The S&P 500 fell by over three percent and the Dow Jones by 268 points and two percent (nearly closing below 10,000). Gold was off $45, or just over four percent. And oil was off by nearly $4, or over five percent. We'll get to what you should do about all that in a moment.

But first, take a look at that chart below if you believe the past is prologue. The chart shows how impressive and fast the rally was in the U.S. dollar from a level of 72 on the dollar index to a high just below 90 in late 2008 and early 2009.

During the dollar's rally, stocks and commodities fell. Yet once low interest rates and government stimuli found their way into stock markets, leveraged traders again bet on equities and higher-yielding risk assets around the global. The dollar fell and the stock market rally got pretty carried away with itself (mostly on the flimsy idea that the global economy had been rebalanced and was recovering, which was palpably not true).

The chart can't tell us what will happen next. This time around, we wouldn't expect the dollar rally to go as high or last as long. We don't think the monetary authorities would be inclined to let a deleveraging positive feedback loop set in again (which indirectly explained the dollar's ferocious rally last time). That is, the powers that be don't want to see falling asset values trigger forced liquidations by leveraged players, leading to more asset sales and further liquidations in property, commodities, and equities.

Now just because Ben Bernanke and the global cabal of counterfeiters don't want something to happen doesn't mean it won't happen anyway. The deflating of the reflated asset bubble is going to happen sooner or later. The world's massive inverse pyramid of debt is supported by a very small asset base. When the underlying assets (often commercial and residential real estate fall) the whole structure becomes unstable (this is what happened in 2008).

That means that this time around, you wouldn't expect the monetary authorities to let liquidity to dry up again. Granted, the fundamental issue is the soundness of bank collateral (and that has not improved much). But if central bankers and policy makers have been publicly worried about inflation in the last few months, you can forget about that now.

A ten percent fall in stock prices (though probably overdue) is just the thing to get policy makers in an accommodative mood again. The U.S. employment figures still suck. And markets are increasingly confused and worried about whether certain sovereign nation states (like Greece and Portugal) can finance their deficits and/or reduce public spending without increasing civil unrest.

Mind you, we don't think more money, credit, or liquidity is the answer. It is, in fact, the problem. The modern world economy is built on a foundation of unsound money. We may all be surprised at how just abnormal everyday economic life gets when the artificial life support of easy money is either withdrawn or simply ceases to be effective.

The young man above, who's keeping vigil outside the RBA in Sydney, would probably agree with us. His brother sent us the picture and this note, "My younger brother has been protesting outside the RBA every second Friday morning for the last three months. After discovering Austrian economics about three years ago Seb and I have been compelled to speak out against central planning through central banking. I have attached a couple of photos above of his mornings outside the RBA. As you can see it's a lonely battle and would appreciate all the help we can get."

Keep hope alive brother!

If you're not familiar with Austrian economics, don't worry. There's actually a small introduction to the subject we wrote last year that we're happy to send you if you're interested. Just send us a note to dr@dailyreckoning.com.au with "Austrian Economics" in the subject line.

The basic idea, when you strip away all the big words, is that the entire free market system is distorted/perverted/corrupted by the fact there's no free market for money. The interest rate is essentially the price of money (or the cost of capital). This rate is set by unelected bankers. The result, since central banking got its start with John Law and the Banque Royale in France, is a series of massive misallocations of capital and destroyed wealth.

When you change the cost of capital willy nilly, you change all sorts of incentives in the real economy. And you alter the economics of tens of thousands of investment decisions. Make money too cheap (always the preference of governments) and you create asset bubbles (in stocks, real estate, and commodities).

In fact there's a pretty persuasive argument that the commodity super cycle is itself a symptom of the de-facto dollar devaluation engineered by Richard Nixon in 1971. Once the world moved to free floating exchange rates and fiat currencies not backed by any metal, a tsunami of paper, credit, and debt has lifted (inflated) prices for everything (houses, stocks, commodities, and bonds).

Some people call this wealth.

But if the super cycle of paper money is ending (a big claim for sure), wouldn't it mean a dramatic contraction in global economic activity? Not just a severe recession like in 2008 but really, a long depression in which debts are worked off and paid down, or in which debtors simply default and their creditors must take capital-destroying losses?

Well, yes. All that would happen if the super cycle in paper money is ending.

We've argued that it IS ending and that one symptom is a series of escalating sovereign debt crises. The funding model for the welfare state is broken because it's base on unsound money. It's time to pay the reaper. Don't fear the piper.

