Roach was what I call a realist, but he was more commonly labelled a bear, a pessimist, and a crank. When the market was soaring to new highs, Roach spoke about his professional ostracism, where so-called colleagues would pass him by, their heads lowered in embarrassment...for him, not themselves, in being so stupidly bearish.

Perhaps for the stress that this treatment brought about, Roach slightly wavered in his conviction and become more sanguine about the global economy he had for years rightly poo-poohed. This was just before credit markets began to seize up.

But he hasn't turned to the sunny side, in all its unthinking radiance, just yet. Roach began a recent column for the Financial Times with, "Hope always seems to spring eternal in liquidity-driven financial markets. That is very much the case today in the aftermath of the biggest liquidity injection in modern history."

Hope is indeed springing eternal, and it is again unfashionable to be pessimistic. Brokers, analysts, and investment bankers are doing a roaring trade in peddling hope over reality, and it pays very well.

Such behaviour is a product of ignorance and, more importantly, the massively conflicted financial services industry. That industry has developed and grown throughout a 25 year bull market. It is an industry plagued by overcapacity, groupthink, and incurable optimism. It is hopelessly ill-equipped to deal with the prolonged bear market we are now entering into.

That may sound like a dumb statement considering the ASX has bounced by more than 50% from its March lows and the S&P500 has surged by around 60%. But bear market rallies tend to be very convincing, and this one appears to be convincing just about everyone. Global central bank induced liquidity is driving this rally, along with huge fiscal stimulus. The fundamentals remain terrible.

As Roach says in his FT commentary, the policy responses have done nothing to correct the global imbalances that caused the crisis in the first place. He writes that, "US authorities cannot resist opting for another dose of excess consumption - despite the fact that the consumption share of real gross domestic product remains at a record high of 71 per cent.

"Nor can the Chinese wean themselves off investment-led growth - even though the fixed investment share of their GDP appears to have surged beyond the already unprecedented reading of 45% in mid-2009. Far from rebalancing, an unbalanced world once again appears to be compounding existing imbalances."

Why let sober reality get in the way of a good market rally? Instead of cautioning their clients to take money off the table as the market has surged from undervalued to overvalued, most market cheerleaders have become more delirious. The reasons to be bullish? The market has bottomed (for good, apparently) and there is still a huge amount of cash on the sidelines waiting to enter the great game (without needing substitution) the recession is over, and people are more confident.

There's a term for such behaviour and it's called "making hay while the sun shines." The clouds have indeed broken over the past six months and the sun is shining through. The finance industry sees an opportunity...get that cash off the sidelines, put it to 'work' and clip the ticket on the way through. All is normal again.

But is it? Normal for whom? For the industry, or for the people the industry is meant to serve. I have a number of questions I'd like to ask the optimists.

What does cash on the sidelines mean? If you're referring to money market instruments, like bank bills, short term commercial paper and short term government debt, why are these interest rates not rising around the world, signifying the flight from 'cash' to higher risk equities? Could it be that freshly minted central bank stimulus is flowing into risk assets, while the 'cash on the sidelines' is displaying more inertia that initially thought?

I would also ask the optimists what has changed in the global economy over the past year to make them so...optimistic. How does a huge increase in government debt do anything but provide a short term boost, masking long term structural problems? How can more debt solve problems caused by too much debt? How do they expect ultra low interest rates - which encourage consumption and discourage saving - to correct the imbalances?

I'm guessing the answers would have something to do with faith in governments and policy makers to get us out of this mess. The fact that they didn't see the mess coming doesn't seem to register.

Roach's analysis is far more realistic. He writes that, "This [government attempts to 'fix' things] is the same dubious script the world followed in the aftermath of the bursting of the equity bubble in the early part of this decade. And look how that ended. With far more excess liquidity currently sloshing over into asset markets, there is great temptation to erase the memories of the Great Crisis. Therein lies a pitfall for the markets - as well as for a still unbalanced post-crisis world.

After a 50% fall on the ASX, which occurred from the 2007 peak to the low back in March, many market pundits were 'cautiously optimistic', the correct call given the significant amount of value opportunities. Now, after a 50% rise from the March low, and the absence of any attractively priced companies, the correct call is to be cautiously pessimistic.

Greg Canavan
for The Daily Reckoning Australia

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Commonwealth Bank reported its full-year results to the ASX earlier this morning. The highlight (or lowlight) was that second-half profit fell by 16% to $4.72 billion compared to the previous six-month period. This happened despite a 19% surge in home lending to $257 billion and a smaller 6% growth in business loans to $135 billion.

Does it look like the bank is doubling down its bet on Aussie houses?

For the full year, if you exclude the $612 million after-tax profit on the acquisition of BankWest, CBA's net profit after tax was down 9%. Cash earnings fell by 7%. CBA also took a $2.94 billion impairment charge for bad loans. It took a loss on notes in failed day-care provider ABC Learning Centres and noted, "Home loan arrears over 90 days and personal lending arrears have increased on the prior year with deterioration in the second half."

Trade the banks if you'd like. In fact, that's what Gabriel says you ought to do - trade the trends. But buying and holding may be a bad strategy if bank earnings and cash flows remain so unpredictable. And we reckon they WILL remain unpredictable.

If we're right, households have just begun reducing their debt loads. It will take years for the leverage in the system to be wound down. If you're buying bank stocks you're assuming credit and debt growth will resume once this recession is over. That's a big assumption. And probably stupid.

By the way, CBA also said - presumably because cash earnings are down - that it's cutting its second half dividend by 25% to $1.15 per share. That puts the full-year dividend at $2.28 per share.

It's not shabby. But remember, you still have your capital at risk. And as Kris Sayce has shown in his debut issue of the Australian Wealth Gameplan, there are other businesses in Australia with strong and regular cash flows that also pay you regular dividend income - arguably with a lot less risk to your capital.

In case you think we're just bashing Aussie banks, we'd suggest that the profit outlook for U.S. banks sucks too. U.S. stocks fell overnight. One big reason why is that JP Morgan came out with a shiny new report that said losses at bond insurer MBIA may wipe out capital at the firm. MBIA's shares fell by 13%.

