottom should be much, much lower. At minimum, the economic contraction will be much longer. We expect it to last at least until 2017, of course with periodic fools rallies.

The Great Depression bear market bottom was three years after the prior bull market top. That would give us at the earliest a bottom in 2010. But remember, the 1932 bottom didn't end the depression.

Stock prices could make a higher bottom next year than we anticipate IF inflation starts rising strongly. Then stock prices would rise in nominal terms, but not in inflation-adjusted terms. In other words, the value of the currency declines and stocks become a hedge against the declining purchasing power of the currency. With the massive money creation we are seeing, this is a possibility.

In our view, we are currently seeing a typical bear market r ally. In the last bear market that started in March 2000, there was a rally late in the year going into January 2001. Many high-profile analysts proclaimed it to be the start of the new bull market and advised "loading up the truck." We gave a new sell signal late in January. That was right on target. And that's when the decline got serious.

In early March, when we called the temporary bottom, we said the rally may go into late summer but it would be very volatile. We don't have a crystal ball, but depend on our indicators to give us the clues when. If there is another rally attempt in the summer, it would be to trap all the hopeful bulls. It would present another great opportunity to sell short.

Sentiment right now is virtually "giddy" amongst the analysts and commentators in the media. The bullish consensus of index traders is now at the level last seen at the bull market top in October 2007.

Furthermore, the selling of stocks versus buying of corporate insiders, the people who know how their business is likely to be over the next year, is at one of the highest levels on record. The sell/buy ratio is over 8, meaning that for every share purchased, they have sold eight. Obviously, they are not that optimistic.

The global financial crisis was caused by an implosion of excessive debt, due to uncredibly high leverage employed by financial institutions. The government is trying to resolve the excessive debt problem by creating more debt. That just won't work. Be prepared.

Bert Dohmen

June 7, 2009....  PROFITS OR ACCOUNTING MANEUVERS?

.......... And it doesn't stop there. Most banks have sold bonds in past years to raise capital. Those bonds may have declined significantly in value because of loss of confidence in the viability of the banks. If a bond has declined 40% in value, the bank may now book that 40% decline as a profit! How is that possible? Well, the accounting theory is that a bank could theoretically buy those bonds back today, and thus reduce the debt obligation by that 40%. Once again, it books a multi-billion-dollar profit.

That's how Citigroup turned a $2.8 billion loss into a $1.6  billion reported profit. Wonders never cease. Over the next several quarters, we will see more "manufactured earnings" by banks. The unknown is how the stock will react to this? Will investors realize that they are being fooled?

For now, we should not be too fast at writing the epitaph of the large banks. They have many things in their favor now. That's why they are able to raise billions of new capital, almost overnight. That's a huge change from the frozen credit markets of the past 20 months.

One great program for the large banks is the TLGP, which very few people have heard of. Financial institutions have been able to borrow money from the government at less than 2% by the billions. When they lend this out at 8%-28%, it obviously helps profits. What is this program?

Late last year, the Federal Deposit Insurance Corp. started its Temporary Liquidity Guarantee Program (TLGP). This program guarantees newly issued senior unsecured debt of banks, thrifts, and certain holding companies, and provides full coverage of non-interest-bearing deposit transaction accounts. The FDIC first adopted the program on Oct. 13. Recently, banks have been taking advantage of it to raise billions of dollars. Some of the large banks have borrowed $20 or $30 billion under this program, much more than they got from the TARP.

Bottomline: Most of the focus of the government action has been on preventing a meltdown of the banking system. Therefore, this is probably the one sector in the economy that is safe for now. But that doesn't mean earnings growth. Most other sectors are still vulnerable to the long-term deterioration of the economy, and thus shrinking or disappearing profits. That's where investors will be trapped for the next many years.

SHOCK AND AWE from WASHINGTON

Excerpt from March 24, Wellington Letter

.............................................$300 billion will be used to buy longer-term Treasury bonds. As a result, yields plunged as bond prices soared. The Fed will widen the types of securities it will accept as collateral for loans. That means the kind of stuff no one can sell. But it helps. The Fed will also buy another $100 billion of agency debt, bringing that total to $200 billion.

Another $750 billion will be used to buy "agency" mortgage-backed securities. That means FNMA and Freddie Mac securities. A lot of these are held by insurance firms, regional banks, and Sovereign Wealth Funds. They have all been complaining that they got stuck with this paper when the government took these firms over. The Fed’s move is a way to reduce the complaints.

All together, that's a huge amount of additional money, especially considering that the Fed’s new TAFT program started last week and is outside the purview of today's announcement.

Also on Monday, (March 23, 2009), the U.S. Treasury announced a plan to take bad assets out of the banking system with the help of private investors. It's a complicated plan and there are obstacles. Treasury estimates that the plan will take $1 trillion of assets out of financial firms and thus enable banks to start lending. You can read all the details on the internet. In my view, the plan is so convoluted and full of question marks, that in the end, it will not bring the desired results. The stock market celebrated the announcement, but that's more hope than brains.

Treasury Secretary Geithner believes that this will encourage banks to start lending again.  Well, banks are lending right now, but they are being much more careful. They lack of lending standards will not be seen again for a long time. Banks are now going back to basics.

Furthermore, the $1 trillion of the Treasury plan is a band-aid. About six weeks ago we discussed the fact that only about $1.1 trillion of bad assets had so far been realized, but that the actual amount in the system, according to Bridgewater Associates, is 5 times greater, i.e. over $5 trillion. That means that this current program will have to be followed up with additional money, much more, in fact, than has been announced.

The Fed announcements will rekindle some optimism. Last week Fed chief Ben Bernanke made it clear that he is in charge. The U.S. Treasury action on Monday may diffuse some of the calls for the resignation of Timothy Geithner, the Treasury Secretary. For a while, the markets will trade on that hope. But eventually, reality will return when it is found that the desired results are just not coming. The plan does nothing for the economy.

We have to consider that it was a financial crisis which produced the current economic crisis. But over the next several years, it will be the economic crisis which will produce continued deterioration in the financial sector.

THE BEST BEAR MARKET RALLY YET: 

..................In our last issue, we wrote: "We believe that the markets are now in a bear market rally phase. The

economy will also show some better numbers in the spring and early summer. All trends consist of shorter-term cycles, even crises, meltdowns, and depressions. The TALF program will inject several hundred billion dollars into the system. That will loosen credit conditions to a certain extent, temporarily."

The rally got into high gear with the Fed statement after its latest meeting on March 18. Now we have to guess how long the rally will last and how high it will go. Late last week, the market had a two-day pullback. That's a normal technical pullback. On Friday we wrote that, “… the market must rally on Monday and stay above that trendline.”

Well, the DJI gained 497 points today (Monday, March 23). That's almost 7%! That's extraordinary!

As we wrote in our SMARTE TRADER service, as well as in PRIVATE PORTFOLIOS, this bear market rally is likely to be more substantial than what we have seen previously. All of our technical indicators are now lined up. The two-day pullback last Thursday and Friday brought a lot of worries to the bulls. But our S&P 500 chart suggested that it was just a pullback and that a rally today, Monday, would be very bullish if it occurred. It did!

The close in the S&P 500 in the 823 area is very positive. The index had resistance at 802. Early this morning, in an email, I speculated that the index would leap over that resistance and continue to rise. It did! This is bullish confirmation of the strength of this rally.

The short sellers are now being forced to close out short positions, which is adding fuel to the fire.

CONCLUSION: After 15 months of gloom and doom, sentiment is ready for a turn to the positive. It's spring, the sun is out, and the warmth from the sun will bring renewed optimism. Everything had been severely compressed to the downside in late February. The break in the major indices to new bear market lows at that time normally would have brought a big decline. The fact that this didn't occur tells us that the market was sold out. When a market doesn't decline much on bad news, and when numerous stocks actually rise on bad news, as we witnessed, it is always a bullish sign.

This is a time to participate in a good bear market rally.

GOLD: A "KEY REVERSAL" DAY

By Bert Dohmen  March 2009

.......     With the financial stocks rallying strongly, the "safe haven" money that went into gold is leaving. That causes lower prices for a short period. But then comes the "inflation hedge" trade, and that involves much more money than the "safe haven" trade. Therefore, a pullback in gold when the financials are strong should not cause concern.

The big, smart hedge funds are putting big money into the gold sector. John Paulson, whose huge hedge fund made billions betting against subprime mortgages, paid $1.28 billion for an 11% stake in AngloGold Ashanti Ltd., one of the world's largest gold miners. The Paulson Group manages about $30 billion. It profited nicely from the subprime crisis. Its main fund was up 37% last year while the average hedge fund lost 19%. The Paulson funds also own about 28 million shares of Kinross Gold Corp., or about 4%.

Eton Park Capital Management LP, Greenlight Capital Inc., and Hayman Advisors LP have all made big investments in this sector.

The CEO of AngloGold Ashanti said: “As the world deals with the global economic crisis, the value of gold, as the only true ‘hard currency,’ is coming to the fore as evidenced by the investment choices of some of the world's most seasoned investors.” 

WHAT IS "CAP and TRADE?"

From Stratford; Cap and Trade Program

......   Establishing a national standard for a cap and trade system would allow utility companies to factor in future costs of emitting greenhouse gases, which currently is an unknown. Utility companies do not know whether it makes sense to build regular coal plants, clean coal plants, solar or wind installations or natural gas production facilities because the rules of the game are not set. Until that happens, energy expansion in the United States will be at a standstill.

