Here are six lawn mowers from the real economy - the parts that don't revolve around Wall Street of Washington, DC - that could easily mow down the green shoots:

1. Stabilizing numbers for continuing unemployment claims are painting a misleading picture. In reality, hundreds of thousands are rolling off of the traditional six months of benefits into extended unemployment benefits rolls. The recent payroll data was temporarily inflated by a rebound in auto production from depression levels, and the government's hiring of census workers. Also, the unemployment rate fell because the number of people actively looking for work keeps falling. There are absolutely no signs that those who were laid off will find a new job anytime soon.

2. The federal government's income tax receipts are still collapsing. Paycheck withholding tax receipts are still falling sharply. As data services like TrimTabs have demonstrated, income tax receipts are far more accurate gauges of trends in personal income than the highly massaged employment figures from the government. Falling tax receipts translate into a higher threat of confiscatory marginal tax rates in the future, deficit monetization and more inflation.

3. Last Friday's aggregation of July same store sales in the retail business confirms that end demand for many products remains bleak (aside from auto sales in the "cash for clunker" program, compliments of the ballooning national debt). For perspective, gasoline prices in July 2009 were about 35% lower than the $4-plus per gallon level of July 2008. One would think that this would be a major tailwind for retail, but it's not.

4. The federal government is spending other people's money like a drunken sailor, yet a good portion of the sugar high "stimulative" effect of this spending on GDP will be offset by lasting cuts in state and local government budgets.

5. The bond market will continue balking at absorbing trillions in new Treasury bond supply to fund the deficit. Rising mortgage rates, which are tied to Treasury Note yields, will limit the positive impact of refinancing those few homeowners that have any equity left in their homes.

6. Has the market noticed that the FDIC is stalling on its duty to shut down and eat heavy losses at several zombie regional banks - Corus, Guaranty, and Colonial to name a few? When it when it does so, it will have to draw down tens of billions of dollars from its emergency line of credit with the Treasury.

These factors all indicate that the economy is most certainly not returning to pre-credit bubble conditions. Yet the stock market is pricing in a return to such conditions - especially in the rallies in junk stocks that we've seen since the market lifted off on July 13.

I'll add a seventh lawn mower: the growing risks posed by debt bubbles in China and other emerging markets...

The Chinese government realizes that its stimulus spending and pressure on banks to expand lending is inflating a massive bubble in the Chinese stock and property markets. The problem with unsustainable economy activity is, of course, that it must eventually end. Michael Cembalest, the Chief Investment Officer of J.P. Morgan Global Wealth Management, describes the Chinese lending bubble in his Aug. 6 "Eye on the Market":

And in China, while there are positive recovery signals, I've never seen a country expand its loan base by 34% in one year without massive inefficiencies and asset speculation in its wake. Only 5% of this year's loans went to private enterprises (which employ 75% of the urban workforce), as 95% went to state-owned enterprises or provincial entities. While there have been substantial productive improvements in rail and other infrastructure, our contacts in Asia also indicate that funds designated for stimulus are ending up pushing up land price auctions to 4 times the original bids.

This is mal-investment on a monumental scale. But for now, the Chinese have much more room to borrow and inflate than the US (which has spent the last few decades doing so). Eventually, the market will cut them off. The end will not be pretty, and at some point in the future, shorting Chinese stocks may be one of the best short selling opportunities in history.

But in the meantime, it makes no sense to bet against China. The Communist government has proven very efficient at stealing the resources of its people (via inflation and taxation) and channeling them into whatever infrastructure project they deem necessary.

This process could end next week, or next year. That's the annoying part about bubbles: they tend to expand until the last patsy has bought in, and there's no telling how many patsies there are. There are already signs emerging that the furious pace of loan growth is slowing down. Today, Bloomberg reports:

"China Construction Bank Corp. will reduce new lending by about 70 percent in the second half after a surge in loans in the first six months increased credit risk, President Zhang Jianguo said in an interview.

"CCB, the world's second-largest bank by market value, plans to extend about 200 billion yuan ($29 billion) of loans, down from 708.5 billion yuan in the first half, said Zhang, 54. The company's new lending through June 30 was 42 percent more than for all of 2008."

Lots of debt loans are being made, but as long as loan growth is running hit, they will be hidden. Once loan growth stalls, bad loans will come to light, and the Chinese government may implement its own version of TARP to recapitalize its banks.

But the situation in the US is different...

Society has too much unaffordable debt at nearly every level. To top it off, we have a Federal Reserve run by central planners who not only misdiagnose their own complicity in the credit bubble, but also remain smugly confident that they can withdraw excess reserves before fears of inflation pick back up. This is turning out to be the financial market's largest ever game of chicken: the Treasury and Fed acting in a brazen manner to depreciate all forms of US paper (government debt and dollars), and, with each passing year, foreign creditors with fewer and fewer reasons to hold the liabilities of a bankrupt government that's accelerating its move deeper into bankruptcy.

The ingredients add up to the potentially explosive move up in gold-related assets. The more developments I see regarding economic fundamentals, and fiscal and monetary policy around the world, the more I want to own gold, and sell most stocks.

Regards,

Dan Amoss
for The Daily Reckoning Australia

• Australian Banks Must Increase Fees or Expand Loans to Remain Profitable
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"I think the American consumer recognizes they've got to hunker down, spend less, and they're doing it. Saks and Neiman Marcus have the worst sales on the planet, and the dollar stores and Wal-Mart are doing terrific because they offer value. That's a huge change in the mind-set of Americans. It's going to be with us forever. Living standards, of course, can never be the same. You can't put [the US] in this kind of financial condition. In our [federal] budget, we have 4% of the budget for debt service. That's going to go to 8. Now, when you do that, what happens to living standards?"