Wait! Haven't we seen this film before? Is it possible that the recovery in earnings everyone used to justify the recent rally was really just a bunch of second quarter cost cutting, and NOT a fundamental improvement in business conditions? Is it possible, as John Hussman suggests below, that the fundamentals that supported the previous bubble have vanished, making it more likely that corporate cash flows are headed lower for years to come?

Hold that thought. One of the factors that led to an increase in second quarter earnings was cost cutting. And officially, cost cutting - when it entails firing people - improves productivity. It does not, however, increase wealth.

There are two kinds of productivity. The first kind is where you produce more because you have new skills and you can do your job faster and better than before and produce something better. Your personal output rises and the aggregate output of the economy rises. That's the good kind of productivity. Everyone wins.

The other kind of productivity is where you end up doing the job of three people because two others have been fired. That is the bad kind of productivity. Your output rises. But your increased work load doesn't mean the economy is using resources more efficiently or producing more goods and services per person. You are also probably at least three times more miserable, stressed, and unhappy...having more than three martini lunches or whiskey breakfasts.

So what do you make of the fact that U.S. productivity grew by 6.4% in the second quarter according to the Bureau of Labour Statistics? It was definitely the second kind of productivity growth. Second quarter output actually fell by 1.7% according to the BLS. But total hours worked fell by 7.6%, raising the output per worker by the most since 2003.

Alan Greenspan started yammering about productivity growth in 2003, when it looked like the U.S had leveraged the tech boom into a huge structural increase in productivity. The argument at the time was that computers and modern telecommunications had led to a huge surge in productivity.

The jury is still out on that. There are some industries that would simply not exist (or exist at the same level) without computers and the Internet (ours being one of them). But whether or not modern technology has made people more or less productive is an open question. Does Facebook make people more productive? Does Twitter?

It also depends on what kind of output you're talking about. If by productive you mean, "make more stuff" or you mean "generate more work." Information technology has generated huge volumes of work - information, trading, transactions - in the financial sector. But is the economy any wealthier for it? Has the capital stock of the nation increased?

Say's Law says that supply creates its own demand. What Jean Baptiste meant by that is that you create your own purchasing power and future demand by producing goods that you can sell. Those goods generate your income and that income becomes the source of your consumption. But in that old-fashioned way of thinking about things, all economic prosperity comes from producing things of value and selling them.

We live in the dying days of an era where people think wealth comes from consumption. Why else would the government encourage consumption without production via cash hand outs? It reckons this money will stimulate production by stimulating demand. But demand comes from people having money to spend to begin with. And they can only do this if the economy and the job market are geared toward producing wealth, not spending it.

Speaking of producing wealth, Chinese firms have been busy this week chasing Aussie real assets. State-controlled Yanzhou Coal has made a $3.5 billion bid for Felix Resources (ASX:FLX). This would be China's biggest Aussie acquisition to date. It values Felix at $18 per share, which is about 10% above the closing price before Felix went into a trading halt on the announcement.

And in today's Age, Barry Fitzgerald reports that Hebei Mining - the State-owned mining company of China's Hebei province - has taken a 14.9% stake in unlisted Western Australia uranium explorer Raisama. Raisama issued Hebei 4.5 million new shares and sold it 2.5 million existing shares at 25 cents a piece.

Raisama also said that, "''The Hebei provincial Government currently has plans to build at least three nuclear reactors and is selectively securing strategic interests in uranium exploration companies internationally that it believes have the best potential to meet the province's growing need for uranium."

Despite (or because of) all the controversy over the arrest of and bribery charges leveled at Rio Tinto iron ore executives in China, Chinese firms are still busy buying Aussie resource real estate. This is happening for a couple of reasons. China has heaps of U.S. dollars it gained in trade that it would like to get rid of before America inflates the value of them away. China also has long-term resource needs.

But since we've covered both those subjects before, let's address a different part of this equation: the valuation. Is China paying too much, too little, or just enough for its stake in Aussie resource firms?

Not all assets are created equal, we mentioned yesterday. For example, Commonwealth Bank's chief assets are its loans to customers and its deposits. But the deposits are callable by customers and the loans are only worth what they're worth if people can pay them back.

With resource companies, the main asset on the balance sheet is a mine, an ore body, or a lease or a permit to drill and/or explore a prospect. Sure, mining companies are capital intensive and this capital equipment shows up (in depreciating fashion) on the balance sheet, along with cash.

But the chief asset of any resource company is the resource it hopes to produce. Just what that asset is worth depends on a number of factors. One big factor is the quality and quantity of the resource. You want to know whether it's a reserve - a clearly defined asset with reasonable projections about how much can be produced economically, given today's commodity prices - or a resource (a less defined estimate of how much of a given commodity might be underground).

Other factors are the capital spending required to produce the asset (including mine constructing and ore processing, in some cases) and the operating expenditure. For example open pit mines are cheaper to build and operate than underground mines, and projects far away from infrastructure (rail, port, roads) have much higher operating costs. Labour and raw materials are also variable costs that tend to rise in a commodity boom, as we all found out in 2007.

The great variable in all this is the price of the underlying commodity itself. That changes based on both supply (other producers) and demand (economic growth, or the variables that drive individual commodity prices, including investment demand and speculation). In the traditional commodity cycle, high prices attract more producers and low prices drive out all but the lowest-cost producers with the lowest cost ore bodies.

Judging by this week's activity, Chinese firms are happy to take a stake in existing producers with clearly defined reserves and resources. But they're also happy to pony up the capital and fund explorers who have big hopes but no production and no clearly defined asset. So what does that tell you?

Maybe China is speculating on real assets the way Australians speculate on house prices and Americans speculate on stock prices. And what does THAT tell you?

For now, it tells us that Aussie assets - both equities and real assets in the ground - are in demand. Frankly it's all sounding bullish isn't it? Will Chinese demand for Australian resources diminish if the People's Bank of China tightens monetary policy to prevent bubbles in property and the share market? More on that subject tomorrow, including the dreaded Fibonacci retracement on the S&P 500.