However, the U.S. domestic climate-change policy must be negotiated at the global level, particularly with China. Obama, or any subsequent U.S. president, will be hard-pressed to adopt carbon emission rules without first getting some sort of a deal with China that would guarantee that Beijing would also address its own greenhouse emissions. Otherwise, U.S. greenhouse gas-emitting industries (chemicals, petrochemical, paper and pulp, steel, cement, etc.) could bolt for China and the developing world.

Therefore, a conversation with Beijing about climate change is high on Obama's list of priorities; his energy envoy, Todd Stern, is accompanying Secretary of State Hillary Clinton on her current trip to East Asia, primarily to discuss some of Obama's energy ideas with the Chinese.

This is how the Wall Street Journal explains the effect of the "cap and trade" tax which will give every American, not just taxpayers, a huge tax increase. However, supporters point out that it only effects people who use energy, such as gasoline, heat for their homes, electricity, etc.

Politicians love cap and trade because they can claim to be taxing "polluters," not workers. Hardly. Once the government creates a scarce new commodity -- in this case the right to emit carbon -- and then mandates that businesses buy it, the costs would inevitably be passed on to all consumers in the form of higher prices. Stating the obvious, Peter Orszag -- now Mr. Obama's budget director -- told Congress last year that "Those price increases are essential to the success of a cap-and-trade program."

Hit hardest would be the "95% of working families" Mr. Obama keeps mentioning, usually omitting that his no-new-taxes pledge comes with the caveat "unless you use energy." Putting a price on carbon is regressive by definition because poor and middle-income households spend more of their paychecks on things like gas to drive to work, groceries or home heating.

You can escape the tax if you don't use energy. Try that!

A "BAD BANK" for BAD ASSETS? The Size of the Problem

Excerpt from the Wellington Letter, Feb. 23, 2009

.....    In the meantime, another huge bill, the so-called "Stimulus Bill," was passed by the House, and is now going through the Senate. It will be around $900 billion and won't do a thing for the economy. This is a garbage collection of all the pet projects their sponsors couldn't get through under the old Administration. If this is the promised "change," I don't want it.

Nevertheless, let's assume they find another "band aid" solution, and a way to implement a "bad bank" plan. That would prevent an imminent plunge in the bank stocks for a little while. But for how long? Nothing they did last year worked.

In my book, PRELUDE TO MELTDOWN, written in late 2007, I said that the coming meltdown would be so large that it was highly questionable whether the U.S. government, together with the central banks of the world, would be able to prevent the meltdown. Originally, the official estimate was that the entire bad asset problem would be around $125 billion. Then the forecasts were raised to $400 billion. I wrote last year, that when everything is done, it could approach 10-$20 trillion.

Now Goldman Sachs forecasts that troubled assets could exceed $5 trillion. That is just over 40% of the $12.3 trillion in total assets of U.S. commercial banks. Imagine, just 18 months ago they were talking about $125 billion. That's 40 times bigger than the official estimate in 2007.

You see, I was counting the Credit Default Swaps, which a year ago amounted to $65 trillion. The implosion of these triggered the bailout of AIG. Currently, it is estimated these have shrunk to $30 trillion, still a huge amount. This unregulated market should never have been allowed for speculation. Another Washington failure.

Just look at the current leverage: Citigroup and Bank of America have $3.8 trillion of assets between them. An "asset" for a bank is a loan it has made. Citigroup has a capitalization of $19 billion, and B of A has about $31 billion. That's a capitalization of $50 billion supporting $3.8 TRILLION of loans. That's leverage of 131 to 1.

 It's obvious that the taxpayer will be the big sucker again. Somebody has to hold all these worthless assets, and it will be the taxpayer. He will get trillions of dollars of bad assets. And then he will get a tax hike to boot to pay for it all. As a taxpayer, be sure to say "thank you."

I propose as an encore, a "Really Bad Bank (RBB)." This would be for all investors who listened to their brokers and made bad investments, in mutual funds, stocks, junk bonds, muni-bonds, etc. They would be able to dump them into the RBB and get back what they paid for them originally. It would be funded by the pension funds of our members of Congress, who now retire with full pay after only one term. Isn't that a great "stimulus" idea? It would definitely help "Main Street," which is what the current people in charge promised they would do. But don't hold your breath waiting for this to happen.

"LONG TERM HOLD" IS DEAD IN A SECULAR BEAR MARKET

Excerpt from the Wellington Letter, Feb. 23, 2009

.....    Some say that Mr. Buffett has lost more than $30 billion. Yes, that's the value of "long-term investing." Big, fat losses! The long-term approach is all right during a secular bull market. And he really capitalized on that over the past 40 years. But when a long-term (secular) bull market changes to a secular bear market, all the value investing in the world won't save you. Investors will not care about the value of a stock today. They sell because of declining economic conditions and, therefore, reduced future profits, and because they need the money.

Here is an example of the financing problems of large firms, as of January 19, 2009. The New York Times was looking for a loan. It finally reached an agreement with Mexican billionaire Carlos Slim. He will lend the firm about $250 million. Mr. Slim, one of the wealthiest people in the world, will receive an annual interest of about 14%. The unsecured notes he receives will have detachable warrants for about 16 million shares, which expire in January 2015.

This is noteworthy. First of all, the NYT continues to raise money, which suggests a significant negative cash flow. Secondly, it is willing to pay 14% interest. Even the most profitable company can't pay that for its money based on operating profit margins. Obviously, they were turned down by their banks. There was no word about their being turned down by the Mafia. This is a sign of DESPERATION!

Given the bankruptcy of another large newspaper in Chicago, after it was bought by billionaire Sam Zell, it's easy to conclude that the NYT may meet a similar fate, billionaire financing or not. It's apparent that Señor Slim will own the firm the next time it runs out of money. But that may be his big mistake.

BAILOUTS DON'T WORK

From the Wellington Letter Jan.13,09

.........................Roosevelt threw huge amounts of money into infrastructure and "make work" programs. I learned to play tennis in the 1950's on a concrete tennis court built by the WPA program under Roosevelt. (It was painful). But in 1940, 10 years into the depression, unemployment was 2.5 times higher than at the start of the depression.

The great economist of the Austrian School, Ludwig von Mises, wrote decades ago: "There is no means of avoiding the final collapse of a boom brought about by credit expansion. The question is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved. There has never been any attempt to abandon the credit expansion. Indeed any crisis was simply an excuse to open the monetary spigots."

Unfortunately, few universities teach this "free market" school of economics. I was a friend of Professor Hans Sennholz, who was one of the students of Dr. von Mises. Auburn University has a Ludwig von Mises Center, and the organization, FEE (Foundation for Economic Education) (www.fee.org), has great articles on the school of free market economics on its website. Pepperdine University has one of the greatest living scholars of Austrian Economics, Dr. George Reisman. He wrote a 1000 page book on it, entitled "Capitalism: A Treatise on Economics."

(Subscribe to Bert Dohmen’s WELLINGTON LETTER today and get the full story, with specific “What To Do” recommendations, including charts to prove the case. Go to: www.dohmencapital.com.)

CHINA IS THE CABOOSE, NOT THE LOCOMOTIVE

From the Wellington Letter Jan.13,09

.....................China is an export economy, in spite of governmental efforts to fuel domestic consumption growth. But that will be tough when tens of millions of people are losing their jobs. Over the past several years, exports have contributed about 20% to GDP. However, in November exports showed the first decline on a year-on-year basis since 2001.

Xinhua Finance of China just reported these statistics, which suggest serious deflation occurring in China right now:

The headline  sentiment index hit its third successive record low at 35.20, down from 39.87 in November, and that gloom was reflected in other key indicators such as new orders and production.

 

But the most alarming signal in the latest monthly survey was seen in the indexes for prices. The index for input prices, which was in the 80s as recently as August as the government fought inflation on a number of fronts, hit an all-time low of 26.36, a record low for the third straight month. The index was at 31.89 last month.

 The index for prices received rose slightly but remained near the record low set last month. The index was 36.82 in December, up from 35.56 last month.

 

Perhaps even more worrying for the prospects of Chinese macroeconomic and monetary policy is that companies appear to expect prices to continue falling.

On January 8 we saw a report that electric power usage, a great indicator of economic trends, is down sharply. Manufacturers used 11% less power, and light industry used a hefty 21% less electricity. That tells you that the economy is not only showing "reduced" growth, but negative growth.

In the media, you still see the Pied Pipers of Wall Street trying to entice investors into the stock market by saying that China will pull the global economies out of the "slump." They don't say who will pull China out. Are there little Martians landing in Beijing with flying saucers full of money?

The same people tell you that raw materials will be in big demand again next year, commodity prices will soar and oil may even get back to $100 per bbl. Well, I haven't believed in fairy tales since I was 5 years old. You shouldn't either.

Disinvesting of Chinese stocks continues. When cash is hard to get, you sell assets. In early January, Bank of America sold its $2.8 billion stake in China Construction Bank. Several other banks around the world did the same. Hong Kong billionaire Li Ka-shing sold a $524 million share in Bank of China. We can't know if this is just to raise capital, or whether they all just want to reduce exposure to China.

China's economic problems will infect all the smaller Asian nations. And that will cause great pain in that part of the world. Therefore, don't count on China bailing out the world. They will be too busy fighting the problems at home, both economic and social. We expect several social unrest over there.  

(Subscribe to Bert Dohmen’s WELLINGTON LETTER today and get the full story, with specific “What To Do” recommendations, including charts to prove the case. Go to: www.dohmencapital.com.)