- Retail expert Howard Davidowitz on a May 14 Bloomberg Radio interview.

The day of reckoning has arrived for California's state government. It will not be pretty. Spending cuts and tax hikes are unavoidable; unlike the federal government, the state cannot monetize its debt with its own fiat currency. On June 10, California Controller John Chiang said in an official statement: "Without immediate solutions from the governor and legislature, we are less than 50 days away from a meltdown of state government."

The golden goose that funded irresponsible growth in state spending is dead. Chiang issued a report detailing a 39% year-over-year drop in personal income tax receipts, a 52% drop in corporate tax receipts, and an 8% drop in sales tax receipts.

Both consumer spending and capital investment will keep dropping in the state of California, because during the credit bubble, which paralleled growth in government spending, so much economic activity that would have taken place in the future was instead pulled into the present. Entrepreneurs suspect that state taxes on businesses will go up and will incorporate this into their plans.

"Sustainability" isn't just a word for environmentalists. In fact, it has a lot to do with the various stages of our financial crisis. In short, unsustainable economic activity fueled by easy credit will fade away quickly under tight credit. As economist Herb Stein said: "If something cannot go on forever, it will stop."

Like California's government, the consumer discretionary sector - which includes specialty retailers, restaurant chains, auto manufacturers, and more - has not been acting in a sustainable manner.

California's budget crisis provides a good example of what happens to institutions that wait until the last possible moment to correct mistakes and gets their fiscal houses in order. Like state governments, many businesses in the consumer discretionary sector must correct mistakes made during the bubble and write off uneconomic investments.

So while Wall Street's shortsighted focus is on the growth rate of the so-called "green shoots" of economic recovery, at Strategic Short Report, we're going to swoop in and seize not one, but two opportunities.

But first, you may ask why the consumer discretionary sector made so many uneconomic investment decisions. In hindsight, it was easy to see that we had, for example, too much auto production capacity. But in the heat of the credit bubble, it simply was easy to be fooled by artificially boosted trends in consumer demand. Think about it this way: Consumer borrowing and government budget deficits both pull what would have been future economic activity into the present, while pushing the associated costs into the future.

When this unsustainable behavior reaches its point of exhaustion, and people finally realize the folly of it all, employment falls, reckless investments are liquidated, and bad debts default. This is why it's healthier (yet politically unpopular) to have small, frequent recessions to keep supply and demand in balance, rather than have massive debt bubbles followed by nightmarish depressions and currency debasement. Such are the perils of government-promoted, debt-driven economic bubbles. It's like trying to live on a diet of candy and energy drinks, rather than wholesome food.

The 21st century gilded age for US consumers ended with the popping of the credit bubble. And this bubble was so big that it may take a decade for specialty retailers and restaurants to shrink store footprint, operations, and product lines to match a more sober customer. US consumers will save much more and spend only on things that provide clear value, and this will crimp demand for things like three-martini lunches.

Meanwhile, the stock market seems to have forgotten that we are facing a long-term adjustment in consumer behavior; it's distracted by noise surrounding the latest taxpayer-funded bailout. Market participants are also mesmerized at the spectacle of the Federal Reserve transforming its balance sheet into a toxic waste dump. It's like a bad reality television show that must up the ante to keep the audience interested.

Consumer discretionary stocks enjoyed full participation in the post-
March 6 stock market rally. However, this sector must endure years of disappointing profits - thanks to the capital investments made during the bubble to meet a level of demand that turned out to be phony. As US consumer demand approaches a more sustainable level, the excess capacity in specialty consumer companies will come to light. In the coming years, bankruptcies, price wars, and shrinking competitive barriers will prompt the market to start treating these former darlings as "commodity companies."

Take another look at the lead quote from Howard Davidowitz, a widely recognized expert on the retail sector. He has lived through booms and busts, seen the rise and fall of winners and losers, and is not sugarcoating the return to sustainability in retail. The message is clear: Extravagance is out and frugality is in.

Davidowitz may not be an economist, but his point about the federal deficit is one that all rational economic actors understand. He emphasizes that you cannot overspend without eventually suffering consequences. There's no getting around the fact that as with California's budget, profit margins in the financial and consumer discretionary sectors must shrink. Sustainability matters. Even the federal government will recognize this as the market charges high interest rates to fund its deficits.

Dan Amoss
for The Daily Reckoning Australia

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Isn't it ironic how creatively regulators were interpreting Reg FD laws with all of this week's leaks to the press? The leaks may not be very relevant, but they are yet another sign that this stress test was designed for public consumption. It was intended to bolster public confidence in the banking system, and I'm shocked at the lack of skepticism among the professional investment community.

Once it was announced that bank executives were pushing back on regulators about their forecasted losses, the stress tests instantly lost a great deal of their credibility. What kind of test in school allowed you to argue with your teacher about the correct answer?

Just like a student either knows their subject or does not, a bank's capital will be sufficient to weather this crisis without obscene levels of government subsidies, or it will not. If it is not, the FDIC should resolve it at a measured pace to minimize taxpayer losses. With Bear Stearns more than a year in the rearview mirror, there's no excuse for top regulators to not have a mechanism for unwinding complex bank/brokerage institutions - in which losses would be borne by shareholders and bond holders - rather than taxpayers. Instead, the authorities are trashing the value of the U.S. dollar and blowing up the deficit to potentially unmanageable levels.

Independent regulators - not bank executives - should be the sole judges of capital adequacy under a stress scenario. We all know what kind of biases bank executives tend to hold about their own loan books.