Dan Denning
for The Daily Reckoning Australia

• Wesfarmers (ASX:WES) Increases Revenues But Not Earnings With Coles
• Banks or BHP?
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• Oil Was Down and the Banks Were Up

But you can chuck all that out the door because stocks are rising, right?! Well, not really. If the equity premium does revert to the mean, it will have major ramifications for your wealth game plan. But in the short term, it may not seem like it.

After all, Aussie stocks ARE trading near eight-month highs. Nothing in Friday's trading activity on the ASX reversed that trend. And as the week begins we read that investors are now pricing global stocks for a 2010 earnings recovery. Confidence about earnings and cash flows is on the rise.

For example, shares in James Hardie were up big in Sydney on Friday on news that U.S. existing home sales were up 3.8%. Houses prices in the States are still down 15.4% in the last year. The average existing home sells for around $181,000-which looks downright affordable by Aussie standards.

Not that the Hardie examples makes a lot of sense. That is, Hardie is the biggest seller of home siding in the U.S. How do existing home sales help its business? They probably don't, at least not directly. As the statisticians say, correlation is not causation.

But even though rising existing home sales might not directly benefit Hardie, a recovery in the U.S. housing market would. That's one way of explaining Friday's performance. And obviously, since the March lows, there's a palpable sense that the worst of the financial crisis is over and that the lingering recession should evaporate later this year.

We'll see about all that. We're sticking to our call that in a Credit Depression, corporate cash flows will revert to the mean and the equity premium will be replaced with a "tangible asset premium." Of course if we're wrong about the Credit Depression and the entire global economy reflates and bank lending resumes at pre-bust levels, well then everything will be fine.

Whatever happens, you can bet shares are going to remain volatile. The key element to volatility is uncertainty. And there's plenty of that going around, especially when you're talking commodity prices.

Take fertilizer and herbicide stocks. Companies like Mosaic, Agrium, and Potash Corp. have all seen falling stock prices. Falling demand for fertiliser and falling prices took an axe to the income statement in the last year. But now these companies-given the long-term bullish case for food-must look pretty attractive as acquisition targets. Buy depressed earnings before commodity price recovery!

That must be what Sinochem is thinking. As we reported to Diggers and Drillers readers last week, Aussie ag stock Nufarm told the ASX that it's in preliminary takeover talks with China's Sinochem Corporation. Sinochem is China's largest chemicals company.

You know that earnings will recover at Nufarm. They'll recover because chemicals prices are going to bounce, and their long-term trend-we believe-is up (given how many mouths to feed there are on the planet). This isn't the first time the Chinese have come knocking on Nufarm's door by the way.

What's that? Did someone say tangible asset premium?

Dan Denning
for The Daily Reckoning Australia

• The Cash Flows Are Coming
• More Money in Cash Right Now Than Equity in U.S. Companies
• Purpose of Funds Management Industry IS to Put People into Common Stocks
• The Iron Ore Pricing War Between China & Australia
• The Profits Depression

It's probably not fair to leave common stocks out of the question. After all, the ASX is on a 5-day winning streak and some analysts are now confident enough to say the bear is dead. No one is exactly predicting a return to the boom-time years of 2003 and 2008. But with oil up, gold up, shares up, property up, commodities up, and bonds up, it does feel a bit like 2003, when everything inflated thanks to low interest rates across the globe.

The Australian share market news is dominated by production figures this week. Back-from-the dead Oz Minerals reported that productionfrom its gold and copper mine at Prominent Hill will meet guidance. Last week Rio Tinto reported an 8% increase in iron ore production, but weaker production for aluminium, alumina, and bauxite.

We'll get to the sector that really interests - energy - in just a moment. But to amplify a point made yesterday - keep in mind that the rally in Aussie resource stocks may be fuelled by a lending bubble in China that's going to pop. That means resource demand and underlying commodity prices may be a lot more volatile in the years ahead, as Chinese regulators struggle with the conflicting goals of full employment and containing inflationary bubbles.

"(We) must control the risk of real estate loans," said Liu Mingkang, the head of the China Banking Regulatory Commission, according to CNBC. He says Chinese banks must take better measures to evaluate the creditworthiness of borrowers. Liu said, "In the first half of the year, our country's banking loans expanded rapidly and helped play an important role in stabilizing the economy, but the loans growth has led to accumulated risks also increasing."

A real estate bubble in China would undoubtedly lead to inflated demand for construction materials in the commercial and residential real estate sector. But let's assume the China lending bubble doesn't pop this week. And let's assume the value of Aussie shares is driven by underlying demand from China that IS sustainable and super cyclical. On that basis, what' worth a look right now in the share market? How about energy.

For starters, there's today's news that Energy Resources Australia has reported unaudited profits that are triple what it expected. The $120 million half-year profit comes from much higher than expected uranium oxide productions and a 27% increase in uranium prices since the March low of around US$40.

The uranium spot price is coming off a low after a big correction. But as we've covered in Diggers and Drillers, the demand for nuclear fuel from global utilities is on the rise. Australia - with over 30% of the world's proven uranium reserves - is in the pole position (side by side with Kazakhstan, arguably) to provide the world with what it needs.

That will only happen if the uranium mining industry really takes off. And maybe that's starting to happen. Last week Federal Environment minister Peter Garrett approved what will become Australia's fourth major uranium mine at Four Mile in South Australia. Four Mile is located about 550km north of Adelaide. It's owned 75% by U.S.-based Heathgate and 25% by locally listed Alliance Resources (which zoomed up on, and even slightly before, the approval was announced).

"Production is set to begin early next year at what will be the world's 10th-largest uranium mine," according to Barry Fitzgerald in the Sydney Morning Herald. "Its predicted annual haul of 1400 tonnes would be worth about $260 million at current contract prices and will increase annual production of the radioactive material in Australia by 14 per cent to 11,400 tonnes."