THE NEXT SUCKER PLAY: INFRASTRUCTURE INVESTING

.......The new scam of "infrastructure" will fare the same. The President-elect is expected to have an economic "stimulus" program costing $1 trillion. To me it’s incredible how the word "trillion" is now thrown around as if it’s nothing. Well, $1 trillion is 1000 times one billion.

So far the government and the Fed have committed the taxpayers to $8.5 trillion of bailouts, without any visible effects. So, another $1 trillion for infrastructure will be considered "great." The big disappointment in late 2009 will be when the President-elect can't fulfill all the high expectations of his supporters. Too many intelligent people expect miracles. 

The Wall Street Pied Pipers are beating the drums for "infrastructure." That's apparently the big play on the President-elect's promises. I strongly caution against these investments, except for another trade to take advantage of the foolishness of the public. It takes a long time to approve such projects, to design and engineer them, to award bids and then to start construction. It's estimated that after all is said and done, about 4 cents of every dollar appropriated enters the consumer spending stream in the first year.

Here are some additional facts, which the Pied Pipers don't tell you. Last year, there was about $750 billion in infrastructure projects. This year, according to Morgan Stanley, there will be zero for new projects. In other words, you need $750 billion of new projects next year just to get back to the business of 2007. There is no chance of that happening.

Even if they commit $500 billion to infrastructure in 2009, it's estimated that in the first year only 4% of this amount would go into the economy. That's $20 billion. It's less than a drop in the bucket. It's a droplet of morning dew. It takes a long time to gear up expensive infrastructure projects. And once they get going, it won't produce the millions of jobs to offset the jobs now being lost.

The first phase of such sucker plays is the psychological part, where these stocks are promoted, analysts on TV hype them 12 hours a day, and the unsuspecting investor puts his last dollars into the stocks, hoping to make up the losses he has had this year in other stocks. The second phase is when the friends of Wall Street dump these stocks on the casual investors just before the next big decline.

Bottom line: the only ones to make money in this will be the lobbyists, the legislators, the few firms that will get most of the booty and, of course the brokerage firms recommending the stocks. However, if you disagree with our view, here is the other side of the story as told by the brokerage firm, Friedman Billings, as reported by www.briefing.com:

It anticipates 2009 will be the year of "infrastructure," as the new Administration and Congress aggressively use an Economic Recovery Plan (ERP) to quickly direct funding to highways, bridges, water/wetlands restoration, institutional buildings, energy conservation, etc. Beneficiaries of an ERP should include: (1) Heavy civil construction companies, which should be immediate beneficiaries given the $64 billion in "ready-to-go" projects (GVA, STRL, URS, PCR). (2) Local engineering and consulting firms should see an immediate increase in bidding opportunities and overall increased activity (URS, ACM, TTEK). (3) Alternative energy and U.S. electric T&D grid legislation and/or funding could benefit several specialty contractors and some equipment manufacturers (PWR, MYRG, MTZ, TTEK, PEC, FLR). (4) A focus on green buildings and retrofits with a goal to improve energy conservation could impact manufacturing companies and eventually the electrical and mechanical contractors as installations begin. The firm also cites OMGI, GLDD, SGR, EME, FIX, IESC, VMC, EXP, MLM, CBE, HUBB, LII, ITX, ASD, and ITRI as potential beneficiaries.

There you have both sides of the story. Take your pick. Who do you trust more?

BUY AND HOLD? As you know, we have always preached against the ruinous investment strategy called the "long-term hold." It is advocated primarily by those who don't have the skills to time the market. In a bear market, all stocks go down, and sometimes significantly. If you are billionaire Warren Buffett, you can hold on while you are losing 50% or more on the stock. If you are the average investor, you will panic at the bottom.

I predict that Buffett will lose about 60-70% of his wealth in this bear market. But he will still have billions left over. Many of the world's former billionaires have already lost 50-90% of their wealth, and some are going bankrupt.

And if we are right in our forecast that the "worst is still ahead," they will lose even more. They could have saved themselves tens of billions of dollars with a $375 subscription to our WELLINGTON LETTER last year. That's a bargain!

(Subscribe to Bert Dohmen’s WELLINGTON LETTER today and get the full story, with specific “What To Do” recommendations, including charts to prove the case. Go to: www.dohmencapital.com.)

 

UNEMPLOYMENT SURGES AS THE ECONOMIC CRISIS INTENSIFIES

Excerpt from January 13, 2009 Wellington Letter

.......    However, according to some analysts,  if the unemployment rate were calculated the same way it was in previous recessions, the current unemployment rate would be a whopping 11.4%.

Furthermore, if you count "discouraged" workers who are no longer looking for a job, and those who are working part-time but want full-time, the unemployment rate would be 14%. Our forecast is that eventually we will see an official rate of 12%. That will cause all the bulls to reevaluate the cheerfulness. On January 3, 2009 the President-elect said unemployment could go to 10%, which is much higher than the consensus of economists.  Eventually, he will agree with my numbers.

Last April, the official unemployment rate was about 4.7%. However, the actual unemployment rate as calculated above was 8.1%. Here is what the author of an article on the subject wrote about that number:

If we examine the BLS data and add up the number of self employed persons who are not working, the number of persons who are working part time because they can not find a permanent full time job, and the number of persons the BLS classifies as unemployed, the total number of people who are either unemployed or underemployed equals 12,395,000 workers.

The government's numbers are fudged to show lower unemployment numbers. Don't believe them. There isn't one economist that I have heard who thinks unemployment can go above 20%. Well, if you calculate it correctly, as above, I think we will get there over the next year or two.

(Subscribe to Bert Dohmen’s WELLINGTON LETTER today and get the full story, with specific “What To Do” recommendations, including charts to prove the case. Go to: www.dohmencapital.com.)

 

UNEMPLOYMENT SOARS..... THE WORST IS STILL AHEAD

Excerpt from Dec. 8 Wellington Letter

Until now we have had a financial crisis, which affected mostly firms and people in that industry, and larger firms that could no longer get credit. But until September people weren't that worried. Everyone considered this to be just a normal "economic slump." I even stopped talking to people I met about what I thought was ahead, because to them it wasn't credible. My job is not to "convince" someone of my viewpoint.

But now comes the "awakening." Since October, the consumer has awakened to the dismal state of his finances. Hundreds of thousands of people are losing their jobs, and they can't find new ones. The crisis is now coming to "Main Street." This is the most painful part, and we are just in the early phase.

It is obvious that all our forecasts of the past 18 months are coming true, unfortunately. Until now consumer spending had plunged because of the inability to get credit. Now comes the harder part: People losing their jobs, which reduces the income of many families to welfare levels. The economic pain will be much more severe than anything we have seen so far in the financial markets.

All the bailouts are aimed at the large financial institutions. However, their problems are not the cause, but a symptom of the real problem. What is the real problem? The consumer is tapped out. He doesn't have any buying power left.

From 2003 to 2006 (4 years) about 80% of GDP growth was attributable to the mortgage refinancing (MEW). That was called the "home ATM."

That money is now gone and so is the driving force for the economy. All the bailouts in the world can only slow the economic decline, not prevent it. And they certainly can't produce new economic growth. It's absurd to call these bailouts "stimulus." They are "rescue missions."

Economists don't consider the "snowball effect." There is a chain reaction all through the economy. The "virtuous cycle" on the upside becomes the destructive chain reaction on the downside. Credit is no longer available, so the consumer stops spending. That leads to downsizing and bankruptcies of firms geared to the consumer, and in the U.S. that's 70% of GDP. This causes unemployment to soar, causing even more businesses to go bankrupt.

The real estate these firms occupy will be empty. Developers and owners of shopping centers can't get credit so they will go bankrupt when the billion-dollar loans come due. As defaults in mortgages and other types of consumer credit escalate, the credit market will freeze even more. That causes further economic erosion, more people downsizing or going out of business, and a deeper recession. Are the people in Washington considering this snowballing effect?

Tax rates must be cut significantly, for everyone, especially small, Sub S firms, which are taxed at the individual rate. But this is exactly the sector that the President-elect has targeted for big tax increases. He calls these people "the wealthy." We can only hope that when faced with the stark reality of a potential depression, his advisors will be able to change his mind.

The dismal state of the retail sector, which is now seeing the worst conditions in about 30 years, confirms what is happening. Retail sales are plunging in the U.S., and around the world. This will be the worst Christmas shopping season in many decades. I predict that retail sales will be down as much as 30-40% in Q4 for the hardest hit stores. Bankruptcy filings in January will skyrocket.

In spite of the holiday season, there are store closings everywhere. Wait until January! The shopping centers will empty out. So far over the past 12 months or so, we have this:

Ann Taylor will close 117 stores, Eddie Bauer 27 stores and two outlets, Lane Bryant 150 stores, Talbots 78 kid/men stores and 22 women stores, The Gap 85 stores, Foot Locker 140 stores, Disney Store 98 stores acquired from The Children’s Palace, Home Depot 15 stores, Macys 9 stores, Pacific Sunwear 154 stores, Pep Boys 33 stores, Ethan Allen 12 stores, Wilson Leather 158 stores, Sharper Image 90 stores, KB Toys 384 stores, Dillards 6 stores.

One retail analyst, who has been correctly bearish all year, expects the bankruptcy of 14 large retail chains early next year. He didn't name them.

The job losses are accelerating. The economists that had been arguing until September that we might not even see a recession, apparently because they felt that they themselves had job security, are now faced with the reality of rising unemployment, which stands now at 6.7%. However, they never give up. Their new story is that we are approaching the "end of the recession." That's the recession that they never saw coming. But now they are the experts in declaring its end.