We have probably not seen the end of the stress test process. If the future data flow on loan delinquencies comes in higher than the current "stress" scenario, then we may see a scenario where a major bank (or three) gets massively diluted. For a model of what night happen to shareholders at the most toxic of the megabanks, consider the proposed exchange offer for GM bondholders, which would leave current GM shareholders with a 1% equity stake in the "new" GM. Why any professional can justify investing client capital in such megabank stocks is beyond my understanding.

The market's reaction to the stress test - in the form of soaring bank stocks - tells me that the consensus is treating this stress test as if it has the ability to magically predict yearend 2010 capital levels with pinpoint accuracy.

Most of us do not have magic predictive powers - only the ability to make judgments based on knowledge and experience. In my judgment, the stress test was not stressful enough. For instance, it is not really accounting for borrower behavior in a scenario where they are underwater on their mortgage and under- or unemployed.

The stress test's estimated losses on second-lien mortgages in particular seem very low. In foreclosure, these are often total losses. With another big wave of Alt-A resets and foreclosures in the pipeline, the performance data on second lien mortgages should worsen. Several state-imposed and bank-imposed foreclosure moratoriums are ending.

The bulk of housing activity right now consists in foreclosure auctions and short sales. How much are second mortgage liens worth under this scenario? Not much.

Most big banks already have low levels of tangible capital relative to towering trillions in risky assets. The cash flow from their existing and new loans must exceed their loan losses in order to simply maintain existing capital levels (let alone increase capital). Here's the illustration I used in the March 27 Strategic Short Report alert:

"Think of this situation as a bathtub. Bank capital is the amount of water in the bathtub, and the faucet pours new water into it (that's cash flow from existing, paying loans and securities, plus new capital infusions) and the drain sucks it out (these are the loan losses). Pessimists claim that the drain of losses is sucking water out so fast that it will empty the bathtub within a year or two, depending on the bank. They tend to ignore or downplay the new water coming in. Optimists claim that if regulators allow the water level to fall to a very low level during this crisis (regulatory forbearance), in time, the water level will eventually rise back to normal levels. There's a risk that if the optimists are wrong about the amount of new water coming in, we'll be stuck with a Japanese-style "zombie bank" situation.

After this week, I think the risk of the zombie bank scenario is much higher. We'll probably see this manifested in continued tight credit conditions. The banks under the most intense scrutiny will tend to reinvest cash flows into less risky assets like Treasuries and agency mortgage-back securities (another form of government guaranteed debt) - rather than write new commercial or consumer loans.

Regards,

Dan Amoss
for The Daily Reckoning Australia

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During the panic, I read many misleading statements about stock valuation. From day to day, stocks are, obviously, worth whatever the potential buyer is willing to pay. In panics, sellers overwhelm buyers.

But over time - in normally functioning markets - a stock's price will reflect its ability to deliver free cash flow to shareholders. The next two or three years of earnings are only a small fraction of any stock's value.

Yet many great companies, including National Oilwell Varco, quickly crashed by 70% or 80%, just because earnings might temporarily slow. NOV's real value did not fall that much. This was an emotional overreaction, so we took advantage and picked up some cheap call options.

The value of any company depends on factors like future sales growth, profit margins, and capital investments necessary to sustain its business. In short, the value of companies, or stocks, doesn't really change very quickly from week to week.

But the market can change its expectations very quickly, especially when fear overwhelms rationality.

Michael Mauboussin, chief investment strategist at Legg Mason Capital Management, recently described how fear and stress can impact the stock market:

"The whole story of how humans deal with stress is really interesting, but there's one facet worth emphasizing. When people get stressed, they tend to dramatically shorten their time horizons. If you're a zebra being pursued by a lion, turning off systems for digestion, reproduction, immunity, and growth makes all the sense in the world because the chase will be done, or you will be done, in short order. But humans, who have many of the same physiological responses, are not dealing with a short-term threat, but rather a long-term system called the stock market. So taking a long-term view is absolutely crucial, although really hard."

Most investors have clearly been acting under dramatically shortened time horizons. Redemption requests and margin calls have forced many fund managers to sell what they don't want to sell at ridiculously low prices. But it finally seems we are heading back into a normally functioning market - where investors can make informed decisions without so much fear and stress.

A more orderly stock market will give us plenty of attractive short ideas. I'll be looking for situations in which the market has already priced in a rosy scenario for a stock. We can all become better investors by honing our abilities to distinguish between the trading noise and the investing signal. In other words: What really matters to the value of this company, and what does not?

It's amazing how often the market projects the fundamentals of the past year into the infinite future. Those who invested in bank stocks two years ago have discovered the hazard of investing on the assumption that the future will look just like the past. The same goes for traders that chase the latest hot stock up to the stratosphere, to the point where it must keep growing earnings at 30% per year for a decade to justify its valuation. Once there's a hint that growth will fall short of expectations, formerly "hot" stocks can crash 30% or 40% in a day - especially if earnings were never sustainable to begin with.

In times of panic, the market tends to project the past year's negative fundamentals into the future. For example, how much does the fact that U.S. gasoline demand is down 4% year over year matter to the value of oil stocks? It matters if gasoline demand keeps falling at a 4% annual rate over the next decade.

But you probably agree that this has little chance of happening, since oil consumption generally doesn't fall quickly in response to higher prices. Yet most oil stocks now trade at valuations that anticipate an endless spiral in demand and prices.

I think the shortsighted fear about U.S. oil "demand destruction" is noise. It's distracting investors from an important signal: sustainable worldwide demand and supply constraints that will determine the long-term price of oil. So you have the opportunity to take a contrarian stand, buy cheap oil stocks, and hold them as long as fundamentals stay intact and valuations stay reasonable.