And there could be more on the way. "Queensland mining 'inevitable'," leads a story by Paul Robinson over at the ABC today." "Just as there's going to be uranium mining on an increasing basis in Western Australia, South Australia and the Northern Territory, we'll see uranium mining in Queensland in due course," says Federal Resources Minister Martin Ferguson.

"Mr Ferguson has told a Resources Conference in central Queensland, uranium mining is no different to developing coal or liquefied natural gas. 'It's about supplying the energy needs of other countries...We are energy rich, we do not need nuclear power, our responsibility is to mine uranium with safe hands and to guarantee that our uranium is used by countries that are only prepared to guarantee that it is used with safe hands."

We're not sure why Australia couldn't benefit from nuclear power too. But the Minister is right that between coal, LNG, and uranium, Australia presents investors with a great portfolio of energy choices. And that's not including traditional oil and gas explorers and producers.

Two more points about energy. First, the trading in shares is going to be volatile. That makes buying and holding a nerve-wracking strategy. The global economy is in transition. And with China and America wrestling over the bigger contribution to global growth - and overall resource demand - there's going to be a lot of unpredictability to both resource prices and demand. The shares will see saw.

That means investors may have to look at more actively managing their positions in resource shares. This is not to suggest that we should all be market timers now. But you'll want to have a strategy for dealing with volatility that allows you to lock in gains on rising share prices, but also buffers you from these big periodic falls that we expect to get as markets - and indeed the whole global economy - make the transition to a new normal.

The second issue on energy is that it may replace bulk commodities like coal and iron ore as Australia's largest export industry. Here we're talking about conventional off-shore LNG production AND unconventional coal-seam-gas LNG production. The unconventional LNG industry is admittedly a much newer (and we'd argue, riskier) industry that iron ore production. But that's what makes it such an alluring investment opportunity.

If you want to know what the oil majors think of the industry, keep an eye on Santos this week. In yesterday's Australian Financial Review, Paul Garvey reports that Santos could be a few days away from offloading a bunch of undeveloped gas fields in the Bonaparte Basin. Those fields could fetch the company nearly $500 million, according to Garvey.

But if you're interested in the kind of transactions that might move the company's share price, it's Santos' 60% stake in the coal-seam-gas fed Gladstone project that may start to attract cashed-up takeover suitors. Garvey reports that, "A series of standstill agreements preventing third parties from launching hostile takeover bids for Santos will expire in August and September."

Santos has a 17.7% interest in Exxon-Mobil and Oil Search's Papua New Guinea LNG project. Garvey says that project, "would be attractive to many energy companies, given its status as the most advanced LNG project now on the relatively cluttered drawing board in the region."

It IS a cluttered drawing aboard. That means there are going to be a lot of losers and a few big winners. Between the more traditional LNG, oil, and gas firms we're looking at in Diggers and Drillers, and the unconventional players in the Queensland CSG market that Kris Sayce is active with at the Australian Small Cap Investigator, there are a lot of intriguing firms to choose from.

Hopefully we've got it right that energy shares are the best way to invest in energy as an asset class. Of course shares are still shares. But one of the reasons we like Australian energy shares so much is that energy itself has become a kind of global capital - gradually replacing the worthless fiat trash pumped out in increasing volumes by governments. More on government debt as an asset class tomorrow.

Dan Denning
for The Daily Reckoning Australia

• Uranium: A Carbon-friendly Substitute for Coal
• Energy Debate in Australia Needs to Get Serious
• Big-picture Case for Energy Stocks is Pretty Bullish
• Australian Iron Ore Shares on China’s Menu
• LNG – The Energy Play for 2009

According to the Australian Share Ownership Study by the ASX, overall share ownership among Australians dropped to 6.7 million in 2008, or just 41%. That was down from 46% ownership near the top of the market in 2006. According to Chris Zappone in The Age, "The study shows risk-wary investors saying they "they preferred blue-chip shares'' amid falling confidence in the overall market."

The public's love affair with stocks began in doubt in 1982, became mundane with mutual funds in the early 1990s, only to reignite into a torrid infatuation with tech stocks at the end of the century. Then, nearly two decades into the affair, it faced a serious crisis in the bear market that began in 2000.

Enter monetary therapist and love counsellor Alan Greenspan. The "Greenspan Put" was a kind of relationship-aiding stimulant for the partnership between the public and stocks. If stocks got too low, Greenspan lowered rates to pump them back up again. This kept everyone happy, Wall Street, the stock market, and the stock buying public.

But there is a psychological element to markets. How else can valuations go from being absurdly cheap to absurdly expensive? It's the public's taste for risk and adventure that changes in the interim. Emotions swing from love to hate and back to love again.

It looks to us like we're swinging back into the hate phase. Right now, though, it's grudging indifference. The public still buys stocks. But the love is gone. It's more out of habit, familiarity. And you know what familiarity breeds.

Before the bottom of this cycle is truly reached, people will hate stocks. They won't talk about them. And if they do, it will be with scorn. But how is this a good thing?

First a note from NAB's Cameron Clyne. Clyne predicted that Aussie banks will have rising debt levels that affect results over the "next couple" of years. It will be worse if unemployment rises, he says.

The deleveraging of the credit boom continues, according to Clyne, speaking on ABC Television. "We are now very much in the same phase of the downturn and we saw that particularly, I think, in most banks' results, with an up-tick in the March half (year) with bad and doubtful debts...We think that's going to be a feature in the next couple of halves...Obviously, consumer default really is a function of unemployment so if unemployment trends (up) ... then that's going to drive consumer default."

That's the bad news. The good news, perhaps, is that once the bad debt cycle begins to really bottom out-households and businesses having scaled back their debts and written down asset values-balance sheets are going to be a lot more transparent. Valuing blue chip businesses is going to be a lot easier. And profit performance should begin to improve (not any time soon mind you).

That means that after the storm blows down all the houses made of cards, whatever's left may have a pretty solid foundation to build on (if you'll excuse the cliché/metaphor). We've been working on this with Swarm Trader Gabriel Andre. Gabriel believes that using a combination of charting, technical analysis, and a handful of fundamental analysis, you should be able to identify long-term entry prices for blue chip stocks.