The latest jobs report shows that 533,000 people lost their jobs. Actually, if you count the "discouraged workers" who are no longer looking for jobs, the number was over 650,000. The average work week is 33.5 hours, the lowest since 1964, when they started keeping records.

In our November 10 issue, we wrote:

The unemployment rate jumped to 6.5% last month, the highest since 1994. Even worse, the job loss for the prior months was revised upward significantly. In a recession, such revisions are normal as the first figures don't capture the job loss at small firms. In my view, the unemployment rate will be at 9% sometime by next summer, and 11-12% in about two years from now.

Let me emphasize that, although the majority of economists would consider my forecasts above as "extreme," I think the numbers are on conservative side. The latest number is 6.7% unemployment.

On Nov. 21, Goldman Sachs revised its own economic forecasts: They forecast unemployment will reach 9% by Q4 2009. We gave that number two months ago.

Their Q4 of 2008 GDP forecast was revised downward from a decline of 3.5%, to a decline of 5% in Q4 (at an annual rate). That has been our forecast for some time.

But these numbers are all "cheerful" compared to what we are likely to see in 2009. We will see economic numbers so bad that even the "perma-bullish" economists will start considering depression. More on that in the next issue. I don't want to spoil the holidays for you.

(Subscribe to Bert Dohmen’s WELLINGTON LETTER today and get the full story, with specific “What To Do” recommendations, including charts to prove the case. Go to: www.dohmencapital.com.)

MORTGAGE TIME BOMBS

Excerpt from Wellington Letter Dec. 8, 2008 issue

Option-adjustable-rate mortgages were very popular during the housing boom. They allowed borrowers to pay interest only for as long as five years. The monthly payment was capped and if rates went up, the difference was just added to the loan.

However, the loans also have a cap. Once that cap is reached the loans are "recast." Because they have only paid interest for several years, and thus have less time to the end of the loan, the monthly principal repayment is much higher.

It's estimated that of the $200 billion in option ARMs outstanding, more than a quarter will be recast in 2009 and 2010.  Payments will rise some 63% on these mortgages, increasing the average borrower's home expense by more than $1,000 a month.

The rating firm Fitch estimates that this dramatic increase could cause delinquencies to double. Wachovia held $122 billion of option ARMs at the end of the second quarter, Washington Mutual about $53 billion

The percentage of mortgages 30 days or more overdue rose to 6.99%. Mortgages in foreclosure rose to 2.97%, both all-time highs in the history of the survey (which goes back 29 years).

And the huge problem over the next several years will be municipalities and states not being able to pay the bills and not able to borrow, except from the Federal government. Therefore, they will cut their highly bloated payrolls, causing even more unemployment. Muni-bonds will default, further exacerbating the credit freeze. How many investors have contemplated these upcoming problems?

One interesting item: We wrote last month that the only booming industries for the next several years will be makers of alcoholic beverages as people drown their sorrows, and real estate firms in Washington, D.C., as the nation’s capital enters another big growth phase. Well, on Dec. 5 the maker of Jack Daniels whisky announced better than expected sales and raised its sales guidance for next year.

(Subscribe to Bert Dohmen’s WELLINGTON LETTER today and get the full story, with specific “What To Do” recommendations, including charts to prove the case. Go to: www.dohmencapital.com.)

THE INCREDIBLE SHRINKING WALL STREET

By Bert Dohmen : Post-election, Nov. 2008

NY Mayor Bloomberg said that Wall Street may lose over 140,000 jobs. Will there be anyone left? Who will fill those buildings? And how will the owners of the buildings service the mortgages?

To my knowledge, there is only one Wall Street investment bank remaining, Lazard. The other two, Goldman Sachs and Morgan Stanley converted to regular banks so they would be eligible for bailouts by the Fed.

The "virtuous cycle" of the boom years is now in reverse. It's like a big rock dropped into a pond. Soon all the ripples envelop everything on the pond. The investment banks were leveraged 40 to 1, with the special consent of the SEC in 2004. William Donaldson, co-founder of a large Wall Street firm, was the head of the SEC. The fox guarding the henhouse. With that much leverage, if your investments decline 2.5%, you have lost 100% of your equity. Imagine, trying to deleverage that! And that is what the financial firms are trying to do now, with taxpayer money.

As New York office buildings empty out, apartments will as well. And then the retailers in NY will see their customers disappear. REIT'S with big exposure to NY will be especially hard hit.

Wall Street guys made unbelievable bonuses during the boom years. Now we have the evidence that the booms were nothing but financial engineering using unbelievably high leverage. "Genius" was nothing more than extreme leverage in a rising market. The private equity guys were in the frontline feeding at the trough of artificial wealth. I met many of these "hot shots" in 2006 and 2007. Last year when several of them said that, "We have never seen conditions this bullish," I asked them if that isn't the perfect description of every major economic boom top? Only one of them said, "When the music stops, we have to be sure we have a chair to sit on."

The others just wouldn't accept my analysis that a major top was being formed, and that we would go into a global financial crisis, created by them and their friends.

Human nature never changes. The business of Private Equity (PE) firms was to buy companies that were public and take them private. They would give the CEO's and top guys huge bonuses to agree to the buyouts. I would describe that as "bribery," because the CEO has the responsibility to work for the shareholders. They didn't. Once the deal was agreed on, the PE firm would get multi-billion-dollar loans, all guaranteed by the assets of the company they were buying. Yes, you can by a company with that company’s own money! Amazing.

After the deal was consummated, the PE firm would take billions of dollars of fees out of the acquired company, such as an acquisition fee, consulting fees, structuring fees, etc. Then the PE firm would usually have the acquired company declare a large dividend, payable to the PE firm. That meant more billions of dollars going out.

In the end, you have an over-indebted carcass remaining. In good times, the company might survive if it can raise the prices of its products substantially. In bad times, as now, these companies will go bankrupt. And that's what we will see over the next five years. In the meantime, the partners of the PE firms will have taken their billions. They paid a low "capital gains tax rate" on that money, instead of ordinary income tax like the rest of us. When last year some members of Congress wanted to tax this money at ordinary rates, the PE guys cried out loud that it would destroy capitalism and the Western world as we know it.

Well, the great thing about a change in regime is that such excesses may be addressed. The emphasis is on the word "may." Never count out the lobbyists and their virtually unlimited check-writing ability.

People ask me, is there any area that will benefit from these terrible trends? I can only think of two: alcoholic beverages and office REIT's focusing on Washington, D.C. When people finally have the courage to open their brokerage statements, they will need a strong drink to reduce the pain. On the REIT side, expect hundreds of thousands of people to be hired to implement all the social programs of "Big Government." They need office space and places to live. Washington will boom. There is great job security in government. The advice to college graduates will no longer be "plastics," but "go to Washington."

(Subscribe to Bert Dohmen’s WELLINGTON LETTER today and get the full story, with specific “What To Do” recommendations, including charts to prove the case. Go to: www.dohmencapital.com.)

WARREN BUFFETT COULD BE WRONG!

October 28, 2008 . By Bert Dohmen, founder of Bert Dohmen's Wellington Letter

Over the years, Warren Buffett has been an extraordinary investor. But times change, and those who don't recognize the changes, will find out that some of the old theories no longer work.

 The stock of Mr. Buffett's company, Berkshire, is down over 21% in just the last 5 months. Yes, I know, the long term investor knows that eventually the stock market goes up again. But what they don't tell you is that sometimes it can take 20 years or more for the market to break even.

Mr. Buffett recently wrote an op-ed piece in the NYT. He wrote that he is buying stocks now in his "personal" account, where formerly he only had U.S. Treasury bonds. He confessed that he didn't know where the stock market would be a year from now, but he did "know" that "5, 10, and 20 years from now most major companies will be setting new profit records." How does he know?

Over the years, Warren Buffett has been an extraordinary investor. But times change, and those who don't recognize the changes, will find out that some of the old theories no longer work.

 The stock of Mr. Buffett's company, Berkshire, is down over 21% in just the last 5 months. Yes, I know, the long term investor knows that eventually the stock market goes up again. But what they don't tell you is that sometimes it can take 20 years or more for the market to break even.

Mr. Buffett recently wrote an op-ed piece in the NYT. He wrote that he is buying stocks now in his "personal" account, where formerly he only had U.S. Treasury bonds. He confessed that he didn't know where the stock market would be a year from now, but he did "know" that "5, 10, and 20 years from now most major companies will be setting new profit records." How does he know?

And then he talked about the Great Depression. Well, let's look at that bear market. First of all, it took until 1954, 25 years, for the DJI to get back to where it was in 1929. Do you have 25 years just to break even? Will you live that long?

When he wrote the article, it was one year from the great bull market top of Oct. 2007. Had he bought the DJI one year from the 1929 top, he would have bought at 246, which was down 36% from the 1929 top. When his article was published on Oct. 17, the DJI was down 36% from the Oct. 2007 top! Amazing! This tells us that so far, the market is following a pattern similar to 1929. The wiggles may not be identical, but it’s the destination that's important. As Mark Twain said, "History may not repeat exactly, but it rhymes."

From the 1930 level cited above, the DJI declined to 41, down another 83% from the Sept. 1930 level. If that repeats, Mr. Buffett may lose 83% of his investment to the eventual bear market bottom. I would prefer not to lose that much. As a billionaire, who uses a small part of his wealth for stocks, that loss may only be a drop in the bucket. For the average investor, it means ruin.