Regards,

Dan Amoss, CFA
for The Daily Reckoning Australia

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Let's hope Obama recognizes the need for incentives, profits, and capital investments in the economy. The economy cannot be taxed and regulated without potentially severe consequences. Former Fed Chairman Paul Volcker (and the last Fed chairman to provide adult supervision for the banking community) is an Obama adviser. So Obama should be apprised of the consequences of Carter-era deficit spending and money printing.

At the very least, Obama must act as a check on the potential for a Democrat-dominated Congress to turn a recession into a depression.

For example, some in Congress are floating a proposal to steal your 401(k), sell the proceeds, and invest in "government-guaranteed" retirement accounts. The only thing this Marxist idea would guarantee is a depression. Call or write your congressman if you feel that your 401(k) is in danger. We shouldn't allow them to steal more from prudent savers than they already have.

Keep in mind that presidencies rarely resemble campaigns. President Bush campaigned on limited government and a humble foreign policy, and we got the opposite. To top it off, we had the illusion of real growth, with credit and housing bubbles that led to the greatest misallocation of resources in history.

The free market has been falsely accused for this financial crisis. But the free market didn't get us here; a combination of government spending and crony capitalism did. Much ink is wasted on how we need to re-regulate Wall Street, but the fact is that the problem would never have grown so large without agency conflicts and a banking system built upon on a foundation of paper money.

The agency conflict on Wall Street is the mentality of "heads I win, tails you lose. " CEOs, traders, and mortgage-backed security factories were paid more for taking more risk. So it shouldn't surprise us that they overdosed on leverage to magnify returns, without considering risk.

Performance pay should be based on creating long-term shareholder value, not on meeting next quarter's earnings estimate. A good place to start would be bonuses in the form of restricted stock that does not vest for 10 years. I doubt Lehman would have blown up if employees were paid modest salaries with the potential for sizeable ownership stakes in the future.

If every employee were paid partially in restricted stock of his or her company, even a small amount, most agency conflicts would be eliminated.

Much of our current mess resulted from totally complacent, incompetent boards of directors. Carl Icahn has good ideas for how this can be addressed without excessive regulation. Icahn explains how most corporate boards behave like government bureaucrats in this post. In my view, we need an economy in which everyone acts like owners, rather than CEO pillagers or union extortionists. For example, look at how decades of management and union looting brought General Motors to its state of current crisis.

A banking system built upon on a foundation of paper money also contributed to this crisis. The Treasury and Fed allowed institutions to grow "too big to fail. " Without taxpayer subsidies (i. e. , Fannie and Freddie - two of the worst crony capitalist institutions in history) and the subsidy of Fed rate cuts, housing prices would have kept growing in step with household income. Instead, house prices went to the moon. Precious capital was thrown into a black hole when mortgage-underwriting discipline went out the window and homebuyers deluded themselves with bubble psychology.

As Albert Einstein noted in the quote above, our problems "cannot be solved by the same level of thinking that created them. " If the federal government proposes "solutions" to this crisis with the same type of thinking that got us here, we could be in for a very long period of economic pain. America's status as a destination for foreign capital is at stake.

If the new government fails to act wisely and understand how we got here, the only "government guarantee" we'll have is depression.

Regards,

Dan Amoss

For The Daily Reckoning Australia

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And few got the memo from Wall Street strategists that they are supposed to stop driving because oil is over $100 per barrel. Americans love their mobility, and they will pay a premium to keep it. I expect the resilience of energy demand to surprise many.

I checked the markets at the end of each day as the list of bear market casualties grew: Fannie, Freddie, Lehman, Washington Mutual, and now, AIG. It's amazing how well the financial stocks we're selling short in Strategic Short Report are holding up, since they're all loaded with leveraged exposure to credit risk. But I'm confident our patience will be rewarded in the coming quarters.

My week off allowed plenty of time to think about the future of this credit crisis from a much broader perspective. Driving though Vermont's scenic Green Mountains and New Hampshire's White Mountains, we had plenty of time to listen to audio books.

One in particular - David McCullough's excellent book 1776 - offered perspective on how far the U.S. has strayed from its founding principles. 1776 is a historical narrative of the American Revolution, with a focus on the early military engagements between General George Washington's Colonial Army and the powerful, yet overconfident British Army.

Two themes from the book seem to parallel recent financial market events:

First, in one scene, British soldiers express their surprise at what motivated the colonists to revolt. Most Americans enjoyed a high standard of living, and nearly all were better off than British regulars. Why did they risk life and limb in a fight against British rule, when they had such material wealth and a decent amount of sovereignty? With historical perspective, we can appreciate even more just how much freedom most colonists enjoyed; taxes in particular were a pittance compared to today's U.S. tax burden.

Despite their many sins - most notably slavery - the colonists had amazing sense of sacrifice and honor. Their willingness to fight for freedom from government abuses stands in stark contrast to the attitudes of most modern Americans. Now, politics focuses on wealth redistribution, rather than harness the American entrepreneurial spirit and human capital to compete effectively in the global economy. It's gotten so bad that most Americans hardly seem to care when the federal government virtually takes over the mortgage industry - and most don't even understand how we got into this mess in the first place.

Will my one-year old son Ben apply directly to the federal government, a.k.a. "Frannie," for a mortgage when he grows up? Will politicians now directly manage the mortgage industry? After this week, it's far more likely to happen. We are watching the slow creep of socialism. That holds enormous long-term consequences for financial markets.

The second interesting point I drew from 1776 concerns leadership. George Washington didn't posses the brightest mind, or the best oration skills, but he quickly learned how to lead through success and failure while maintaining great humility.

