Market downturn is too likely to ignore

Sep 7, 2010

London, England

Strikes make travel tough today - in both London and Paris. The unions have called for massive snarl-ups to protest governments' efforts to bring spending under control. The subways aren't running. Trains are halted. The French leftist newspaper, Liberation, says that "millions are expected to take to the streets."

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Just another pain in the neck for travelers? Or, the beginning of the end for the welfare state? More below...

Meanwhile, Wall Street did no damage yesterday. It left peoples' money where it found The Street took off for Labor Day. But the financial press didn't stop...and neither did we at the Daily Reckoning.

The most amazing thing is that the people who are supposedly the most able thinkers seem unwilling to do any thinking. So many well-educated, smart economists spend their lives trying to understand what is going on. So few really seem to care.

So many economists.... If you could take all the world's economists and lay them end to end, you should do it. The world would be a better place with out them.

And take Paul Krugman...please! He's in the New York Times this morning with an analysis worthy of a Ph.D. economist/Nobel prize winner...but unworthy of a first year philosophy student, cab driver or hair dresser. At least he is efficient. In the space of just a few well-chosen paragraphs he is able to misunderstand the entire economic world.

More on that too...but not today...

Today, we're waiting... Wise investors spend 90% of their time waiting for something to happen. The other 10% of the time they are caught off guard when it finally does happen.

Here at the Daily Reckoning we are still waiting for the washout...the sell-off...the final leg down of the bear market that began in January 2000. The Dow should sink below 7,000. Most commodities should go down...along with art, collectibles, and labor costs. (Oil is down below $75 this morning.) US housing should lose another 10% to 30% of its value. Even gold should sell off...

...or maybe not.

How do we know this market downturn is coming, you ask?

We don't. But it's too likely to ignore.

"Stock market valuations actually hit their last low in the mid-'70s. They spent the next nearly 10 years shilly shallying around," said an investment pro yesterday. Our friend in London has been operating an independent investment research company for nearly 30 years.

"It's so complicated," he went on. "And inflation distorts the picture. It's probably best to think about it in terms of gold. Gold is the only real money. And bear markets are fundamentally an adjustment between money and stocks. Sometimes people are hopeful and want the upside of stocks. Sometimes they are fearful and want the protection of cash in hand. The adjustment can happen in either direction -- either with an increase in the price of money or a decrease in the price of stocks."

At the ratio's peak in 1998, it took 43 ounces of gold to buy a single unit of the Dow - a single share in each of the companies that make up the average. Back in '98, investors really took leave of their senses. They thought computers and modern communications were creating a brave new world where the old rules no longer applied. "This time it's different," they said, and paid good money for stocks in companies with no earnings, no history, and business plans that were little more than wishful thinking. Since then, investors' optimism has been hammered out of them. By a bust in the Nasdaq, the 9/11 disaster, Bush II, Hurricane Katrina, Iraq, Afghanistan, the huge bubble of '05-'07...sub-prime, another stock market bust, 10% unemployment, Lehman Bros., Obama, and other catastrophes. The ratio of gold to stocks has already come down to under 10. But there's much further to go. At its low-point, gold and the Dow tend to trade at a ratio of 2 to 1...or even 1 to 1.

Where might we find the low point of this market?

"Well, maybe if gold were to rise to $3,000 and the Dow were to fall to 6,000, we might be at a bottom," continued our London sage. "And we might be talking about another 5 to 10 years with no positive returns for the average stock market investor."

We're not wise enough to know what will happen. And we're not fool enough to think we know. But there's no need to take the analysis too far. A bull market takes prices up. A bear market brings them down. A bear market began in January 2000. The big risk is that the bear market hasn't completed its work...that stocks, housing, commodities, etc, still haven't reached their ultimate lows for this cycle. The danger of a new, major low is high. Investors should beware.

So we wait. And hold gold. Gold is not the only form of money. But it's the best form . And money becomes more and more valuable as people seek protection from the bear market...and from other forms of 'money.'

If we're right, sometime in the future investors' fear will reach its climax. Money will be as valuable as it's going to get. Assets such as stocks and houses will be as cheap as they are going to get. Then, it will be time to reverse the trade...

But hold on. You can get a good deal on great US companies now. The last time we looked, dividend yields over 5% were available now on some of the world's best brand name stocks - Altria, Eli Lily, Reynolds, Diamond Offshore Drilling..

Well, yes...there are some good deals available.

But if we're right, even better deals are coming.

*** "I think Marx was basically right. History is largely a class struggle," said another friend last night.

"Back in the 18th century, people wondered how society could function without divinely-appointed kings to hold things together. But then came the American Revolution and the French Revolution...and then they booted out Napoleon...and turned kings and queens into celebrities. The ruling classes realized they had to find a way to keep a lid on the public.

"Bismarck created the welfare state. He figured he could buy off the public. As long as they were getting money from the state, people wouldn't revolt.

"There was a long boom in the 19th century. Everything seemed to be going along smoothly. But then came WWI and the Bolshevik uprising; the rich saw that socialism was real...and dangerous. They knew they needed to come to terms with protect themselves -- or they'd be ruined.

"Essentially, the deal that Bismarck struck was the one that caught on and endured. The rich agreed to pay a lot in taxes so that the poor would stay in their places. Then, every time this new order was threatened - in England after WWI, in France before and after WWII, in America in the 1960s - governments just gave out more money. They spent money on guns AND butter...military and social welfare programs.

"In France after WWII a quarter of the population voted with the communist party. And the communists were armed. But the government bought them off with more social spending.

"Then they started to run out of money. They tried taxing the wealthy classes even up to 100% of their income. In Britain and Scandinavia, the marginal rate went up above 100%. But that just depressed the state's revenue. Kennedy proved that you could lower tax rates and still squeeze more money from the wealthy. Reagan tried that too, but the results were less positive. Art Laffer showed that you had to find the optimal tax rate...and once you had it, you could raise it or lower it, it didn't matter. Either way, you got less revenue."

"But the ruling elites just kept making more and more promises. That was how they were able to hold onto power. And now they can't make more promises. The welfare state has reached the end of the road."

If our friend is right, we are facing more than just a sovereign debt crisis. We are facing a crisis in democracy. The ruling classes can no longer buy off the mob.

In a sense, democracy was always based on a fraud. Imagine that you are the government. You go to the taxpayer and you say: 'Give me your money. I'll take 10% or 30% or 50% off the top and then give the rest back to you in services.'

Not a good deal for the taxpayer, right?

So, instead the implied deal is this: 'Give me your money. I'll give you MORE in services than you gave me."

That is the deal that makes sense to the voter. Trouble is, if you're the state, you can't really do it. Overall, taxpayers get back in 'services' what they paid in taxes minus overhead, waste, corruption and so forth. You can rob the rich on behalf of poorer voters, but after you've already pumped the rich at the optimal rate, what do you do. You then have to turn on future generations. You take one generation's pension contributions and spend them in the present. Then you use the next generation's pension contributions to pay off the first generation... It all works until 1) you've promised too much and 2) the next generation is smaller or poorer than the one that preceded it and 3) a credit contraction makes further borrowing impossible.

Then, the mob feels betrayed. It looks for a leader to give voice to its disappointments...and make new promises... and start new wars.

Oh! Bama! Wherefore art thou?

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

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1 Responses to "Market downturn is too likely to ignore"


Sep 7, 2010

Very interesting article that makes a lot of sense. Corruption and inefficiency seem to have faced no trade barriers and have spread all over the world! One can not miss the sense of impending doom in the writings of Bill Bonner.

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