The problem is that all these allegedly intelligent people go by the experiences of the past 50 years. But as we warned last year, we are in the part of the cycle which at minimum will be similar to the 1930's, or potentially a 200-year event. Hope won't change that. The above is based on analysis, not the misplaced optimism you hear everywhere.

Some high profile people believe it is their “duty” to be optimistic, in the hope that it will change the trend of the markets. Well, if all the governmental bailout programs and guarantees of the past month, amounting to about $2 TRILLION, can't stop the bear market and evolving financial crisis, do they really think that expressing false optimism in the media will do it? Of course not. The only thing it accomplishes is to mislead the uninformed public, their clients, causing them to lose their savings and retirement funds.

As I wrote earlier this year, if you follow the "buy and hold" guys, you had better start packing for a trip to the poor house.

And then he talked about the Great Depression. Well, let's look at that bear market. First of all, it took until 1954, 25 years, for the DJI to get back to where it was in 1929. Do you have 25 years just to break even? Will you live that long?

When he wrote the article, it was one year from the great bull market top of Oct. 2007. Had he bought the DJI one year from the 1929 top, he would have bought at 246, which was down 36% from the 1929 top. When his article was published on Oct. 17, the DJI was down 36% from the Oct. 2007 top! Amazing! This tells us that so far, the market is following a pattern similar to 1929. The wiggles may not be identical, but it’s the destination that's important. As Mark Twain said, "History may not repeat exactly, but it rhymes."

From the 1930 level cited above, the DJI declined to 41, down another 83% from the Sept. 1930 level. If that repeats, Mr. Buffett may lose 83% of his investment to the eventual bear market bottom. I would prefer not to lose that much. As a billionaire, who uses a small part of his wealth for stocks, that loss may only be a drop in the bucket. For the average investor, it means ruin.

The problem is that all these allegedly intelligent people go by the experiences of the past 50 years. But as we warned last year, we are in the part of the cycle which at minimum will be similar to the 1930's, or potentially a 200-year event. Hope won't change that. The above is based on analysis, not the misplaced optimism you hear everywhere.

Some high profile people believe it is their “duty” to be optimistic, in the hope that it will change the trend of the markets. Well, if all the governmental bailout programs and guarantees of the past month, amounting to about $2 TRILLION, can't stop the bear market and evolving financial crisis, do they really think that expressing false optimism in the media will do it? Of course not. The only thing it accomplishes is to mislead the uninformed public, their clients, causing them to lose their savings and retirement funds.

As I wrote earlier this year, if you follow the "buy and hold" guys, you had better start packing for a trip to the poor house.

(Subscribe to Bert Dohmen’s WELLINGTON LETTER today and get the full story, with specific “What To Do” recommendations, including charts to prove the case. Go to: www.dohmencapital.com.)

LONG TERM: WHY THE WORST IS STILL AHEAD

Excerpt from Bert Dohmen’s Wellington Letter of Oct. 13, 2008

Although the stock markets should have a rally, looking out over the next year, the worst is still ahead. As we have advised previously, if you want to see whether financial stress is easing or intensifying, just watch the credit spreads. One I like is the TED Spread. It’s the difference in yield between LIBOR and T-bills. When it widens, it indicates stress. Currently, it’s at the highest level ever. But even that is fictitious, as no one is lending at the LIBOR rate – or any other. The credit markets are frozen.

That means the global economies are now plunging off of a cliff without a safety net below. The wheels of commerce are grinding to a halt.

During this year the freeze in the vital commercial paper (CP) market intensified. I warned about this late last year when the CP outstanding diminished by about $1 TRILLION because new CP’s could not be sold. This market is used by companies to get short-term (90 days) money for corporate purposes, such as preparing for seasonal cash needs like Christmas. Now that market is basically shut down.

Although the stock markets should have a rally, looking out over the next year, the worst is still ahead. As we have advised previously, if you want to see whether financial stress is easing or intensifying, just watch the credit spreads. One I like is the TED Spread. It’s the difference in yield between LIBOR and T-bills. When it widens, it indicates stress. Currently, it’s at the highest level ever. But even that is fictitious, as no one is lending at the LIBOR rate – or any other. The credit markets are frozen.

That means the global economies are now plunging off of a cliff without a safety net below. The wheels of commerce are grinding to a halt.

During this year the freeze in the vital commercial paper (CP) market intensified. I warned about this late last year when the CP outstanding diminished by about $1 TRILLION because new CP’s could not be sold. This market is used by companies to get short-term (90 days) money for corporate purposes, such as preparing for seasonal cash needs like Christmas. Now that market is basically shut down.

The Fed announced last week that it may become a buyer of CP, but so far nothing has been done. A shut down of the CP market used to be considered impossible because of the horrendous economic consequences. Now we have it.

And it gets worse: 90% of world trade is done with Letters of Credit (LOC). The sellers of goods ask for an LOC from the buyer, where a reputable bank guarantees payment if the goods are loaded on the ships, or upon delivery. Now sellers are no longer willing to accept LOC’s because they don’t trust the banks who issue them. World-trade without LOC’s is considered nearly impossible. The world would retreat to the Stone Age.

CONCLUSION: The most essential parts of the global economy are at a standstill. Here they are:

  1. Banks are not lending to each other, while at the same time many banks can’t make additional loans as they are at or below the capital reserve requirements. Therefore, businesses can’t finance the normal stocking up for Christmas.

  2. The CP market is frozen, so companies can’t produce goods for the holidays.

  3. And goods can’t be shipped, because sellers don’t trust the LOC’s. Without an LOC, the buyer has to pay cash to someone overseas and then trust the seller that he will actually ship. That’s a huge leap of faith.

So, there is no money to produce goods, no money for retailers to buy them and no LOC’s to ship them. The store shelves will be pretty bare. Not that it matters, because there will be very few shoppers. And that means huge employment cuts, because business activity will plunge.

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ON THE ROAD TO MELTDOWN

Excerpt from Bert Dohmen’s SMARTE TRADER service of Oct. 6, 2008

It was a pretty interesting day (10-6-2008). The selling started even before the NYSE opened, and the DJI was down over 200 quickly. The selling continued all day. Rally attempts were very week. I saw technicals as negative as I have ever seen. In fact, I was thinking it was similar to the Oct. 1087 crash. At one point I saw only one stock of the S&P 500 with a gain. It was unbelievable. At the low, the DJI was down almost 800 points.

 Then a rally attempt in the last hour had some legs and at least reduced the loss by 50%. Although to some that may seem like a bottom, just because they want it to be, “hope” doesn’t change the markets. There was almost a total absence of buying all day, and the buying late in the day looked like short covering. You see, traders don’t want to be heavily exposed to the short side overnight because the central banks can always come up with something before the opening the next day.

 Today, the Fed increased its lending line, where it swaps valuable Treasury securities for worthless mortgage paper from the banks, from $450 billion to $900 billion. That’s an incredible amount. They are obviously panicked and are trying desperately to prevent a meltdown.

It was a pretty interesting day (10-6-2008). The selling started even before the NYSE opened, and the DJI was down over 200 quickly. The selling continued all day. Rally attempts were very week. I saw technicals as negative as I have ever seen. In fact, I was thinking it was similar to the Oct. 1087 crash. At one point I saw only one stock of the S&P 500 with a gain. It was unbelievable. At the low, the DJI was down almost 800 points.

 Then a rally attempt in the last hour had some legs and at least reduced the loss by 50%. Although to some that may seem like a bottom, just because they want it to be, “hope” doesn’t change the markets. There was almost a total absence of buying all day, and the buying late in the day looked like short covering. You see, traders don’t want to be heavily exposed to the short side overnight because the central banks can always come up with something before the opening the next day.

 Today, the Fed increased its lending line, where it swaps valuable Treasury securities for worthless mortgage paper from the banks, from $450 billion to $900 billion. That’s an incredible amount. They are obviously panicked and are trying desperately to prevent a meltdown.

Amazingly, the markets didn’t react at all. They know that the problem is much more serious and needs more than even this massive, record attempt to inject liquidity. At the lows today, the Dow, NASDAQ and S&P 500 were down 7.8%, 8.8% and 8.3%, respectively.

The volume was very heavy today and it was mostly to the downside. The fact that the market rallied from the low should not lead you to believe that there is a bottom.

The negative is that the market couldn’t close in positive territory. Technically, that makes the rally late today unimportant. Recovering half of a huge loss is not indicative of anything except short covering. Traders are suspicious that the Fed in cooperation with other central banks, will produce a big rate cut. I would expect a cut to 1%. But that won’t do anything to unlock the credit markets. The Fed is now pushing on a string. And as you know, you really can’t push a string.

However, the stage is set for either brief rally, which will just prolong the agony for the bulls, or we will have a crash which will provide a better bottom. The technical indicators are now more oversold than I have ever seen, worse than 1987. The VIX (volatility index) got up to the 60 area. Remember, last week when it got to 45 many pundits said that this was a bottom. But we said it would have to get above 55-60 first. Now we have that.

It is unlikely that today was a bottom because we didn’t see the big volume which would indicate a selling panic. I would still like to see that before taking some positions on the long side of the market. Now everyone is discussing the end of the short selling ban on Thursday. Don’t worry, the SEC will extend it again.

On Friday we wrote:  The actions of the European nations this weekend will be very important for gold. If Europe gets serious about reflating, gold could resist the global deflationary plunge.

Well, the European meeting didn’t result in anything that important. They are just as puzzled as Washington on what to do. But what did gold do? It soared over $40 at one point. In other words, gold is resisting the deflationary plunge. That’s important.