The argument we hear most often against our position is that all of that would be terribly inconvenient and people would prefer to not believe it. People would prefer to believe that debt is wealth, that you can spend your way out of recession, that we all can live at each other's expense, and that the misallocation of real resources (capital, labour, land and commodities) doesn't have real long-term consequences.

But paper money has always been a con game based on belief. The emperors of Rome, the Kings of France and England, the chairmen of the Federal reserve cannot resist debasing the currency. It makes both warfare and welfare possible. Guns and butter are the health of the state and the death of sound money.

The counterfeiters always get first use of the bogus money before its purchasing power is diminished by the increased supply. And after all, the modern banking system IS debt-based money. The banker's product is debt...and the more you have, the better for them.

All of this is absurd and, as Murray Rothbard said about fractional reserve banking, deeply immoral. It's a pretty dodgy way to run a world economy. But the assumption - encouraged by the powers that be - is that the economy is a complex machine which can be controlled with the right tweaks to the right dials by the right people wearing the right suits in the right government offices with the right university degrees.

This is also absurd.

But enough of the theory. What now? If the correction becomes a rout, expect more quantitative easing or policy measures designed to mask the pain (more stimuli). That won't solve the basic problems either. But it might arrest the dollar rally and the commodities sell off. At some point, much more aggressive measures might be needed, at which point we'd expect to see a huge increase in inflation and interest rates (as deficits spiral out of control).

But in the short term, we'd say this is a chance to lower your average purchase price on gold and other precious metals. We hope you used the rally as a chance to liquidate some of your stocks and increase your allocation to cash. Our preference right now is for liquidity over capital gains or yield. Cash doesn't yield much. But you can keep it in your hot little hands.

Of course no one can see too far into the future. We're pretty sure that at some point down the road, the sovereign debt crisis will again become a U.S. dollar crisis. But it could be that the sovereign debt crisis is going to take out the smaller welfare states in Europe first and that this will actually lead to dollar strength as global investors concentrate their remaining capital in a few very liquid markets (like short-term U.S. Treasuries). Under this scenario, emerging markets (including Australia) would probably sell off more than developed markets.

One final note today. The South Australian Attorney-General, Michael Atkinson, has changed his tune on the new law requiring internet commenters to reveal their identity when commenting on the upcoming election. That seems like good news.

Atkinson wrote in a statement, "From the feedback we've received through AdelaideNow, the blogging generation believes that the law supported by all MPs and all political parties is unduly restrictive. I have listened. I will immediately after the election move to repeal the law retrospectively."

Hmm. "It may be humiliating for me, but that's politics in a democracy and I'll take my lumps...This way, no one need fear now that they are being censored on the net or in blogs, whether they blog under their own name or anonymously. I call upon all the other political parties who supported this review to also review their position."

Maybe Mr. Atkinson should review his analysis as well. From his comments, he seems to be unrepentant about the spirit of the law. But he says that because all the young whipper snapper bloggers don't like it, well that's democracy so we'll respect that, even if all the youngsters are a bunch of dunderheads.

The danger here is still clear. You have an elected official exercising his own discretion about what speech ought to be free, and then exercising even more discretion about whether to apply the law or not. How capricious. The law is the law. How can the Attorney-General not exercise it?

But really this shows why you need a constitutional protection for free speech in Australia. Take it out of the hands of legislators and put it above statutory law entirely. In some sense, this IS un-democratic in that you're telling the legislature there are some individual rights they can't tamper with just because it seems like a good idea at the time. In that case, we're happily un-democratic.

Protecting individual liberties is the fundamental reason (we think) for consenting to be governed in the first place. If the legislature becomes a tool for systematically stripping you of your economic and political liberties (as well as grabbing, without your consent, a larger and larger percentage of your productivity via the income tax), you'd have a serious think about withdrawing your consent.

Hmmn.

Dan Denning
for The Daily Reckoning Australia

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There are, I know, politicians and pundits who blame the financial crisis on a "lack of regulation." Frankly, anybody who says that has failed the IQ test, or perhaps the ethics test. For all practical purposes, the American banking system is a branch of the federal government. It has been for decades.

Without government guarantees, backed by taxpayers, Fannie Mae and Freddie Mac could not have attracted the level of investor trust they did. The subprime mortgage and housing bubble wouldn't have been funded. Nor would politicians have had the leverage to pressure banks into offering bad loans. Perhaps most importantly, financial institutions would have had no reason to lavish huge campaign contributions and cushy make-work jobs on the political classes.

The banking crisis, however, is not my primary concern right now. It's happened, despite numerous warnings for years from rational economists and commentators. And it will pass. It is a structural problem, and restructuring is happening even now.

