As an example, the September 0.6% increase in U.S. retail sales simply doesn't rhyme with data such as truck tonnage, railroad car loadings, state sales tax receipts and the shrinking trade deficit. The American Trucking Association's truck tonnage index is 2.7% lower than a year ago, and railcar loadings were down 2.8% year-on-year (also, in October, Ryder System - "R" - revised its earnings forecast, primarily due to lower expected results in its US Fleet Management Solutions business segment).

The decline in volume of freight shipped is also confirmed by the Cass Freight Index, which peaked out in June 2006. According to contraryinvestor.com, Cass Freight Systems is a "freight payable processor" that deals with 1,200 divisions of 400 individual companies representing a broad spectrum of industries; therefore, the company has a very good feel for the flow and character of the US freight industry (part of the decline in the Cass Freight Index since June 2006 may have been due to the decline in energy prices in the second half of last year, but with energy prices now back to peak levels the index has failed to approach its 2006 high. Shipments by Canada's largest railway, Canadian National Railways, which derives 33% of its revenues from the US, are down 12% year-on-year).

In theory, it could be that trucks and railroads are suddenly carrying fewer but higher-value goods, but a more likely explanation is that volumes are down but prices in retail stores are up, which explains the surprisingly strong September retail sales. But even if this were the case, it doesn't tally entirely with the declining trend in states' sales tax receipts. In California, September's sales tax receipts were down 7%, compared to the previous year. One possibility we shouldn't exclude is that the economic condition of US households has deteriorated to the point where they are curtailing the purchase of discretionary items, which are subject to sales taxes, but increasing the dollar sales of groceries, due to price increases (not because of an increase in volume).

Since a large number of groceries are sales tax exempt, their price increases can boost retail sales while at the same time - due to the deficiency of demand for discretionary consumer goods - sales tax receipts decline.

I should just like to emphasise once again what I have said before, which is that cost-of-living increases for households bear no resemblance to "core inflation". I recently asked a level-headed friend of mine who lives in London (the UK should have a lower inflation rate than the US, given its strong currency) to estimate his cost-of-living expenses increase (in short, his inflation rate). After checking with his wife, he told me it was 8.6%. Then, over a drink in Hong Kong, a rather intelligent woman told me that her grocery expenditures had recently increased by 15% (since Hong Kong's currency is pegged to the US dollar, its inflation rate should be similar to that of the US). Also, if in the Euro Zone, whose currency has appreciated by more than 40% against the US dollar since 2001, price increases seem to be higher than in the United States, one has to wonder about the reliability of the Bureau of Labor Statistics' data.

Other signs of economic weakness in the United States include car sales, which are down year-on-year, and imports, which have slowed. In August, inbound containers at US ports were down year-on-year by more than 1% (at Los Angeles-Long Beach, inbound containers were down 7% in August). Fred Hickey notes that the North American semiconductor equipment book-to-bill ratio collapsed between June and August. The same seems to have happened in Japan, where the semiconductor equipment industry reported "a free fall" in its book-to-bill ratio, from 1.02 in June to 0.88 in July (another indicator that all is not well in tech land is that Taiwanese direct exports to the United States were down year-on-year both in August and September). According to Fred Hickey, "the declines in these forward-looking indicators are warning that industry revenues and earnings are about to fall off sharply worldwide. It fits with all the other data we have. The memory markets are glutted with capacity and prices are falling."

According to Fred, "bulls have been hanging on to their semiconductor equipment stocks all year despite deteriorating market conditions". Not surprisingly, Fred holds several put options on tech related stocks, including Apple, Research in Motion, Amazon, Applied Material, and Texas Instruments. I might add that, despite all the bullish comments about high-tech stocks, the Philadelphia Semiconductor Index (SOX) is down 11% from its June 2007 peak, while the NASDAQ 100, driven by a few stocks such as Apple, Google, Research in Motion, Garmin, Wynn Resorts, and Amazon, whose combined weight in the index accounts for more than 23%, has risen by 20% since the August 16 low. It would seem to me that the performance of semiconductor stocks is a better leading economic indicator than a few momentum-driven concept stocks.

Another indicator of an economy that has slowed to a crawl, or is already, as I believe, in recession, is the shrinking trade deficit. But, not to worry! With Mr. Bernanke at the Fed and Mr. Paulson at the Treasury, both of whom are well-advised by the Wall Street elite, "there have been extraordinary rises in the quotations for all shares, the chief cause being the catastrophic change in the economic situation". More to the point, the recent strength in the stock market has been due, as Bill King pointed out, to "the Fed creating credit at banana republic-like rates". Since August, the compound annual rate of change of MZM of the average four weeks is 24.3% and for the third quarter it is 18.7%.