"But what if they're still going down," we asked?

"The charts will show this too. Often you find stocks trading in a range. Neither bullish nor bearish. But even this is useful. You know what levels they must break out of to begin a new move up, or what levels indicate a new bearish move down."

We'll keep you posted on Gabriel's work. By the way, he's a regular contributor to Money Morning, edited by Kris Sayce. You can sign up for that or read the latest posts at www.moneymorning.com.au

Dan Denning
for The Daily Reckoning Australia

• CRB Index Correction Likely to Go Further
• Discussing the Dreaded Fibonacci Retracement
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• Gold, the Aussie Dollar, the Greenback and You
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For starters, billionaire investor/guru/jovial-grandfatherly-figure Warren Buffett has said the American economy is a "shambles." Buffett told CNBC that the worst of the financial crisis peaked late last year (we're not so sure). But the economic crisis? That's still in full flight.

"I get figures on 70-odd businesses, a lot of them daily," said Buffett. "Everything that I see about the economy is that we've had no bounce. The financial system was really where the crisis was last September and October, and that's been surmounted and that's enormously important. But in terms of the economy coming back, it takes a while."

"A while," is not a precise unit of time. But Buffett is probably right. "There were a lot of excesses to be wrung out and that process is still underway and it looks to me like it will be underway for quite a while. In the (Berkshire Hathaway) annual report I said the economy would be in a shambles this year and probably well beyond. I'm afraid that's true."

Buffett remains optimistic that eventually we'll grow our way out of this recession. He said the same thing, by the way, after the U.S. debut of "I.O.U.S.A." But that was before the U.S. stacked on several trillion more in debt to "deal" with the financial crisis.

Speaking of "I.O.U.S.A," we're hoping to bring it to Melbourne in late July for its first official Australian screening. A plan is being made. You will be alerted to this plan once it's down. We're organising what we hope will be Australia's first real frank discussion about household debt, government borrowing, and the banking sector. No holds will be barred. Stay tuned.

One more comment from Buffett. "I don't worry about deflation at all," he said. We haven't seen the entire interview. But we are presuming that means he's more worried about inflation-unless he's worried about neither, which we suppose is possible. But Buffett did say he thought the stock market was attractive over the next ten years, compared to other alternatives.

If, by other alternatives, he means cash, then maybe he IS worried about inflation and thinks that stocks are a better asset class to own than cash during inflation. He certainly can't mean that government bonds are a better bet than stocks for inflation, can he?

Enough of trying to read Warren's mind. Let's take a quick look at what the Federal Open Market Committee said today regarding U.S. interest rates. Remember yesterday we said to watch for language which tipped the Fed's intentions regarding the bond market. It all begins with the bond vigilantes these days. So what did the Fed say?

It made clear low rates-at least the Fed's target rate-are here to stay. "The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

Whether the Fed can talk down or manipulate long-term rates into staying dormant is another matter. But it had more to say on the subject. "As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year."

The important part here is "as previously announced." This sounds a bit like, "I really mean it. I'll do it. I'm dead serious. Don't make me buy those mortgage bonds. I'll do it if I have to. Don't push me."

In other words, the Fed is merely repeating what it said it would do earlier. It did not announce a new policy or its intention to expand quantitative easing to keep bond yields down. We imagine it would not want to advertise its willingness to keep buying bonds. That might induce a lot of selling and have the perverse effect of pushing U.S. yields up and investors into other assets.

But just for good measure the Fed repeated itself one more time. "In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted."

So it's a waiting game now. The Fed hopes the economy recovers this year and that it can withdraw its massive liquidity measures before they leak through into the economy to cause inflation. So far, its credit facilities have not translated into an expansion in the money supply. That's what the bond market fears (which is also why ten-year Treasury yields were up on the day).

Here in Australia, yesterday's bleak global forecast by the World Bank was immediately countered by a ray of sunshine from the Organisation for Economic Cooperation and Development (OECD). The OECD says Australia's economy will only shrink by about 0.3% this year. That's less than any other economy in the OECD. It also says the economy will grow by 2.4% next year, more than any other OECD economy.

Just how it reached that conclusion we don't know. Will unemployment peak out this year? Will housing roar ahead? Are exports to China about to soar again? What will be the engine of the Aussie economy in this recovery? It probably won't be bank lending.

Today's Australian reports that, "The Commonwealth Bank has flagged a sharp decline in its business lending portfolio as the bank admitted there would be future increases in provision charges due to the slowing domestic economy. The bank's chief financial officer, David Craig, told an investors conference in Sydney yesterday the operating environment for the bank remained difficult, but the economy was well-placed compared with its global peers."

Commonwealth Bank said it had total impaired assets of $3.9 billion at the end of the March quarter. That was up $785 million in three months. But it said the rate of growth in asset impairment slowed down. Hmm. We'll have a think on that and get back to you tomorrow.

Dan Denning

for The Daily Reckoning Australia

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Oh wait. We forgot about the 'stress tests.' Remember that's the official government report of how the 19 largest U.S. banks would hold up under further loan losses or asset write downs. It's designed to give investor (and the banks) a transparent picture of how much capital the banks need to be unequivocally healthy.

Actually, it's not designed to do that at all. The 'stress tests' are a white-wash. There's no way the government would release a report to the market that said the banks were in horrible shape (insolvent) and needed billions more in capital to make up for billions of losses in residential and commercial real estate.

That means either the 'stress tests' were a bogus exercise in deception. Or, to the extent they uncovered anything legitimate, it will be leaked in the press and priced into the relevant banks shares before the tests ever hit the public. Besides, the 'stress test' began in 2007. The market's already told us what it thinks of the banks.

One more quick note on commercial real estate. Is it still 'the other shoe to drop' on the banks this year? Maybe it already dropped! The Guardian reports that, "Global sales of investment grade real estate plunged 73% to $47 million in the first quarter from a year ago, or just one-sixth of the level two years ago, according to real estate research firm Real Capital Analytics on Friday."