After a stinging defeat at the Battle of Long Island, Washington engineered a brilliant overnight retreat that salvaged the awkward, inexperienced Continental Army. Rather than gamble his army on a low- probability recovery of lost ground, he swallowed his pride, and retreated to fight another day.

Washington's humility in retreat stands in stark contrast to the type of leadership we've seen in the boardrooms and executive suites on Wall Street. In nearly every big financial blowup of the past year, executives have failed to make tough choices that might have salvaged shareholder value, and instead gambled on a miraculous future turnaround.

Think about how much better off Lehman Brothers would be if its management hadn't put off the process of reporting losses, dumping impaired assets, and raising new capital. Would its stock be $4 today? Probably not.

While all of those decisions would have been painful at the time, they could have salvaged much more shareholder wealth - just as a successful retreat preserves an army's ability to fight another day.

The speed of Lehman Brothers' deterioration is shocking even to its skeptics. Despite my already low opinion of Lehman management, expressed several times in this space, I'm amazed at its failure to structure a deal or asset sale to salvage a respectable amount of shareholder value. Lehman even had the advantage of immunity to a "bank run," thanks to the Federal Reserve's lending facilities. Bear Stearns wished it could have used the same; it was finished as soon as creditors lost faith in its solvency. Lehman shareholders and its 25,000 employees deserved better.

These are tumultuous times - times that show us all the importance of good leadership. The importance of management leadership skills is never greater than it is in a crisis.

Best regards,

Dan Amoss
for The Daily Reckoning Australia

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But by the time you entered the workforce, you realized that the Soviets were only good at building conditions for shortages and black markets. With no prices or profits, the economy was destined to collapse, and everybody would become equal - equally poor. Finally, in 1991, the Soviet Union officially dissolved. Your suffering continued as you bartered your way through the economic chaos of the 1990s. Economic productivity kept falling until the 1998 financial crisis brought your country to the brink of failure.

But ever since then, things have been getting better. Since 2000, President Vladimir Putin has been a strong, yet controversial force behind restoring Russian pride and power. You don't have a problem with Putin's tough tactics, thinking that Russia's turnaround required bold action. But it's hard for the West to relate to your experience. They don't realize how hopeless the Russian people felt before Putin came along.

Regardless of what the West thinks of your president, Putin is a hero where it counts - in his own country. He's so popular and powerful that TIME Magazine named him "Person of the Year." The currency is strong, the stock market is soaring, and Putin wants to keep the boom going.

The Financial Times reports that the Russian government is pushing a plan to invest $1 trillion, roughly the size of its entire GDP, in modernizing its infrastructure over the next 10 years. Most of this investment would come from private sources, a clear reversal from the Soviet days.

Russia will follow the lead of other emerging economies in establishing its own "sovereign wealth fund." Export earnings that the Russian government had parked in U.S. Treasury bonds will start flowing into infrastructure and natural resource projects with higher long term returns. It's likely that some of this money will find its way to Gazprom, the state-controlled natural gas monopoly.

Lately, Putin has been setting the stage to consolidate his political gains. He's endorsed his protégé, Dmitri Medvedev, in the upcoming March 2008 Russian presidential elections. Putin's endorsement means certain victory for Medvedev, who also happens to be chairman of Gazprom.

As part of his consolidation strategy, Putin will be prime minister in Medvedev's administration. There's even a legal precedent for Putin to return to his current post - president Yeltsin resigned in December 1999, handing Putin the top job. Medvedev could do the same thing.

Some suspect Putin's stake in the future of Gazprom extends well beyond his relationship with chairman Medvedev. In November 2007, the Moscow Times described Putin's alleged personal holdings: "Stanislav Belkovsky, the well-connected insider who initiated the Kremlin campaign against Yukos in 2003, made specific claims about Putin's wealth. He alleged that Putin owned... 4.5 percent of Gazprom, [a stake worth $13 billion]."

Whether or not the rumors are true, Gazprom will likely remain the world's most politically influential corporation well into the future. Gazprom will get what it needs, and what it needs right now is to accelerate its drilling activity.

The International Energy Agency projects Gazprom's natural gas production will decline rapidly through the year 2020, and it tends to issue optimistic supply forecasts. Gazprom management knows production is too dependent on a few large, mature gas fields, so they greatly expanded drilling activity from 2001 to 2006.

Thus far, it has yielded disappointing results. As you can see in the first chart, Gazprom expanded its drilling activity at a 30% compound annual rate from 2001 to 2006. Industry sources estimate this was the fastest drilling growth rate among all national oil and gas companies over this period.

Gazprom will probably try improving its supply shortfall by acquiring smaller independent gas producers, and try to strike deals to transport Central Asian gas to its European customers. But eventually, the company will not be able to ignore the need to redouble its drilling activity. Morgan Stanley oil service analyst Ole Slorer agrees, and described the amazing growth in the Russian rig fleet since 2000:

"Activity in Russia is now shifting from rig-less activity towards more drilling intensive services. According to the MI-Swaco rig count, there were only 40 active rigs in Russia in 2000 or about 4% of the U.S. onshore activity. This stabilized at about 75 rigs in operation over the 2001 through 2003 period (about 7% of average U.S. activity), before escalating by 70% to average 128. The growth has continued unabated and rig count averaged 246 rigs in 2006 although exiting the year at a 300 run-rate. In our view, we are entering a period of double-digit drilling growth."

Gazprom management is on record with a goal of quadrupling the company's market value to $1 trillion within a decade. "We'd like to be the most valued and most capitalized company in the world," said Deputy CEO Alexander Medvedev in an April 2007 interview. He expects Gazprom's market value will double in five years. To achieve this goal, there's no question the company will have to drill heavily to stem its gas production declines.