I should like to add one more thought. It is, of course, "slightly" embarrassing for a government that the stock market is at an all-time high while the median household is struggling with illiquidity. According to Greg Ip, writing for the Wall Street Journal, the wealthiest 1% of Americans earned a record 21.2% of all income in 2005 (it is likely to be even higher today), while the bottom 50% earned just 12.8% of all income (lower than at the peak of the stock market in 2000). Greg Ip also quotes a study by University of Chicago academics Steven Kaplan and Joshua Rauh, which "concludes that in 2004 there were more than twice as many such Wall Street professionals in the top 0.5% of all earners as there are executives from nonfinancial companies.

Mr. Rauh said 'it's hard to escape the notion' that the rising share of income going to the very richest is, in part, 'a Wall Street, financial industry-based story.' The study shows that the highest-earning hedge-fund manager earned double in 2005 what the top earner made in 2003, and the top 25 hedge-fund managers earned more in 2004 than the chief executives of all the companies in the Standard & Poor's 500-stock index, combined." (According to Ip, "IRS data show that the median tax filer's income - half earn less than the median, half earn more - fell 2% between 2000 and 2005 when adjusted for inflation, to US$30,881.")

Because of this "embarrassment of riches" in the financial sector while the middle class and the workers struggle, one can safely assume that the US government and Wall Street will have the tendency to paint the economic picture for the average American household in a favourable light.

Following the August 16 low, the recent rally in equities led to new highs in several indexes and individual stocks. The S&P 500 is, as of this writing, up 10% year-to-day, but in Euros it is up just 2.44%. From the August low the S&P 500 is up 11% and 5.9% in Euros. However, it is down in Euro terms by 4% from its June high (high in Euros was in June). Gold has appreciated by 21% since the beginning of the year, and by 14.7% since the August 16 low. (Since the beginning of 2001, gold is up by 194%).

Money has three principal functions. It is a convenient "medium of exchange", "a unit of account", and a "store of value". The "store of value" function requires that money can be reliably saved, stored, and retrieved, and that it is predictably useful when it is retrieved (purchasing power should have been maintained). As a "unit of account", money is a standard unit of measurement for the market value of goods, services, and assets. It is also a measure or a standard of relative value and deferred payment, which is necessary for the formulation of commercial agreements involving debt.

In last month's report I described the hyperinflation in Zimbabwe and how the Zimbabwe dollar had entirely lost its "store of value" function and had also become largely useless as a "unit of account". I might add that in all the hyperinflation economies I have looked at, sooner or later goods, services, and assets were valued in a strong foreign currency or in gold. Has the time now come where we should consider gradually presenting US economic statistics such as GDP, and assets such as bonds, stocks, and real estate, in a strong currency such as the Euro or in gold? This would bring to light a totally different economic performance of the United States, and of its asset markets, since the expansion began back in November 2001. In both Euro and gold terms, the economy wouldn't have expanded, but contracted. Bonds and cash, as well as most equities (but not resource, material, and oil stocks), would have provided a negative return.

I am fully aware that my economist friends will shake their heads at this heretic thought and doubt my sanity. They will argue that employment is up since the expansion began, and that this is a good indicator of an economic expansion. To this I shall respond, "Yes, employment is up, but far less so than in previous expansions since the Second World War". Moreover, I shall also point out what kind of employment is up. For September 2007, healthcare employment is up year-on-year by 494,300, to a record high of 15.4 million. Restaurants and hotel employment rose year-on-year by 367,000, to a record of 11.6 million. Professional and business service payrolls added year-on-year 314,000 jobs, to a record of 17.9 million. Retail employment fell moderately to 15.3 million.

Manufacturing employment continued to slide to 13.9 million (year-on-year, manufacturing has lost 223,000 jobs). In construction, residential specialty trade, contractors cut 15,000 jobs in September and more than 160,000 since February 2006. Moreover, as Bill King reported, the Bureau of Labor Statistics announced that the next benchmark revision will show that March 2007 payrolls were overstated by roughly 297,000 jobs.

King: "Please take a minute and think about the absurdity of suddenly producing better than expected NFP [non-farm payroll] growth with upward revisions of the past few months and at the same time admitting that prior NPF growth was overstated by 297,000!!!!" King then quotes John Williams, who believes that "these data from the BLS are nearly worthless as economic indicators and are highly suspect, given the global financial markets in ongoing crisis and given the positive ratings of US President and Congress hitting historic nadirs. The reported numbers continue to run counter to better quality employment indicators such as new claims for unemployment and the collapsing help-wanted advertising index."