The so-called bailout will delay the emergence of new institutions, but it won't stop it. Alternative institutions are rising that will avoid many of the past mistakes. Some are likely to be offshore. Even Vladimir Putin is talking about metal-backed currencies. It is ironic evidence that others are learning the lessons our political class has forgotten.

My concern at the moment is the federal budget and ongoing deficits. This new expansion of government spending and debt is not some one-time event that markets can repair. According to the Congressional Budget Office, current annual deficits have quadrupled. Independent CBO economists forecast that they will level out in a decade to about triple pre-stimulus levels.

Frankly, I failed to predict the magnitude of these budget increases coming. I expected increases and never believed candidate Obama when he promised to cut net spending. Neither, however, did I imagine he would increase it as much as he has.

It is inevitable, however, that this level of spending will be reduced. It will happen for a variety of reasons. For one, such levels will slow the economic growth Americans are used to. It will stifle productivity and reduce income tax revenues. As it always has before, this will send the political pendulum swinging away from big government.

Incidentally, claims that the spending increases are either a "bailout" or a "stimulus" are bilge. No one has ever seriously tried to explain how spending that does not take place currently can appreciably stimulate the economy in the short run. Still, less than 24% of the stimulus will occur this year. That other 76% stimulates nothing but advocates of government spending.

So today, I want to take the time to deal in some depth with the effects all this will have on breakthrough technologies. I realize, incidentally, that some of my comments may be interpreted as partisan. They shouldn't be. I was a critic of President Bush's spending record as well, though it pales compared with current levels. And for the record, I don't think I've ever registered with either major party, even when I was working with a candidate in the last presidential campaign. He was a Republican, but he understands Federalist principles that would have limited the power of the GOP.

I would gladly vote for the sort of tax-cutting Democrat my father was. Ours was a loyalist Democratic household and my parents revered John F. Kennedy - one of America's great tax cutters. His across-the-board tax cuts were greater proportionately than those passed during the Bush administration. They were enormously successful in promoting spending and economic growth. Give me a Kennedy over a Nixon any day.

Nevertheless, I am prepared for e-mail from those who mistake my criticism of destructively high taxes for partisanship. It's not. Honestly. Economics is called the "dismal science" for a reason. And it often falls to rational economists to play the role of parent, explaining that we just can't afford all those cool toys people want right now.

The term "dismal science," by the way, was coined by a Victorian historian describing the work of Thomas Malthus. Malthus set the standard for doom and gloomers. An Anglican minister and a terrible economist, he predicted the imminent destruction of civilization, if not humanity itself, in the late 1700s. Despite our survival and amazing progress since then, others make similar predictions to this day.

I am, in fact, optimistic about the long run. The economy will not only recover. It will continue to grow exponentially when it does. That doesn't, however, mean that we don't face serious challenges in the short to medium run. This, however, is a unique time historically, with unprecedented opportunities for patient farsighted investors. Rahm Emanuel and Hillary Clinton have both said that you should never let a good crisis be wasted. Though my means of exploiting the crisis are quite different than theirs, I agree with the general sentiment.

There will, however, be delays in technology development. Because so many of the emerging breakthrough technologies today are related to health and longevity, I take those delays personally. While the economy will recover, there are people who will miss out on lifesaving therapies because new technologies are not being funded. This irritates me.

Nevertheless, we need to look at the situation clear-eyed and figure out how to profit from it. And in the process, we may help move some of these revolutionary new technologies forward. There is another Chinese proverb about crises creating opportunity, and this is no exception.

Now, to business.

The most onerous impact of excessive federal spending is the absorption of capital. When finite capital is appropriated through taxation and federal debt creation, this necessarily reduces the level of funding available for research and development.

This simple math is ignored by those who believe it's a good thing to tax the rich, the people who direct most investment capital into emerging technologies. Historically, overall economic well-being is best accomplished through the promotion of new technologies and businesses. Kennedy made that point with his famous statement that "rising tides lift all boats." Right now, the deficit is lowering the tide. Until this sapping of our R&D lifeblood is rectified, transformational technologies will face challenges.

Typically, we know, investors abandon unproven sectors for traditional stability when things get scary. This includes even venture capitalists. New data from PricewaterhouseCoopers, the National Venture Capital Association and Thomson Reuters verify that this is the case.

In the first quarter this year, US venture capital investments fell 61%. In the same quarter a year ago, venture investments were $7.74 billion. This year, the total was barely $3 billion. This is the lowest level in 12 years. Acquisitions of venture-backed companies fell by nearly half from last year. There were no venture-backed IPOs. None.