Gazprom isn't the only Russian energy company with aggressive growth plans. The December 2007 Lehman Brothers E&P Spending Survey estimates that the six largest Russian oil and gas companies will spend $28.5 billion on exploration and production in 2008, up 21% from 2007 levels. Out of all the Western oil services companies, Schlumberger has the largest chunk of this business - with Baker Hughes, Halliburton, and Weatherford contending as well. Russian companies still perform most oil service work. But they use inferior technology and equipment, so Western oil service companies should keep winning contracts.

On the equipment side, our own National Oilwell Varco (NOV) has repeatedly cited Russia as an enormous growth opportunity. Once NOV's acquisition of Grant Prideco (GRP) closes, the combined company will be even more of a "one-stop shop" to retool and supply the Russian rig fleet. Tesco (TESO) has a huge opportunity to outfit this antiquated fleet with top drives, which improve productivity and efficiency. Natco Group (NTG) is a major player in wellhead gas processing equipment. As more oil and gas wells are completed, the opportunity for Natco equipment sales grows. Chart Industries' (GTLS) equipment will play a key role in building LNG liquefaction plants to process the huge untapped gas resources under the Barents Sea and on Sakhalin Island.

Dan Amoss, CFA
for The Daily Reckoning Australia

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Clean Energy Fuels (NASDAQ: CLNE) is one of these companies. It's leading the charge to promote natural gas as a transportation fuel. It builds the infrastructure necessary to store and dispense natural gas at fueling stations. It's also backed by billionaire investor T. Boone Pickens.

Pickens is a great energy investor. He made his fortune investing in oil and gas. He's often been right about the big picture in energy, spotting trends long before the crowd. Today, he expects a future in which oil and diesel prices remain very high and consumers will use natural gas to fuel many more types of vehicles. He controls 60% of Clean Energy's stock, a stake worth $400 million. That's a big bet, even for a billionaire.

But there's one big hurdle to his vision. Pickens knows the U.S. natural gas market as well as anyone, and he says he expects it will remain tight. Domestic gas drillers are working as fast as possible to meet demand from power plants, chemical plants, and homes. A growing fleet of natural gas-powered vehicles would propel natural gas demand to another level, spurring huge investments in liquefied natural gas (LNG).

Most of the world's natural gas reserves are located far from major population centers. When gas is too expensive to transport by pipeline, it's called "stranded" natural gas. The only way to get stranded gas to market is to cool it until it reaches a liquid state and transport it on ships designed to carry LNG.

Pickens' vision of the future, along with continued global growth in gas demand for industrial uses, sets the stage for a massive boom in LNG infrastructure. Douglas-Westwood, a leading industry authority, forecasts investment in the LNG supply chain to grow dramatically over the next four years and beyond.

The importance of natural gas extends well beyond its role as an emerging transportation fuel. It's a vital feedstock in electricity and chemical production. Synthetic nitrogen fertilizers, which use natural gas as a feedstock, greatly enhance agricultural productivity. Other chemical compounds created from gas are the building blocks for electronics and plastics. Gas is also becoming a popular fuel for home heating. Natural gas furnaces are much more efficient than oil or electric heat furnaces. Without natural gas, many businesses would simply have to close their doors. Reliance on natural gas is a weak link in the global economy.

Because of its importance, governments and industrial companies will keep favoring policies that secure reliable natural gas supplies. Since the industrialized world no longer includes just North America and Europe, many more countries have entered the competition to lock up the most promising stranded gas reserves.

For decades, LNG has not been cost competitive with oil and coal. But continually rising oil prices are heightening the sense of urgency to develop a tradable LNG market. Also, climate change activists will keep pushing to tax, regulate, and eventually banish coal. This benefits LNG because natural gas electric power plants can replace coal plants. The financial and political incentive to develop the world's stranded gas reserves is strong and growing. Energy companies are responding.

Even Exxon Mobil - a consistent optimist about plentiful future oil supplies - doesn't assume the United States has enough domestic natural gas to meet growing demand. "Energy independence [within 20 years] is just impractical, and we will have to rely on additional imports of natural gas," says Ron Billings, Exxon's vice president of Global LNG.

The Wall Street Journal recently reported on Exxon's plans to build a huge LNG re-gasification terminal 20 miles off the coast of New Jersey:

"Exxon said it expects demand for gas to rise in North America, outstripping the ability of gas drillers and producers to keep up. Globally, it said, LNG demand could more than triple, to 500 million metric tons a year, in 2030, from 150 million metric tons a year today. About 20% of gas consumed in North America could be imported by then, up from 3% today."

Like the U.S., China produces almost enough natural gas to meet its needs. Both countries rely on LNG to satisfy the extra 2-3% of domestic demand not met by local production. China's use of LNG is small, but it can grow dramatically. China is an underserved market. It's consuming as much gas as its limited pipeline and LNG capacity will allow. Supply constraints and high costs force many Chinese provincial markets to use coal for electricity when they'd rather use gas.

Residents of Beijing and Shanghai would certainly prefer gas-fired power plants to the coal-fired plants currently ruining air and water quality. Until now, China has constructed coal-fired plants at a maddening pace simply because they were cheap. But the health costs resulting from coal-based pollution are growing to a critical level. As Chinese wealth grows, the country will look to secure a leading position as a consumer of LNG - much in the same fashion as Japan. It may be more expensive, but China will weigh the extra cost of gas over coal against the benefit of lower health care costs and better social stability.