I find the BLS data more useful than John Williams, for the simple reason that they reveal what kind of a consumer-oriented economy the United States really is. Sure there are numerous productive jobs among the healthcare, retail, hospitality, and business service payrolls, but the majority is geared towards consumption, which raises another  question about the economic growth of the United States. Is consumption equivalent to economic growth, or rather, is a consuming economy contracting?

Part II coming tomorrow...

Dr. Marc Faber
for The Daily Reckoning Australia

Editor’s note: Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report and author of Tomorrow’s Gold, one of the best investment books on the market.  Headquartered in Hong Kong for 20 years and now based in northern Thailand, Dr. Faber has long specialized in Asian markets and advised major clients seeking bargains with hidden value, unknown to the average investing public.

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Comparing the current global economic expansion, which began in the US in November 2001, with previous economic expansions, it seems to me that the "real economy" isn't showing any signs of the overheating that, in the past, led to aggressive central bank monetary tightening. So, I am, like my strategist friend with the bearish trait, also impressed by the prospects for the global economy. However, I am increasingly concerned about the inflated asset markets around the world, and about the almost unanimous belief that nothing will ever come between the "Goldilocks" economic conditions and the Fed, in conjunction with the US Treasury standing ready to support markets should they decline meaningfully and disturb the current heavenly asset market conditions.

Let us examine the differences between the "real economy" and the "asset inflation economy" more closely. The real economy is typical of people's daily lives, their income, and their spending. If there is a boom in the real economy, wages and prices will tend to increase and the increased demand will be met by corporations' increased capital spending. The overheated economy eventually brings about a slowdown or a recession, because money becomes tight irrespective of the central bank's monetary policies. The recession then cleans up the system and allows the next expansion to get under way. Put very simplistically, this is the typical business cycle.

In the asset inflation economy, we are dealing with a totally different phenomenon. The higher the asset markets move, the more the increased asset prices can create liquidity. Let us assume an investor owns a real estate or stock portfolio worth 100 and that his borrowings are 50. For whatever reason (usually easy monetary conditions), the value of the portfolio now doubles to 200. Obviously, this allows the investor, if he wants to maintain his leverage at 50% of the asset value, to double his borrowings to 100. With the additional 50 in buying power, the investor can then either spend the money for consumption (as the US consumer has done in the last few years) or acquire more assets.

If he acquires more assets, the investor will drive the asset markets - ceteris paribus - even higher, which will allow him to increase his borrowings further. Now, I am aware of some economists who will dispute the fact that rising asset markets create liquidity. They argue that the seller of a portfolio or real estate or stocks at an inflated price will have to be met by a buyer at the inflated price. So, the increased liquidity of the seller is offset by a diminished liquidity of the buyer. However, the situation isn't quite that simple. Let us assume we are dealing with the market for Van Gogh's paintings, and let's assume that with the exception of just three works, Van Gogh's paintings are all in the hands of museums, foundations, or dedicated art lovers who wouldn't consider selling them except under the most unusual circumstances. Now enter the Russian oligarch who wishes to acquire a Van Gogh at any price. He might pay double the previous price paid for a Van Gogh, for one of the three paintings still available on the market. As a result of this one buyer, every Van Gogh work will now need to be revalued, and, in theory, all the owners of Van Gogh paintings could now increase their borrowings against the value of those works.

Two works by Van Gogh now remain on the market, one of which a hedge fund manager and an oil sheik from the Middle East both wish to acquire. In a bidding war, they push the price of that painting up another 100% above the previously paid price. Again, all of Van Gogh's works will need to be revalued and their owners can increase their borrowings against them. In other words, the buyers on the margin can move asset markets sharply higher in the absence of ready sellers and thus increase, through the additional borrowing power of the works' present owners, the overall liquidity in the system.

Under normal circumstances, the increased borrowings by the present owners would drive up interest rates. However, in a world of rapidly expanding money supply, this may not be the case. Moreover, which owner of a Van Gogh wouldn't mind paying 6% instead of 4.5% interest on his loans if Van Gogh's paintings were appreciating by 30%, or even 100%, per annum? (This is one reason why the Fed doesn't believe it can control spiralling asset prices with monetary policies.) In the real world, we are not dealing with just one Van Gogh market, but with many asset markets, but the point is that the marginal buyers set the price for assets. It should also be clear that not every owner of a Van Gogh will use his borrowing power and leverage his works of art or other assets.