However, most of the gold stocks were down. That’s interesting. It either means that gold will start declining soon, or that mining firms will have great difficulties handling higher mining cost, such as power and labor, in spite of rising gold prices. I have discussed in past issues. We prefer gold to mining stocks, and gold over silver. The latter is an industrial metal although some buy at as the “poor man’s gold.” I don’t care for that metal in this environment.

Gold is fighting the strong headwinds of deflation and massive liquidation of all physical assets. For that, gold is doing very well. Once the credit crisis eases, assuming it’s before the entire financial system collapses, gold should soar. We have never seen such incredible artificial money liquidation. The dollar is soaring, but that’s because of the record short position.

Oil was down over $6 at the low, around $87 per bbl. Wow! Can you remember when it was over $130 we said it would first go to $85, then to $77, and next year to $50.

But the energy bulls are still stubborn. One bull lost about $2 billion in his hedge fund this year. He still talks about production of oil being less than consumption. Apparently he doesn’t think that in a deep, deep, global recession oil consumption will decline. Well, it will, when people start riding bikes again.

The Russian stock market had a big problem again, declining over 20%. Trading was halted several times. The Brazilian market had similar problems. Remember last month we wrote that the best long-term shorts would be the emerging markets. They will seriously submerge. There is no saving them.

Bert’s note: And so the slow meltdown of the global financial system continues. All the regulators, central banks, and finance ministers just go from one crisis to another, without ever planning ahead. About 18 months ago I started predicting the likelihood of a global meltdown. A few other analysts gave similar warnings. I finally wrote a book published in January of 2008, PRELUDE TO MELTDOWN (www.meltdownbook.com) describing what would happen. I concluded that all the central bank action in the world eventually might not be able to rescue the financial system. We just don’t have the proper people in power to handle this crisis. The Senate majority leader said recently one the latest crisis started, “We just don’t know what to do…And neither do Ben Bernanke or Hank Paulson.” That’s a candid statement, but probably the most truthful he ever made.

(Subscribe to Bert Dohmen’s WELLINGTON LETTER today and get the full story, with specific “What To Do” recommendations, including charts to prove the case. Go to: www.dohmencapital.com.)

ANOTHER WEEKEND—ANOTHER CRISIS

Excerpt from the WELLINGTON LETTER, September 14, 2008.

It seems that weekends are now used by officialdom to handle one financial crisis after another. And yet, economists tell us that everything is fine, the economy is doing well although a little on the weak side, and the stock market is a great bargain. My view is that these people are either deaf, dumb, or blind, or all three.

 This weekend it's the Lehman Brothers crisis. Our view has been that it's ready to go out of business. In our SPECIAL BULLETIN of Sept. 8 during the Fannie and Freddie crisis, we wrote:

 No one can know if the rally will last one or two days, or maybe even a week. In fact, it may not even last to the end of Monday. We will see. But an end to the credit crisis is far, far away. Its important to remember that everything that the Fed and the U.S. Treasury have done over the past 12 months, which includes the Fed using half its balance sheet, i.e. $400 billion of Treasury securities, has not resolved anything, but only prolonged the inevitable. The major indices last week started breaking down to new bear market lows, unemployment is soaring, and the economy is in a certain recession that the guys with their Ph.D.'s won't recognize until next year.

The ill-defined Fannie and Freddie bailouts won't be any different. It's like using an aspirin to fight terminal cancer. We wrote about the intensifying credit crunch:

It seems that weekends are now used by officialdom to handle one financial crisis after another. And yet, economists tell us that everything is fine, the economy is doing well although a little on the weak side, and the stock market is a great bargain. My view is that these people are either deaf, dumb, or blind, or all three.

 This weekend it's the Lehman Brothers crisis. Our view has been that it's ready to go out of business. In our SPECIAL BULLETIN of Sept. 8 during the Fannie and Freddie crisis, we wrote:

 No one can know if the rally will last one or two days, or maybe even a week. In fact, it may not even last to the end of Monday. We will see. But an end to the credit crisis is far, far away. Its important to remember that everything that the Fed and the U.S. Treasury have done over the past 12 months, which includes the Fed using half its balance sheet, i.e. $400 billion of Treasury securities, has not resolved anything, but only prolonged the inevitable. The major indices last week started breaking down to new bear market lows, unemployment is soaring, and the economy is in a certain recession that the guys with their Ph.D.'s won't recognize until next year.

The ill-defined Fannie and Freddie bailouts won't be any different. It's like using an aspirin to fight terminal cancer.  We wrote about the intensifying credit crunch:

....................................Major firms, such as Lehman, Fannie Mae, Freddie Mac, GM, Ford, etc. are totally unable to raise long-term capital to strengthen their balance sheets. Their preferred stock yields, and yields on long-term debt, are sky high, implying that the market believes they will not be able to survive. The preferred issues yield from 13%-18%. They can't raise new capital issuing new preferred at these yields, as it would accelerate their demise. GM's short-term debt is now yielding well over 20%. Investors obviously are not worried about the return ON their money, but OF their money.

At this time (Sunday, September 14, 2008) word is that the weekend crisis meetings on Wall Street are still continuing. Barclay's Bank of Britain, which yesterday was deemed to be the top contender to buy LEH, is said to have backed out. The hopes are now that Bank of America will do the dirty work. In my opinion, this is not so much a matter of bailing out LEH, but keeping the counterparties to LEH's derivative transactions from being damaged too much.

Subscribers know that I have been concerned for the last 15 months about the $65 TRILLION of Credit Default Swaps (CDS) outstanding. These are like insurance policies that financial institutions buy or sell to protect against defaults by financial institutions. The seller pockets the premium, but carries the risk of paying off. In many cases, the seller doesn’t really have enough capital to make good on the insurance sold. If you assume that LEH may have sold billions of dollars of CDS's, the risk is that if LEH fails, all the CDS's it sold will be worthless.

We will probably have the Washington Mutual (WM) crisis next weekend.

And after that, we have AIG. As you can see, the crises in the financial markets are lined up just like the hurricanes in the Atlantic. These are exciting times that you will tell your children about, much like your parents and/or grandparents may have told you about 1929.

(Subscribe to Bert Dohmen’s WELLINGTON LETTER today and get the full story, with specific “What To Do” recommendations, including charts to prove the case. Go to: www.dohmencapital.com.)

 

CHINA: BOOM WILL TURN TO BUST

Excerpt from the WELLINGTON LETTER, August 18, 2008.

Now that the end of the Olympics is near, it's important to see what the Chinese economy is likely to do. Will it have a gigantic hangover from the frenzy of construction activity ahead of the Olympics?

In my view, China was already on the path of sharply reduced growth before the Olympics. Now we hear that industrial production expanded in July at the slowest rate in 17 months. In China, tire sales growth has dropped from 16% annual growth to 12% growth. I consider tire sales, just like freight, a very sensitive barometer of economic activity. The bulls will say that this is still terrific growth. But longtime subscribers know that when you come down from 12% economic growth to 7% growth, it seems like a depression.

China will not stop growing, but reduced growth will be very painful when "expectations" are so high. The China bulls will continue to say that growth is far stronger than in Western nations. But that won't keep the stock market from declining, or the economy from producing severe turmoil.

.............................Here we have that word again, "expectations." I often talk about them, and the fact that the markets work on "expectations," not necessarily reality. Expectations change more frequently than reality. And expectations are usually wrong. Eventually, reality always wins out over "expectations."

As the major customers of China go into recession, manufacturing facilities in China will be in deep trouble. The government will try everything not to have millions of unemployed people in the street, because the unemployed often get nasty and overthrow their government. That means big price cuts in order to maintain sales levels. That results in huge financial losses. The government-operated facilities can take that, but private firms cannot. They are highly leveraged with very expensive debt.

I just heard an analyst recommending investing in the emerging markets, especially China, because of the stocks being "cheaper now than U.S. stocks." Yes, after the 50% decline in the Chinese market, stocks are cheaper. But isn't that justified? Much of the reported earnings of Chinese firms include profits from speculating in the stock market. Those large profits have now turned into big losses as the stock market is down more than 50%. When CEO's of firms in countries with few accounting standards are confronted with desperate situations, they do desperate things, such as "cooking the books." We will hear about many accounting scandals in Asia over the next several years.

Another important factor to consider is the "platform" companies, which we have discussed in these pages. These are the large U.S. or European firms which largely outsource production to the emerging countries. This has many advantages, such as low wages. But in my view, the greatest advantage is what happens during a recession. Instead of the U.S. firm having to lay off tens of thousands of employees, which is very expensive, and closing factories, now that burden has been transferred to the emerging countries. That spells great danger to the emerging countries over the next several years.

This is probably why the current financial crisis has not produced a deeper recession in the U.S. The layoffs are occurring abroad. But it will make a global recession that much worse for the emerging countries, especially China. Manufacturing is about 50% of China's economy, twice that of the industrialized countries. Slowing orders from the U.S. and Europe will produce a killer wave in China's economy.

Many of the Chinese factories built lately are geared towards “future” demand. In other words, they are betting on demand continuing to grow at double-digit rates. But it’s clear that this won't happen now with the major economies in the first stages of recession. Eventually Chinese factories may be running at 10-20% of capacity. And that will cause not only economic problems in China, but civil unrest.

I just read an article in John Mauldin's excellent "Outside the Box" that was very interesting. In 2005, the N.Y. Times wrote about the world's largest shopping centers now being in China. Four shopping malls in China were already bigger than the Mall of America. Two, including the South China Mall, were bigger than the world's largest mall up to that time, the Edmonton Mall in Canada.