The one notable bright spot in this picture is health care services. Venture capital investment there is actually up somewhat. As I wrote on several occasions while we were waiting for the train wreck, health care is countercyclical. When times gets tough, the last thing consumers cut back on is medical services.

This is one reason that my Breakthrough Technology Alert portfolio is so heavily weighted with medical biotech today. It's not the only reason, however. It is simply true that a huge percentage of the biggest and most profitable technologies on the near horizon are medical. Significantly longer healthy life, i.e. "time," is the product they will deliver.

Economists talk about the "backward-bending demand curve." It refers to the fact that we max out on stuff. Eventually, if we get enough of something, we value additional units less. Demand for life, however, is unlike any other good or service. It is, in effect, infinite.

Regards,

Patrick Cox
for The Daily Reckoning Australia

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What's changed? Well for one, rising layoffs are having an effect on the real economy. Today's papers report that mortgage delinquencies are on the rise. Delinquencies on full-documentation loans are still relatively low. Just 1.75% of full-doc loans are more than thirty days past due, according to a story in the Sydney Morning Herald.

It's the non-conforming, low doc, dare we say subprime-esque loans that are even more delinquent. Nearly twenty percent of low-doc non-conforming loans are more than thirty days past due according to ratings agency Fitch. Fitch says that lower rates haven't helped folks with non-conforming low-doc loans because borrowers can't refinance now that most of the non-traditional non-bank lenders who were making the loans a few years ago have vanished in the credit crunch or been swallowed up by the Big Four.

"Fitch expects delinquencies to deteriorate further during the March quarter and a gulf to develop throughout 2009 between struggling borrowers and those feeling relief from the Reserve Bank of Australia's five interest rate cuts since September. The key factor will be each borrower's ability to retain full employment during the economic downturn, Fitch said."

What else had changed that would cause the RBA to revise its forecast? GDP growth for Australian trading partners has fallen off a cliff. Fourth quarter GDP figures in Japan showed in contracting at a 12.1% annual pace (easily making it the Biggest Loser). American GDP shrank by 6.3% in Q4. Overnight we learned that house prices in the United States have fallen 29% from their peak and 19% in the last twelve months alone, according to the Case-Shiller index, which measures house prices in twenty U.S. cities.

Of course this could get worse later this year if the Option ARM problem we wrote about recently gets worse. The entire current round of stimuli and bailouts assumes no further deterioration in bank loan books. That's a big assumption. The only good news was that Chinese GDP expanded by 6.8% in Q4, although as the chart below shows that's a lot lower than the heady days of 2007, when GDP grew by an almost unbelievable 14%.

Source: www.worldbank.org

But March wasn't all bad, was it? Did you see that the ASX Small Ordinaries had its best month in sixteen years in March? By yesterday's close the ASX Small Ordinaries was up nearly 10% for the month. It hasn't had a big month out like that since December of 1993. The chart below tells the tale.

Small Caps Rally

Source: www.google.com/finance

The energy sub sector of the small caps was the big star in March, up 26.01%. Financials stormed home second, with a 25.29% gain. What a contrast though! Small cap rallies almost always lead broader rallies in the market. And rallies in the market tend to lead recoveries in the economy. Kris Sayce has more on why this is the case in his essay.

We're not prepared to say that one month of good small cap returns heralds a reversal of the major trend in the market. But if you're a punter, it certainly has been good news. And we have always had a soft spot in our heart (and perhaps our head) for the small cap market. It's the small businessmen who lead economies out of recessions by taking risks. This is why the entrepreneur and not the capitalist is the real protagonist of Austrian Economics.

You wouldn't think the best way to beat a recession is to take more risk. But entrepreneurs take advantage of the lack of competition in recessions to find long-term customers. What's more, you have to be a low-cost producer of anything to make it in a recession. And you have to do better with capital than competing firms or investors punish you.

It also depends on the kind of risk you're taking. There are some risks inherent to some businesses, while other risks are more general. Some businesses are more like tightropes and some are more like the trapeze. Small cap finance? Tightrope walking with no net. You might make some money. You could easily break your neck.

Small cap energy? You could break your neck if the firm's management fails to execute its business strategy. But entrepreneurial risk is a different animal entirely than being in something that is by its nature a dangerous business. Taking a punt on finance stocks in the middle of a bear market in credit seems...well...insane. Energy stocks? Not as insane, especially if you're early.

Speaking of energy, the New York Times is reporting that as many as 35 new exploration and production projects from OPEC member nations could be delayed over the coming years, thanks to the oil price crash. Don't mistake dollar strength via competitive currency devaluation with long-term oil weakness.

Yes, oil is going to be a proxy for the strength of the global economy. But over the coming years, a lot of people in the industry are saying that the oil price crash virtually locked in future shortages. The only question is how soon.