But if an asset bull market has been in existence for a while, more and more investors will become convinced that the up-trend in asset prices will never end and, therefore, they will increasingly use leverage to maximize their gains. But not only that: lenders will also become convinced that asset prices will rise in perpetuity at a higher rate than the lending rate, and they will therefore relax their lending standards. This certainly seems to have occurred in the sub-prime lending industry.

There is one more point to consider. Liquidity isn't evenly distributed. Let's say that on an island there are two tribes. Ninety-nine percent of the population are the "Bushes" and 1% are the "Smartos". The two tribes arrived on the island at about the same time and had little capital at the time. So, initially, both tribes worked very hard in industry and in commerce to acquire wealth. But because of the Smartos' superior education and skills, their frugality, and also partly because of their greed and immorality, they soon acquired significantly more wealth than the Bushes, who, for the most part, were likeable but quite inept. After 50 years, most of the island's businesses were therefore in the hands of the Smartos, who make up just 1% of the population. Being clever, the Smartos generously gave some of their wealth to the tribal leaders of the Bushes, who controlled the entire government apparatus, the military establishment, and much of the land.

For a while this system functioned perfectly well. Among the Bushes there were also some smart people, and they were encouraged to accumulate wealth as well. However, they had to pay an increasingly high price to acquire assets, since most of the island's assets were owned by the Smartos and by the elite of the Bushes who, because of their wealth, never really had to sell any assets. Cracks in the system began to appear because more and more of the wealth began to be increasingly concentrated in fewer and fewer hands. (According to the Financial Times, the concentration of wealth is extremely high in the United States, with 10% of the population currently holding 70% of the country's wealth, compared to 61% in France, 56% in the UK, 44% in Germany, and 39% in Japan.)

However, the Smartos then stumbled upon another avenue to wealth: globalization. The island was opened to foreign trade and investments, which allowed the business owners to shift their production to low-cost foreign countries and, at the same time, to keep the masses among the Bush tribe happy through the imports of price-deflating consumer goods. In the same way that, in the 18th and 19th centuries, the European settlers of America had exchanged with the Indians worthless beads and booze for land, now the Smartos and the elite of the Bushes exchanged cheap imported goods, whose supply they controlled and from which they earned handsome margins, for assets. As a result, the majority of the population of the Bushes experienced a relative wealth decline compared to the wealth of the Smartos.

Again, this worked perfectly well for a while: the populace was happy to buy deflating consumer goods (like Mr. Faber's wife who, whenever a favorite shoe store holds a sale, immediately buys three pairs instead of one), but it overlooked the fact that its wages and salaries were decreasing in real terms because manufacturing jobs and tradable services were increasingly shifting overseas. For some time this wasn't a problem, because the Smartos had bought the island's central bank.

They made sure that sufficient money was made available to the system to sustain the consumption binge, which was largely driven by inflating asset prices. Plenty of liquidity and rising asset prices created among the Bushes the "illusion of wealth". Naturally, the island's trade and current account deficit began to worsen as it consumed significantly more than it produced, but initially that wasn't a problem, for the Smartos had encouraged the Bushes to engage - in the name of all kinds of good, just, and well-meant causes, and without any self-interest whatsoever - in overseas military expeditions, which led foreign creditors to believe in the island's economic and military might, and social stability.

For a time, they were, therefore, perfectly happy to finance the island's growing current account deficits. At the same time, the increase in defense spending shifted wealth from the masses to the elite of the Bushes, who largely controlled the military hardware and procurement industries. As a result, wealth and income inequity widened further as the masses became largely illiquid and had difficulty in maintaining their elevated consumption, while the Smartos and the elite of the Bushes accumulated an ever-increasing share of the national wealth. But never at a loss when it came to creating additional wealth, the Smartos devised another scheme to enrich themselves even further: lending to illiquid households (read sub-prime lending). Not that the Smartos would have lent their own money to these uncreditworthy individuals (they were far too clever for that); for a fat fee, they arranged and encouraged this novel type of financing. Credit card, consumer, and mortgage debts were all securitized and sold to pension funds and asset management companies whose beneficiaries were the majority of Bushes, who accounted, as indicated above, for 99% of the population.

In addition, these securitized products were sold to some credulous foreign investors. By doing so, the Smartos achieved three objectives. They earned large fees, and unloaded the risks indirectly on to the very people who borrowed the money, and on to foreigners. But most importantly, they provided the Bush tribe with a powerful incentive to support their expansionary monetary policies, which ensured continuous asset inflation. After all, any breakdown in the value of assets would have hurt the Bushes the most, since they carried most of the risks by having purchased all the securitized lower-quality financial instruments. But not only that! The Smartos knew that as asset prices increased, their prospective returns would diminish.