That was in 2005. Now the South China Mall, the largest in the world, which has space for 1500 stores, has only "a dozen stores open for business."

Over the near-to-intermediate term, we have the Olympics. There will be a significant hangover. Soon you will read stories of many of the new office buildings, especially in Beijing, standing totally empty. Some of the large developers will go out of existence.

The bulls point to the post-Olympic experience of Greece, which produced a nice gain in the stock market. But Greece was a widely ignored country, which finally got some attention. With China, we have exactly the opposite. More people will now realize that this "holy cow" of growth stories has a lot of warts.

CONCLUSION: China is one of the greatest "expectation bubbles." The very greatest is probably Dubai. Recessions are nature's way of taking care of hubris and excessive enthusiasm. You can bet that there has been huge stockpiling of commodities to meet the demand from China. As commodity prices decline, these inventories will be dumped on the market, resulting in further declines.

One of the best bets for the next two years is not shorting the U.S. market, but short selling the emerging markets, especially China, and the minor Asian countries. They will suffer tremendously.

(Subscribe to Bert Dohmen’s WELLINGTON LETTER today and get the full story, with specific “What To Do” recommendations, including charts to prove the case. Go to: www.dohmencapital.com.)

A GLOBAL RECESSION IS AHEAD

Excerpt from the WELLINGTON LETTER, August 5, 2008.

 

While economists spend their time debating whether the U.S. is in a recession, the U.S. and other economies around the world are weakening and on their way to long-term recessions.How can I say this? Well, it's simple: credit makes the world go around. Tens of trillions of dollars of credit were created during the 5 years of global boom. And now that credit creation has come to a screeching halt. It's that simple. Individuals took $900 billion of equity out of their homes last year through refinancing, using the money for various things. That refinancing is now down about 90%. Therefore, the consumer has no choice but toretrench.

At the same time, financial institutions don't want to create more credit because they are loaded up with so much bad paper already. They are desperately searching for money to raise their capital base. But it appears that the former sources of capital, to a large extent the Sovereign Wealth Funds of foreign countries, are becoming reluctant.

.....................Bridgewater Associates’ recent estimate of losses from mortgage-related securities in the financial institutions is $1.6 trillion. If you look at the leverage ratios of these firms, they seem to average around 25 to 1. That means each dollar of capital supports $25 of assets. If $1.6 trillion has gone up in smoke, than we multiply that times 25, and get a reduction in lending capacity of $40 trillion.

The world's economic product (similar to a country's GDP) is around $55 trillion. So we can see that the reduction in lending capacity is 80% of what the world produces each year. However, we also have to consider how many institutions, banks or financial firms, have severely cut their lending voluntarily just to be more cautious.

And then we have Wall Street's incredible money machine, which pooled loans of all types and resold them via certificates, coming to a screeching halt. In fact, that was one of the largest contributors to worldwide liquidity creation. European banks also participated in such techniques. This involved trillions of dollars.

The result is that money will be very tough to borrow over the next many years. The bad stuff has to be liquidated first before new credit can be created. And when money creation flips from creating tens of trillions of dollars to liquidating similar amounts, you have a drastic change in liquidity. And that can only result in a serious, long-term recession, globally.

People ask me, why haven't we seen the U.S. economy plunge into a deep recession? There are several reasons:

  1. The recession is being hidden by the government intentionally depressing the official inflation numbers. We are already in a meaningful recession. I have discussed this many times in past issues. GDP is calculated by taking the numbers for goods and services, and then deducting the rate of inflation. But actual inflation, as calculated in 1980, is now at 12.6%. Deduct this from the 5% nominal GDP growth, and we get negative 6-7% GDP.

          James Turk of the excellent FGMR report, calls attention to an interesting website for this. John

Williams, who publishes Shadow Government Statistics, (www.shadowstats.com), writes:

“Inflation Explosion Likely to Continue…Adjusted to pre-Clinton (1990) methodology, annual

CPI growth rose to roughly 8.3% from 7.5% in May, while the SGS-Alternate Consumer Inflation Measure, which reverses gimmicked changes to official CPI reporting methodologies back to 1980, rose to a 27-year high of roughly 12.6% in June, up from 11.8% in May.”

  1. U.S. firms have outsourced a lot of manufacturing to firms abroad. In other words, large U.S. firms have become "platform" companies, which do research, design, and then market. Ex.: Nike. But they don't manufacture very much. These foreign outsourcing firms now have the burden of having factories and tens of thousands of employees. When sales decline, the U.S. firms just reduce orders. The outsourcing firm has the problem of firing employees and idling the factories. In other words, we have pushed many of the problems of a recession to the less-developed countries. That's why we think that the emerging stock markets will have a much more severe plunge over the next several years.
  1. Individuals had substantial monetary reserves from the refinancing boom. I wrote over one year ago that these reserves might last a year or so, and then the consumer would see his assets depleted. The home ATM machine is closed. Corporations will follow the same path. They had large cash reserves going into the recession, but as it becomes more difficult to get loans or sell commercial paper, the cash hoards get depleted in a recession as profits turn to losses. This is a lagging factor, and may take another year to fully emerge.
  2. (Subscribe to Bert Dohmen’s WELLINGTON LETTER today and get the full story, with specific “What To Do” recommendations, including charts to prove the case. Go to: www.dohmencapital.com.)

The Fannie Mae and Freddie Mac bailouts

Excerpt from the WELLINGTON LETTER, July 16, 2008.

 

Over this last weekend, Treasury Secretary Paulson stuttered a statement on the steps of the U.S. Congress, asking Congress for steps to rescue these two GSE's. He asked for a "temporary'' increase of the companies' lines of credit with the U.S. Treasury from the current $2.25 billion each. Furthermore, he wants the government to have the right to buy equity, i.e. stock, in the GSE's  "if needed.'' Paulson wants unlimited authority for 18 months to buy as much stock as he deems necessary. The urgency was that FRE had planned to raise $3 billion of short-term funds on Monday morning. There probably would not have been any bidders had the government not taken any steps this weekend. That's what we said in our SMARTE TRADER of this last weekend, and it happened.  What does it mean? These two GSE's were spun off from the government years ago as the politicians wanted to get the trillions of dollars of debt of off the balance sheet of the government. But now it appears evident that the GSE's will once again be "nationalized." That means an increase in the governments' debt of over $5 TRILLION. The government will eventually own them. What happens to current shareholders? The market expects them to be wiped out.

..................Predictably the stock market opened strongly Monday morning. But the rally lasted only 5 minutes, taking the DJI to a gain of about 120 points. Then the smart traders, noting that really not much had changed, hit the financial stocks again. The DJI closed with a loss of 45 points.

Banks and finance firms worldwide have so far reported losses of about $410 billion in writedowns and losses. There is much more to come, but they can't do it all at once, as they have to raise new capital every time they take more writedowns. Ray Dalio, founder of the huge hedge fund, Bridgewater, estimates losses of $1.6 TRILLION. My estimate for the next 10 years is much higher.

Think of the implications: Where will these financial firms find the capital to compensate for these losses? Are there any investment firms or Sovereign Wealth funds willing to provide such capital, especially those who were too early at the end of last year, and now are sitting on multi-billion dollar losses on these investments? Bankruptcies, or "shotgun weddings," are inevitable. In fact, last year I predicted that some of the major U.S. financial institutions would eventually be controlled by foreign entities. Guess what: now legislation is being considered which would give a blessing to foreign firms wanting to own more than 25% of such institutions. The groundwork for the inevitable is being laid.

(Subscribe to Bert Dohmen’s WELLINGTON LETTER today and get the full story, with specific “What To Do” recommendations, including charts to prove the case. Go to: www.dohmencapital.com.)

(for website: Excerpt from Wellington Letter June 9, 2008)

 THE CREDIT CRISIS: STILL IN THE EARLY PHASE

I am amazed at how many analysts appearing in the national media say that the bottom for the stock market occurred in March, the financial crisis bottomed at the same time and that the "good times will roll again." How naïve! They don't differentiate between a decompression rally, which is what we predicted in early April, and the greatest deleveraging in the history of the financial markets, which is still in the early phases. For those who disagree and think my view is extreme, here is what a few others say.

In early 2007, when I called the convergence of disastrous forces "The Perfect Financial Storm," the idea seemed ludicrous to many. But it was right on target. The fact is that market tops are by definition the point when bullishness reaches an extreme and can't go any higher. When in April 2007 I heard the CEO's of the leading private equity firms at the Milken Global Conference say that they had "never seen conditions this good," it was a confirmation that the top had been reached.

.................................The very successful hedge fund firm T2 Partners in March wrote in a report:  "We are seeing only the tip of the iceberg: An enormous wave of defaults, foreclosures and auctions is just beginning to hit the U.S. We believe it will get so bad that large-scale federal government intervention is likely."

Jim Bianco, head of Bianco Research, a very astute analyst of the credit markets, said in March:  "Equity guys are completely clueless as to how bad it is in the credit markets. They're as bad as they've been since the Great Depression." (Quote from Barron's.)

This week we heard about proposals circulating in Congress that it’s time for STIMULUS PLAN #2. And where do they get the money for these bailouts? No, it's not the printing press. Now we have computers that can create billions of dollars instantaneously out of thin air. No paper required. The turmoil in the financial markets will worsen. Later this year, there is a good chance for a crisis. Will the Fed be able to handle that? No one knows.

(Subscribe to Bert Dohmen’s WELLINGTON LETTER today and get the full story, with specific “What To Do” recommendations, including charts to prove the case. Go to: www.dohmencapital.com.)