A 73% cliff dive is as good as a crash in our book. But that figure only refers to new sales. There is a lot of existing debt that has to be refinanced. "Making things worse," the Guardian adds, "the number of properties that need to refinance or need capital infusions is soaring. New reports of defaulted mortgages and failed commercial property companies surpassed $55 billion in the first quarter, bringing the total known distressed commercial properties to $153 billion."

This is one reason to remain suspicious of property and financial stocks this year. In fact, you can pretty much bank on the idea that these stocks will never lead the market again in the way did over the last five years. The sector that leads the market up in a credit boom never really fully recovers as the best-performing sector (think tech stocks).

One thing to watch for? The financial sector and state governments using the Federal wholesaled funding guarantee to trash the country's international credit rating. Macquarie Group used the Fed guarantee to raise $14 billion on international debt markets at the end of the financial year. The company has already set aside $200 million to pay the Feds for the use of the guarantee this year (think about that for a second, this government is 'selling' its credit rating for $200 million).

Macquarie is raising capital this way, "Mainly because Macquarie could actually save money on its deals because it did not have to rely on its lower (and therefore higher risk-rated) single "A" credit rating. Analysts have estimated Macquarie's benefit at $580 million for every $10 billion of new debt raised," reports Danny John in today's Age.

To be fair, Macquarie is also raising money from equity investors too. After announcing write downs that slashed its full year-profit in half, the company told the ASX it had sold $540 million in new equity to institutions. So here's the question...what is the bank loading up for?

By 'loading up' we mean that it's essentially re-arming itself to get back in the market...and do what? "Macquarie is already aiming to build a global stock-broking business centred on Asia, London and New York and to become significantly bigger in energy trading, specifically in oil and gas. It plans to buy new businesses and increase its existing operations with capital injections on the other side of its balance sheet."

Hmm, oil, energy, and Asia? That sounds like a strategy based on decoupling. Remember that? It was the idea that the credit crisis would hurt the U.S. and Europe but not so much the emerging market countries. But it depends on what you mean by 'hurt.'

Equity investors everywhere were 'hurt' in the last 18 months. Nowhere was safe. Nothing was decoupled. So now the question is which economies will recover first: the high-saving emerging markets with growing populations and rising incomes, or the highly-indebted industrial economies that are going even deeper into debt to bail out financial institutions (this is not a trick question.)

By the way, Western governments have been so fixated bailing out their banks they haven't noticed how Chinese banks and companies are providing critical capital to world-class mining projects. China picked up another valuable pebble when China Non-Ferrous Metal Mining Company picked up a controlling stake in the world's largest non-Chinese rare-earths producer for the paltry stake of $505 million on Friday. We'll have more on the sad strategic case of Lynas Corporation tomorrow and whether there is good news buried in the story of Aussie resource investors.

Is it fair to blame the government for leaving strategic assets hung out to dry? That's debatable, and the Treasurer still has to sign off on this deal. But obviously the government has other problems on its mind. On Friday, Treasurer Wayne Swan said government 'revenues' would be about $100 billion less than he expected with last May's budget.

What does all this lead to? We reckon the combined burden of Federal, State, and government-guaranteed bank borrowing is going to put a lot of pressure on the Aussie dollar and lead to higher interest rates. State governments are already under pressure. "Victoria may lose its prized triple-A credit rating as the State Government pushes the state deep into debt to fund new roads, railway lines, hospitals, schools and water projects, one of the big four banks has warned," today's Age reports.

The Wall Street Journal (and international investors) are on to the story too. The Journal reports that, "Australia's major states are all expected to post in the next six weeks a significant deterioration in their fiscal positions, strengthening expectations of a surge in state government bond issuance. A dramatic erosion in traditional revenues from land taxes and mining royalties will be a common theme for all states."

Dan Denning
for The Daily Reckoning Australia

• Economy Free to Recover?
• Bank Stress Test Not Stressful Enough
• Is the Macquarie Model Dead?
• Australia to Borrow as Much as $300 billion
• House Prices Down and Aussie Market Enters Second Wave of Rebound Rally

The Treasurer said that Prominent Hill-OZ's major copper and gold asset in South Australia-is too close to the Department of Defence's Woomera Testing Facility. It's about 160km away. Swan said, "The Woomera Prohibited Area weapons testing range makes a unique and sensitive contribution to Australia's national defence," and that, "It is not unusual for governments to restrict access to sensitive areas on national security grounds."

That means you China. Stay away, sort of. That is, Swan did not rule out an alternative bid for OZ that does not, presumably include Prominent Hill.

This is no laughing matter for OZ or its shareholders. The company has $1.3 billion in debt it must refinance by Tuesday. The $2.6 billion bid from Minmetals would have solved that problem. But now the question is whether OZ's bankers will give it more time, or pull the plug.

Part of this problem is of the company's own creation. As of August last year, it classified the $1.3 billion in debt as a "non-current liability," assuming, we presume, that it would be able to refinance that debt easily enough. That was obviously not the case. And now the clock is ticking.

But would the Treasurer make a decision on Friday night that would put the company in receivership by Tuesday? Is the government convinced that OZ is being run by the gang that couldn't shoot straight and is better off being cut up into parts and sold rather than delivered into Chinese hands whole?

Maybe we'll never know what the Treasurer is thinking. But it may not matter. The Australian Financial Review reports this morning that Minmetals revised its offer over the weekend. The offer excludes Prominent Hill but includes the Sepon gold mine in Laos and the high-cost but massive Century zinc mine in Queensland. More on this story tomorrow. OZ is currently in a trading halt.

The big G-20 meeting gets going later this week. Stocks in New York were down Friday but have enjoyed a pretty good month so far. Here in Australia, stocks are up 16.75% since the ASX/200 closed at 3,145 on March 6th. Does this rally have legs?

If the market is channeling the market from the Great Depression, then yes, the rally could last months and recoup as much as 50% of the losses since it peaked at 6,828 in November of 2007. It's hard to say what kind of economic news might come down the pipe to cheer investors that much.