But this wasn't an immediate problem, as they promoted increased leverage to boost returns to the investors and at the same time their own fees. This strategy worked, of course, for as long as asset prices appreciated more than the interest that needed to be paid on the loans. On first sight, the debt- and, consequently, asset inflation-driven society of the island seems to work ad infinitum. But in the real world this isn't the case. Sooner or later, the system becomes totally unbalanced and entirely dependent on further asset inflation to sustain the imbalances. It is at that point that even a minor event can act as a catalyst to bring down asset prices and produce either "total", or at least "relative", illiquidity in the system, because a large number of assets whose value has declined no longer cover the loans against which they were acquired. "Total illiquidity" occurs when the central bank, faced with declining asset prices, doesn't take extraordinary measures to support asset prices. "Relative illiquidity" follows when the central bank implements, in concert with the Treasury, extraordinary monetary and fiscal policies (cutting short-term interest rates to zero, and the aggressive purchase of bonds and stocks) in a desperate effort to support asset prices. In both cases, a degree of illiquidity occurs and depresses asset prices, but in different ways. In the case of "total illiquidity" (1929-1932 and Japan in the 1990s), asset prices tumble across the board in nominal and real terms with the exception of the highest-quality bonds and, possibly, precious metals (flight to safety). In the case of the island's central bank taking extraordinary monetary measures, asset prices don't necessarily decline in nominal terms, and in fact can even continue to appreciate.

However, they collapse in real terms, and against foreign currencies and precious metals. How so? Above, we have seen that the island's asset inflation led to excessive consumption and to growing trade and current account deficits because the Smartos and the elite of the Bushes were quick to understand that much larger capital gains could be obtained by playing the asset inflation game and by manufacturing overseas, than by investing in new production facilities and producing goods on the island. The growing trade and current account deficits of the island were not immediately a problem, because they were offset by external surpluses in other parts of the world, which were frequently and erroneously labeled as "surplus savings" or a "savings glut". But whatever one wishes to call these surpluses or reserves, it is interesting to note that where they accumulated (mostly in China, Japan, Taiwan, Singapore, and Switzerland), they led to an interest rate structure that was lower than on the island. For the Smartos, this was an extremely fortuitous condition. For one, it was easy to convince the recipients and holders of these rapidly accumulating reserves to invest them in higher yielding assets on the island. In addition, it was for a while extremely profitable to borrow in low-yielding foreign currencies and to invest in relatively high-yielding assets on the island.

Obviously, this all changed when asset prices began to decline and the island's central bank had to take extraordinary measures by aggressively cutting short-term interest rates and supporting asset markets through bond and stock purchases. The interest rate cuts immediately narrowed the spread between the interest rate on the island and foreign currencies and led to a run on the island's currency, not only by foreigners but also by the Smartos, who had known all along that the asset inflation game would one day come to a bitter end. The deleveraging of this carry trade led to "relative illiquidity", which the island's central bank had to offset with even more liquidity injections, which while stabilizing asset prices led to even greater loss of confidence in the soundness of the island's currency, and in its bond market, which by then was mostly owned by foreign creditors.

As Mao Tse Tung had observed much earlier, there was by then "great disorder", but the situation was "excellent" for the Smartos. On the short end, interest rates had been cut so much that they were in no position to compensate for the continuous depreciation of the island's currency. So, the Smartos and the Bush tribe's elite began increasingly to borrow in the island's currency and to invest in foreign assets and precious metals. In fact, the island's central bank, by its market-supporting interventions, encouraged this process. Stocks and bonds were dumped on to the central bank and the Treasury's plunge protection team at still high prices, and the proceeds were immediately transferred to foreign assets and precious metals, which appreciated at an increasing speed compared to the island's assets, which suffered from the continuous depreciation of the currency.

And in order to facilitate this trade, the Smartos, who controlled both the Fed and the Treasury, continued to make positive comments about "a strong currency being in the best interest of the island". Sure, it would have been in the best interest of the island to have a strong currency, but it was certainly not in the best interest of the Smartos, who had devised their last grand plan: shift assets overseas and into precious metals, let the currency of the island collapse, and then repatriate the funds and buy up the remaining assets of the Bush tribe's middle and lower classes at bargain prices since they had never understood that their currency had collapsed against foreign currencies and against gold.

Regards,

Dr. Marc Faber
for The Daily Reckoning Australia

Editor's note: Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report and author of Tomorrow's Gold, one of the best investment books on the market.

Headquartered in Hong Kong for 20 years and now based in northern Thailand, Dr. Faber has long specialized in Asian markets and advised major clients seeking bargains with hidden value, unknown to the average investing public.

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