THE NEXT FINANCIAL CRISIS

Sheila C. Bair, the head of the Federal Deposit Insurance Corp (FDIC), said that another wave of U.S. credit stress was coming, involving non-mortgage loans. She said delinquency rates on loans for construction, development, commercial and consumer debt were rising.

Here are some of the areas outside of residential mortgage loans:

 

1. Construction: Costs to developers have risen to the point where even new hotel construction is stopping. At the high costs of materials today, the economics just don't work out.

 

2. Commercial & Consumer debt: As business slows, profits decline and in many cases turn to losses. Remember, profits are the very top of the revenue pyramid. Just a small decline in sales can cause profits to vanish. Losses mean debt gets difficult to service. Many loans have been securitized, i.e., put into pools, in which pension plans and other investors could buy participations. It's much like the mortgage-related CDO's that blew up last year. Commercial and consumer debt will implode next year.

 

3. Development: Developers who are in the middle of construction can't stop. They have to finish the construction. They hope they'll be able to sell part of whatever they are building before completion, but that's hope, far removed from reality in today's environment.

The economists who talk about a “Goldilocks” economy, predicting good times ahead, are missing something important. Usually recessions occur when the consumer has exhausted his buying power, rising inflation causes the central bank (the Fed in the U.S.) to hike interest rates, retail sales decline and the entire economy contracts. This usually triggers problems in the financial sectors because of rising defaults.  But this time, the situation is reversed, which is unusual. It's the implosion of the highly leveraged financial derivatives that is causing a gigantic deleveraging of the financial system. That means contraction of credit. You can't have a contraction in the credit markets without an economic contraction. And this the crucial point.

By the fall of this year, we will see the recessionary economy kick in and start doing its destructive work. We haven't even seen that part of the normal recession yet. That will accelerate the credit market contraction, and probably bring one, or several, crises. The person who is elected president will have a job similar to the captain of the Titanic.

 (Subscribe to Bert Dohmen’s WELLINGTON LETTER today and get the full story, with specific “What To Do” recommendations, including charts to prove the case. Go to: www.dohmencapital.com.)

 

THE DERIVATIVE BUBBLE:  NEW REVELATIONS

The problems of last year are still festering. Earlier this year, we learned about Auction Rate Securities for the first time. When the Port Authority of New York suddenly had to pay 20% interest on its debt, versus just 4% the prior week, these instruments became more widely known. 

Hundreds of firms had invested in these so-called "safe money market instruments." Now they are trying to get their money out, mostly unsuccessfully.

Companies invested their operating cash in these, and pension plans did the same, thinking they were as good or better than money market funds. And then they blew up. Currently there is no market for these securities. But there are $330 billion of them outstanding. So far, 15 lawsuits have been filed, and they are seeking "class action status." The brokers who sold these are also being sued.  Investment banks are trying to refinance some of these, but the amounts are from $1 billion to $4 billion in many cases, much too small in relation to the size of the problem. An additional problem for the holders of these securities is accounting for the losses of these complicated instruments.

Another class of financial instruments that came to light late last year is SIV’s (Structured Investment Vehicles). These are off-balance sheet entities the major banks created to speculate, using high leverage, in mortgage-backed securities. They didn't want the shareholders to know, so these SIV's didn't appear on the financial statements. Until they blew up, only a few people knew they existed.

Now we hear of another derivative, previously unknown to us, and probably most professional investors, Constant Proportion Debt Obligations (CPDOs). Who thinks up these names? They are designed for institutional investors who want to make a bet on the credit-worthiness of debt of the largest corporations. Therefore, the ratings are crucial, and these ratings are issued by firms such as S&P, Moody's and Fitch.

Apparently, the bond rating firm of MOODY’s made another mistake in its ratings. The firm blames this one on a “computer glitch.” It resulted in billions of these strange derivatives having AAA- ratings, or 7 grades higher than they should have been. That's quite a glitch. Institutional investors reportedly lost billions of dollars as the value of these instruments plunged as much as 60%. A British newspaper that reviewed internal documents said that Moody’s senior staff was aware of the problem as early as the first part of 2007. However, the firm maintained the ratings, and adjusted some of the assumptions going into the ratings. In college, we used to call that working the problem backwards, or fudging.

Last year we also warned of the Credit Default Swaps, a huge problem that will produce some big waves later this year. There are $45 trillion of these derivatives, which are basically insurance speculations on mortgage derivatives. The amount is almost as large as the GDP of the entire world. With billions and trillions of dollars of derivatives imploding, the poor homeowner who can’t pay his mortgage is still being blamed for the financial crisis. He is a convenient scapegoat. He has little to do with the crisis. He was only the spark that started holders of all derivatives to question their value. After that, the gigantic global debt pyramid, designed primarily on Wall Street, started to crumble. Greed took over in many other sectors, even in corporate and governmental pensions. Everyone wanted to increase the “alpha,” i.e., out performance. 

So, who is to blame? As con artists always say, you can’t con an honest person. Therefore, we shouldn’t feel sorry for the cons, nor for the holders of these securities. But in the end, the taxpayer, who had nothing to do with all this, and did not benefit, will be presented with the bill. Moral of the story: Never invest in something you don't understand. If the salesman (broker) can't explain it so you can understand it, forget about it.

 

(Subscribe to Bert Dohmen’s WELLINGTON LETTER today and get the full story, with specific “What To Do” recommendations, including charts to prove the case. Go to: www.dohmencapital.com.)

BARGAIN HUNTERS—TOO EARLY

Construction starts on new U.S. homes rose by a big 8.2% in April and applications for new building permits rose for the first time in five months. Many observers consider this positive. My reaction was, do we really need more houses when there is already a glut of about 3.5 million unused homes on the market now?

 The bargain hunters were buying the homebuilder stocks over the last 5 months, causing the sector to rally. Now the rally is over. New lows should be ahead. Prediction: There will be a bankruptcy, or bailout, of at least one major homebuilder this year, which will shake up investors in this sector.  

Bargain hunters are also out in force in the residential home area. In Florida, prices dropped 29% but sales surged 41% over the same month last year. That's encouraging. It shows that during the bubble, prices soared too high, to levels that became unaffordable and uneconomical. Last year, I said that residential prices would eventually get back to 2003 levels, which is when the boom started. That's where demand can come in. In Florida, they must be approaching those levels.

But that doesn't resolve the nation’s problem of 3.5 million unoccupied homes.  Two major homebuilders, TOL and HOV, just reported earnings. They were dismal. The CEO of Toll Brothers, Robert Toll, said:  “Demand continues to be weak in most markets as our clients worry about selling their existing homes or entering the market before prices stabilize.” 

According to Senator Christopher Dodd, there are about 12 million homes worth less than the mortgages. That means these homeowners have little to lose by just walking away.

 

Bert Dohmen

Bert Dohmen's WELLINGTON LETTER

BUYING OPPORTUNITY FOR A TRADE                                                       

Excerpt from the WELLINGTON LETTER, late April , 2008

Our April 7 issue was headlined: A DECOMPRESSION RALLY. Our view was that the Bear Stearns fiasco in March had compressed stock valuations, produced massive selling and short selling, and now it was time to snap back towards more normal conditions. That would mean short covering, some new investment buying, and a “sigh of relief” that the financial system did not melt down. The authorities, together with Wall Street, are now pulling all the levers to get the stock market going. So far, the response has been less than stellar. A stock market surge of course would be the ultimate sign of easing. In our CHARTIST’S VIEW section, we discuss the potential of such a rally.                                                      

........................... Bernanke recently commented on the U.S. situation with that of Japan in the 1990s, and even with the Great Depression in the U.S., probably because private sector analysts, such as ourselves, had made such comparisons. Of course, he says that the current situation is much different. What else can he say? He says that in the 1930s the Fed let the financial crisis infect the entire economy. The Fed will not allow that to happen now. But in early 2007, he also said that the subprime mortgage problem couldn’t possibly infect the rest of the credit markets. Now it has.

He rejected a comparison with Japan in the 1990s. He said that Japan did not act to get bad loans off the banks’ balance sheets, which stopped lending. The Fed will not make the same mistake. However, that’s exactly the problem now. Only U.S. banks are more proactive. They are now busily raising new capital by selling stock or convertible securities. This dilutes the current shareholders, who will take painful hits. But at least the firms stay in business, and eventually may start lending again.

At least Ben finally seems to recognize the seriousness of the situation; otherwise, he wouldn’t make these comparisons. And that’s the first step to finding a solution. Then the question becomes, is the problem solvable? He may know the problems of the 1930s and of Japan in the 1990s, but is he and his crew astute enough to find the solutions?

There are so many rescue plans in the works, at the Fed, in Congress, and in Europe, that it’s hard to keep up with them. The IMF (International Monetary Fund) is floating a proposal to have the governments, i.e., taxpayers, buy all the unsalable paper (CDOs, Mortgage Backed securities, etc.) from the banks so that banks can start lending again. The government would then hold these until such a time that they can be sold. I ask, if the taxpayers are asked to take such a risk, will the banks give us taxpayers some of the profits they made over the last 5 years?

CONCLUSION

The (technical) signals for the U.S. market are positive right now. No one can know how long a rally will last. Instead of relying on guesses, we prefer to let our technical indicators tell us when the end of a rally has been reached.

Last time we also wrote: “We will watch carefully over the next week or two for a confirmation of a tradable rally. However, only experienced investors should try to play such rallies.” Well, it seems that we are there.

(Recommendations are excerpted out of fairness to subscribers)

 

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Excerpted For Fairness To Subscribers

 

 

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