Chinese land drillers are pushing very hard, yet still cannot satisfy demand. China's onshore oil and gas basins are fairly mature. State-controlled oil companies have been scouring the country for decades. Offshore drilling may eventually bring more gas supplies online. A few promising underexplored basins exist in northwestern China. But the pipelines necessary to deliver this gas to coastal cities will take years and tens of billions of dollars to build.

Chinese leaders have signed long-term gas supply agreements with the leaders of Turkmenistan and Kazakhstan, two Central Asian countries endowed with plenty of untapped reserves. But Gazprom, the Russian gas monopoly, also wants access to these reserves. The pipelines required to transport this gas would be very expensive and risky from a geopolitical perspective. The Chinese would probably find it easier to safeguard LNG supplies sourced from emerging exporters like Qatar, Malaysia and Australia.

I expect China will increasingly turn to LNG to satisfy growing natural gas demand. But it must compete with the rest of Asia, the U.S., and Europe to invest in the most promising LNG projects. Many European countries are looking to diversify away from politically risky Russian gas supplies. They're investing in LNG projects that strengthen connections to longtime suppliers like Algeria.

Since natural gas provides the building material for so many modern products, its consumption grows as living standards improve. According to the BP Statistical Review, the entire Asia-Pacific region consumed just 3% of global natural gas in 1975. This figure expanded fivefold, to 15%, by 2006, and this trend should continue on its current course.

Japan was the first Asian country to invest heavily in LNG facilities. After suffering through the oil market disruptions of the 1970s, Japanese leaders decided it was wise to diversify supply of hydrocarbons. South Korean gas demand accelerated from a low base as its industrial machine matured in the 1990s. There's an interesting aspect about the natural gas market in these two economic powerhouses: Neither of them has a viable domestic gas resource. They both rely on imports. Japan relies on LNG for 97% of its gas and South Korea relies on it for 100%.

Japan consumed 39% of the world's LNG supply in 2006. South Korea came in second, at 16%. Both countries have a huge stake in LNG, so they will keep expanding their LNG re-gasification and storage infrastructure. LNG equipment companies have the opportunity to meet this demand over the long term.

Recent events have caused Japanese LNG demand to accelerate. Japan suffered a powerful earthquake in July 2007. It reignited fears of radiation leakage from nuclear power plants, forcing the shutdown of a major nuclear reactor. Ever since the shutdown, Japan has had to make up for the lost electricity with gas-fired power. Utilities have been importing as much LNG as storage facilities will allow, paying premiums of about 50% over benchmark U.S. natural gas prices.

After this scare, it appears that the Japanese government is rethinking its commitment to new nuclear reactors. In a recent research note, Bernstein Research described this important policy shift, which remains below the investment community's radar screen:

"As a result of new [Japanese government] guidelines, nuclear plant operators will now have to analyze seismic events over a 130,000-year period, in stark contrast to the current mandated 50,000-year period. Geological faults screened to be active... would nullify greenfield site proposals, and could lead to closures of operating nuclear capacity..."

Nuclear power supplies 30% of Japan's electricity. Regulators may delay or cancel some of the 10 gigawatts in new nuclear capacity slated to come online by 2015. If this happens, Japan's LNG and gas-fired power facilities must expand.

Dan Amoss
for The Daily Reckoning Australia

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Three weeks later, Citigroup (NYSE: C) announced that its third-quarter net income would fall roughly 60% from a year earlier, blaming “dislocations in the mortgage-backed securities and credit markets, and deterioration in the consumer credit environment.”

Apparently, “pretty good” in the current environment is “pretty dismal.”

Additionally, Citigroup disclosed that its securities and banking unit would be writing off $3.3 billion worth of losses – a large figure for even a megabank like Citigroup. This loss stems from its LBO-related leveraged loan commitments and the frozen CDO market.

The most troubling part of this preannouncement was the $2.6 billion increase in credit costs in Citigroup’s global consumer business. Of this figure, nearly $2 billion was an increase in Citigroup’s loan loss reserve. (The loan loss reserve account is a bank’s estimate of the losses it expects to take on its loan portfolio). This large write-off was a clear message from Citigroup that the credit quality of its loans is deteriorating much faster than expected. To put Citigroup’s $2 billion allocation to loan losses in context, during the first and second quarters of 2007, Citigroup added just $646 million and $545 million, respectively, to its loan loss reserve account.

We should expect many, many more dismal pre-announcements from the banking industry over the next few months. Just yesterday, for example, Thornburg Mortgage (NYSE: TMA) said its subprime losses will be 27% higher than expected. As our colleagues at the 5-Minute Forecast explained, “Thornburg Mortgage will throw another $1.1 billion on the mortgage carcass pyre.”

Once a major asset bubble pops – and the housing bubble was one of the largest asset bubbles of all time – the companies at the center of the mess usually try to take their lumps in a single quarter, often referred to as a “kitchen sink” quarter. By cramming losses and write-offs into a single quarter, they try to give Wall Street the impression that the bad news is out of the way and nothing but blue skies are ahead.

This game works very nicely sometimes… especially among gullible investors.

But “kitchen sink” quarters have an inconvenient way of recurring. It is improbable to believe, for example, that banks will be able to cram five years of reckless lending into a single quarter of writeoffs. More likely, this quarter’s write-offs will begin a long-running trend.

“Kitchen sink” quarters will occur repeatedly in the financial sector, just like they did in the tech sector after the dot-com bust of 2000. Cisco, Intel and Corning reported a series of disappointing quarters.

The homebuilders are also playing the “kitchen sink” game, as Lennar and KB Home demonstrated in their most recent horrid results. Both of these homebuilders sliced large chunks off of their book values by writing off $848 million and $690 million worth of shareholder equity, respectively.