Investors are currently a pretty gloomy bunch. But perhaps the aggressive monetisation of debt by the Fed will drive institutions out of bonds and into stocks. There is a lot of cash in money market funds that could get back into the market and send stocks up quickly.

Or perhaps not to all of that. The Economist Intelligence Unit has just released a report that predicts a 40% chance of global depression. The report is called "Manning the Barricades: Who's at risk as deepening economic distress foments social unrest."

To be fair, it also says there is a 60% chance the various stimulus efforts in the developing world successfully stabilise the global economy and share markets. But it says there's a 30% chance of global depression and a 10% chance of global depression with massive social upheaval.

Magazine cover contrarians know that any time a big claim is safe enough to put on the cover of a mainstream publication, the trend behind it is probably over. If this is the case, the Economist article is a massive buy signal. But it's also possible the Economist has gone as far as it can without terrifying its readers and more importantly, its advertisers.

In other words, it's possible that things are a lot worse than the Economist is willing to say, which is not exactly a comforting thought. More on this tomorrow as well.

Amidst all these dire forecasts comes another prediction of higher oil prices. In a Wall Street Journal article on Friday, Richard Jones, the deputy director of the International Energy Agency, said the oil crash of 2008 may prevent around 8 million barrels of oil per day from ever reaching the market.

The oil price crash has caused so many projects to be deferred or cancelled that Jones says, "Unless sufficient companies have the will and financial ability to invest through the downcycle, there is a real risk that supply growth may lag the eventual rebound of demand, leading to substantial price increases -- possibly as early as this year."

We sent a longer letter out this weekend about the oil markets. Please note, if you're already a Diggers and Drillers reader, you have already read our full reports on the stocks mentioned in "The Coming Oil Supply Crunch." If you're not a D&D reader, this report contains our analysis of the oil market and three of our favourite Aussie energy recommendations.

Dan Denning
for The Daily Reckoning Australia

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• Alan Greenspan Bears Blame for Intensity of Financial Crisis
• Rio Scraps Deal to Sell to Aluminium Corporation of China

"Diversify your portfolio," say the stockbrokers.

I say, "Don't listen to them."

The idea of having well diversified portfolios is probably the best piece of spin doctoring to have come from the funds management industry in the last twenty years.

The problem with well-diversified portfolios is they usually aren't well diversified. They tend to be diversified in the same direction. Look at the make-up of any 'balanced' managed fund. A fund split between Australian shares, international shares, property, bonds and cash isn't a diversified portfolio at all.

In fact, based on the current market, three out of five of those asset classes require a bullish market sentiment. As for bonds and cash, they just cancel each other out - what you gain on the rise in bond prices you lose on the falling cash rate.

The problem is, when you diversify your portfolio too much across a single asset class or across multiple asset classes you tend to neutralize your returns.

For instance, what has a diversified portfolio done for most investors during the last eighteen months? Just take a look at the stock indices, that should paint a pretty clear picture of the damage.

Instead of investment managers preaching portfolio diversification, they should be telling clients to take a view and either stick with it, or have exit strategies if the view turns out to be wrong.

But of course, it's not in the interests of fund managers to promote such a strategy. They want to convince you that managing investments is too hard for the average punter - leave it to them, your money will be safe in their hands... No thanks.

The key to investing really is to take a view and back your convictions. If you do that, and you're right, then you'll do much better than the average investor. If you get it wrong then you may do worse. But if you are actively managing your investments you can switch out of the investment if it moves against you. Traders do this all the time using stop-loss orders.

Let's take the current market as an example. Last November when the S&P/ASX200 hit a low point, I - perhaps foolishly - called the bottom of the market downturn.

Does that mean you should have gone in 'boots and all' to the stock market last November. No, because I had an important caveat, and that was to look only for share market investments in the small cap sector and for those shares that are paying sustain a dividend payment.

In addition, my view was to stay away from finance sector stocks.

Four months later and little has happened to change that viewpoint. Let's take the small cap sector as an example. Of course, I've a vested interest as editor of the Australian Small Cap Investigator newsletter. But the facts speak for themselves.

Since the market hit the previous low point in November the S&P/ASX200 has fallen by a further 3.28%.

In comparison, the stocks in the Australian Small Cap Investigator portfolio have gained by 16.59%. If you had diversified your portfolio across the whole market on the basis of market capitalization you would have received almost none of that gain from the small cap stocks.

As for the dividend paying stocks? Well, late last year I decided that it was almost time to release a new newsletter based on income investing. Now that interest rates have fallen to a pitifully low level, and many companies have slashed their dividends, I think that now is the perfect time to offer an income investing service to investors.

I'm currently putting the finishing touches to it, but hopefully we'll be ready to launch in April. [Ed note: If you want to be among the first to find out about my new income service send an email to moneymorning@moneymorning.com.au and type "Keep me informed about your new income newsletter" in the subject line]

In my opinion, if you have a view on a particular asset class or particular investments, it makes sense to back yourself. Providing of course, you are prepared to accept the potential downside if you're wrong. But that's where your risk management strategy comes in.

If you really believe the banking sector is undervalued right now, why shouldn't you load up your portfolio on bank stocks? Especially after CBA's decision to maintain its interim dividend. But if bank stocks start to head further south then you've got to be prepared to cut your losses quickly. You can always jump back in again later.

Unfortunately, the only risk management strategy that many investors use is 'diversification.'

Considering that investing is supposed to be about getting wealthier, sticking to the convention of diversifying will only result in your fund manager getting wealthier while you see your investments barely keep pace with inflation.

Actively managing and monitoring your short-term and long-term investments is the only way to keep ahead of the market and ensure you are not just an 'average' investor.

Kris Sayce
for The Daily Reckoning Australia

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Then, shares rallied nearly 5.7% for the rest of the day. The All Ords closed up 54 points on the day. But from the intraday low to the close, it was more like 186 points. Now that's what we call a bounce back!

Maybe Mr. Market had a few martinis for lunch and came back in a reckless mood. We know the feeling. Or maybe he just needed a stiff drink to give him the courage to say that scariest of words these days, "buy."

Source: www.yahoo.com

Others too courage too. At much-maligned, forever-falling Oz Minerals (ASX:OZL), new CEO Andrew Michelmore told the market he was buying $30k worth of shares. Director Barry Cusack said he was in for $100k. The insider buying was enough to engineer a 25% turnaround on the day, with the stock closing up nearly 13%.

Whatever the cause was, we came in the control room at the Old Hat Factory this morning around 7am and found Swarm Trader Gabriel Andre already at work. It looks like the rally triggered a host of signals. But will it continue?

It's been a tough market to trade. There's no real momentum. No one really knows what's going on. One day, you're up three percent. The next, down four.

The Dow started its Friday bounce back work a little later than the ASX did. It didn't begin its late-afternoon run until 1pm in New York. But when it finished, it had climbed 494 points above the open, for a daily gain of 6.54%.

The Dow Bounces Back

Who knows why these things happen? The story making the rounds in the papers is that traders "cheered" the news that Tim Geithner, President of the New York Fed, would be Barrack Obama's new Treasury Secretary. He'd replace "Bazooka" Hank Paulson.

No word on Geithner is as good for Goldman as Paulson. But he has been one of the three big wheels behind the various bailout plans engineered by the Wall Street/Treasury Axis. He's a known known, as Donald Rumsfeld might say. And since we're going with the Roman metaphor, we'd say Geithner has been Caesar to Ben Bernanke's Pompey and Paulson's Crassus.

Of course the first Triumvirate coincided with the beginning of the end of the Roman Republic. It was never official. Just three men calling the shots from behind the scenes.

But it certainly marked the beginning of the Empire and dictatorship. Crassus was one of Rome's richest men. He'd put down the slave rebellion led by Spartacus in 74 BC (still one of Kirk Douglass' best performances, if you ask us). But he died fighting the Parthians at the edge of Empire at the Battle of Carrahae in 53 BC.

Pompey lasted longer. He gained fame in Rome after defeating pirates in the Mediterranean in 67 BC. He formed an alliance with Julius Caesar in 59 BC and cemented in by marrying Caesar's daughter Julia.

But when Caesar famously crossed the Rubicon in 49 BC and brought his armies into Italy for Civil War, he put Pompey on the run. Caesar chased Pompey all over Italy for a bit, eventually defeating him in battle and driving him to Egypt, where he was promptly assassinated by his own friends and beheaded.

Tough place, ancient Rome.

But back to the modern world. There are no financial Rubicons left to cross that we can see. They've all been crossed already. And we believe they all lead to inflation in 2009. The New York Times Reports that Senator Charles Schumer wants the new stimulus plan to be around US$700 billion. That would match the TARP, providing some classical symmetry.

Gold must've noticed. It was up forty three bucks on Sunday. In the spot market, gold's back over $800. By the way, Australian gold production fell by 8% in the third quarter, according to Bloomberg. Australia is the world's third largest gold producer. But high production costs are biting.

In the bigger picture, gold traders and investors realise that the Great Fiscal Stimulation of 2009 is being prepared as we speak. President-elect Obama is conversing with his fiscal and monetary generals. He is marshalling his armies of inflation to go forth and multiply the money supply.

If gold investors are right (and we think they are), the upcoming war on deflation should unleash the epic inflation we've all (except for Bob Prechter and Marty Weiss) expected.

Obama and his Consuls Geithner, Summers, and Bernanke are preparing the public for operation GFS 2009. "We now risk falling into a deflationary spiral that could increase our massive debt even further," the President-elect told Americans in a speech this weekend.

He's right. The rising value of cash (in a deflation) makes debt harder to pay back (especially when you plan on adding so much more). That's why all governments everywhere prefer the policy of soft, slow-motion inflation. Obama does not represent change here. Just more of the same borrowing and spending we've had for years.

Inflation gradually erodes the value of accumulated debts by allowing you to pay them off in an increasingly weaker currency. If you're having trouble with that idea, think about this way. Say you borrowed $1,000 twenty years ago. Twenty years ago, $1,000 had more purchasing power than it does today. If you inflate steadily enough, it gets easier to pay back your accumulated debts. $1,000 ain't what it used to be.

The United States also enjoys the luxury of paying off its debts in a currency it prints. So inflating the debt away is easier than, say, defaulting on it because you don't have enough of the currency in which the debt is denominated. There is no reason to default, in fact, when you can print the currency in which your debts are owed.

This is why we increasingly think inflation is coming. Up until now, the best laid plans of Paulson and his team have been focused on recapitalising banks and keeping the financial system from imploding. Deflating financial assets have chewed up that new capital, and prevented it from becoming new lending in the economy.

But the next step is the reflation of household balance sheets. Wall Street got its bailout. Now it's Main Street's turn.

Already, Obama's team has indicated it will let the Bush tax cuts expire naturally in 2011, rather than repealing them now. Expect an expanded foreclosure mitigation effort too. And eventually, a new government-backed refinancing plan will be floated to try and put a floor under U.S. house prices.

Yep. 2009 is shaping up to be quite the year if you love big spending government with big plans. Yet here in Australia, the government seems scared to follow Obama's lead and go into deficit to "get things going." The unemployment rate will have to go higher, or house prices will have to fall further, before the Australian public demands more rate cuts and deficit spending (rather than resisting the latter).

Here are a few problems to think about until tomorrow. First, if you're a large owner of U.S. dollars and a major creditor to the U.S. government, and you see that the U.S. won't default on its debt but instead, inflate it away, what do you? What policy levers can you pull to exert influence on your debtor?

Second, what happens to the world's stock of available savings when governments start hoovering it all up to be used as fiscal stimulus? Does it crowd out private investment, leading to fewer new jobs, and a prolonged crisis? In other words, is the big government push to "fight the crisis" actually setting it up to be much longer and more painful than it otherwise might? More on this tomorrow...

Dan Denning
for The Daily Reckoning Australia

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• Geithner and His Toxic Asset Bailout Plan
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