These massive write-offs illustrate how much raw land inflation and irrationally priced finished homes were hiding in the homebuilders’ inventory accounts. The most indebted homebuilders will likely experience some form of bankruptcy.

A little over a year ago, I wrote a Whiskey & Gunpowder article entitled, “Are Homebuilder Stocks Actually Cheap" in which I warned that low price-to-earnings and price-to-book multiples were deceptive:

“After major declines, [homebuilder] stocks are trading for an average trailing P/E ratio of 4.7. This is incredibly cheap in the current market, but trailing earnings represent the very peak of the most speculative housing market in history (in other words, 2007 earnings are likely to decline significantly, making the forward P/E ratio potentially double or triple the trailing ratio). Your macro outlook for the housing market over the next couple of years will determine whether you think these stocks are bottoming or just pausing before another round of declines…

“The measure of book value for most homebuilders will be a moving target in the future, as further inventory charges and margin compression is very likely. So the argument that homebuilders are cheap rests on shaky accounting and extrapolation of the past into the future. That adds up to a ‘value trap,’ in my opinion.”

I see a similar value trap unfolding among the bank stocks. Most of the analysis I read doesn’t extend much beyond the parroted mantra: “Bank stocks are cheap on a price-to-earnings and price-to-book basis.” Citigroup’s earnings preannouncement reminds us that earnings and book values only reflect past results, not future results.

But for the moment, very few investors seem to fear the uncertainties of the future. So financial stocks are rallying on the garbage rationale that “bad economic news is cause for celebration because it will bring more interest rate cuts from the Fed.”

Unfortunately, negative surprises on bank balance sheets will far outweigh any benefits they receive from Fed rate cuts — benefits that tend to re-stimulate the credit creation process only after a very long time lag.

Finally, on the subject of further Fed rate cuts, the financial markets are flashing many glaring signs that monetary inflation is spiraling out of control. So Fed Chairman Bernanke will receive ample opportunities to establish his credentials as an inflation fighter…or not.

With gold and commodities soaring, and most global stock markets either approaching or blasting through July peaks, he may decide to put further rate cuts on hold for the time being.

Indeed, if the dollar continues sinking – and commodities continue soaring – rate cuts may be on hold permanently…and that’s when the real carnage in the finance sector might begin.

Stay tuned!

Dan Amoss
for The Daily Reckoning Australia

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During this particular credit cycle, investors might suffer even more pain than usual. That's because there was nothing "usual" about this particular credit cycle. In fact, the world has never known anything like it.

In the modern financial system, the ability to create credit extends far beyond the reach of the traditional banking system. A labyrinth of credit contracts and derivatives provides sources of financing that never pass through the door of a traditional bank.

This labyrinth is known as "Securitization."

Every imaginable stream of future cash flow - from car and mortgage payments to the loans that fund private equity deals - can be "securitized" and sold to the highest bidder. Securitization is simply the process whereby a stream of future cash flow becomes pledged to a separate legal entity, which then divvies up the cash flow among different "tranches," or classes, of creditors.

Like everything in life, the securitization revolution has its positives and negatives. One negative consequence is that securitization creates a vast expanse between borrowers and lenders. The two sides never know each other…or care to know each other. But obviously, the further a lender is separated from a borrower, the more potential there is for fraud on the part of the borrower and underestimation of risk on the part of the lender. Very bad loans tend to be made when this is the case, as those who've dabbled in subprime mortgages are discovering. On one end of the lending chain are plenty of fraudulent "liars' loans" yet to default, and on the other are plenty of lenders who don't fully understand the risks they were taking.

Bill Gross, the most accomplished bond fund manager in the world, recently published his views on the subprime debacle. In his July Investment Outlook, Gross acknowledges that securitization and derivatives diversify risk and "direct it away from the banking system into the eventual hands of unknown buyers, but they multiply leverage like the Andromeda strain. When interest rates go up, the Petri dish turns from a benign experiment in financial engineering to a destructive virus because the cost of that leverage ultimately reduces the price of assets…

"The flaw, dear readers, lies in the homes that were financed with cheap and, in some cases, gratuitous money in 2004, 2005, and 2006," Gross concludes. "Because while the Bear [Stearns] hedge funds are now primarily history, those millions and millions of homes are not. They're not going anywhere… except for their mortgages, that is. Mortgage payments are going up, up, and up… and so are delinquencies and defaults. A recent research piece by Bank of America estimates that approximately $500 billion of adjustable-rate mortgages are scheduled to reset skyward in 2007 by an average of over 200 basis points. 2008 holds even more surprises, with nearly $700 billion ARMS subject to reset, nearly three-quarters of which are subprimes…"

The housing market will remain sluggish far longer than most expect. $800 billion of ARM resets can only add to the supply of distressed sellers in 2008. This will further depress an already sluggish housing market that's having enough trouble working through a huge supply overhang. To say the least, this scenario will weaken demand for securities backed by residential housing.

Until now, hedge funds have been creating a great deal of the miraculous "liquidity" sloshing around the globe. By buying the highly leveraged equity and mezzanine tranches of collateralised debt obligations (CDOs), the buyers provided the cash to make new loans and create new CDOs. Liquidity surged; share prices soared; everyone was happy… until homeowners began defaulting on their loans in record numbers. Suddenly, CDOs were not providing the returns the buyers expected. Instead, they were providing the large losses the buyers did not expect. Indigestion resulted.

Indigestion tends to suppress an appetite. That's where we are today - in the indigestion phase. Institutional investors' appetite for mortgage-backed securities is spoiling just as Wall Street tries to serve them heaps of new portions.

Get ready for the days of expensive credit.

Dan Amoss
for The Daily Reckoning Australia

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