Saudi oil minister Ali al-Naimi told the Times, "I have often described unsustainably low oil prices as carrying the seeds of future spikes and volatility. In a low-price environment, the trend is often to focus on survival instead of expansion...If we place a low priority on preparing for the future, that lack of action can come back to haunt us through supply shortages and another round of high prices."

Both the International Energy Agency and the International Monetary Fund agree. IMF deputy managing director John Lipsky says, "The lower that oil prices drop now and the longer they stay low, the greater the negative impact on future supply...In other words, today's low prices could be setting the stage for another price run-up in the future."

No one is interested in the oil story from an investment angle right now. That's what makes us so interested. Industry insiders couldn't be more clear about what they think is coming. And we think that means a big move in oil and oil stocks. You can read more about it here.

Houston based oil man Matt Simmons says, "We are three, six, maybe nine months away from [an oil] price shock...We are not talking about three to five years away -- it will be much sooner...These prices now are dangerously low. The lower prices fall, the less oil will be produced and the greater the chance of an oil spike."

"Unless oil demand falls by 10% or 15% per annum, which it is not going to do, then we don't need to wait for oil demand to come back before we have a supply crunch. Within a few months, we are going to realize our visible inventories are really tight -- squeaky tight -- and what would really be inconvenient is to see a recovery in the economy."

A lot of people would probably disagree with Simmons that a recovery in the economy would be "inconvenient." But it doesn't look he has much to worry about anyway. In fact, the size and scope of the various plans to end the recession are nearly bigger than the economy itself in America.

"The U.S. government and the Federal Reserve have spent, lent or guaranteed $12.8 trillion, an amount that approaches the value of everything produced in the country last year, to stem the longest recession since the 1930s," reports Bloomberg. That number is up 74% since Bloomberg first researched in November of last year. It tallies up to about $42k per American.

Now do you wonder why Russia and China are getting serious about getting out of the dollar? Those commitments by the U.S. authorities are nearly 100% of US GDP (US$14.2 trillion in 2008. Investments like Hunan Valin Iron and Steel's $1.2 billion, which Treasurer Wayne Swan approved last night, make a lot of sense given the unhappy days ahead for the dollar. Tomorrow, more on the "alternative risk scenario of dollar collapse," as presented by the Economist Intelligence Unit.

Dan Denning
for The Daily Reckoning Australia

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Is there a better example of Unternehmergeist than Andrew Forrest? Forrest has become Australia's richest man by taking a series of risks everyone else thought was crazy (llama farming, an experimental method for leaching laterite nickel deposits, and becoming the third-great iron ore producer in the Pilbara. He's richer, on paper, than James Packer and Rupert Murdoch.

What's Unternehmergeist?

That's the term coined by Joseph Schumpeter, the economist from the Austrian school born near the turn of the 19th century (a time of huge, disruptive change in the global economy). You've probably heard Schumpeter's name in association with the phrase for which he is most famous, creative destruction. It is, we confess, the spiritual heart and soul of our research efforts at the Australian Small Cap Investigator.

Creative destruction was a popular expression during the dot.com boom, when every Silicon Valley start-up dreamt not of competing with Microsoft, Oracle, and Intel, but destroying them. These entrepreneurs wanted to be Henry Ford to Microsoft's buggy whip.

Of course it didn't turn out that way for many firms. They did not have truly disruptive technologies or services that wholly replaced what already existed. But Schumpeter's point stills stands.

"Every piece of business strategy," he wrote "acquires its true significance only against the background of that process and within the situation created by it. It must be seen in its role in the perennial gale of creative destruction."

The "perennial gales of creative destruction" are still blowing early in the 21st century. Like a big bad wolf, they are blowing down Wall Street's house of financial cards. And in the energy sector, they are shaking the very foundation of the world's petroleum economy.

But don't lose site of the creation. Schumpeter realised that wild human spirits (his term for it was Unternehmergeist) are always prowling on the periphery of the economy. These men and women challenge the established way of doing things. They are not after merely marginal profits, but massive ones. And they are not necessarily (indeed hardly ever) inventors.

They are, however, innovators. These entrepreneurs, Schumpeter argued, popularize new products, technologies, and services that replace the established order. They are not just disruptive but destructive. Schumpeter argued that in the grand scheme of business cycles, resources (capital, labour, land, energy) gravitate toward better solutions (the winners) and away from losers.

He described an inherently evolutionary process of wealth creation, albeit a process punctuated with great, disturbing leaps forward. He identified five types of situations in which new profits could be made on a large scale: (1) The introduction of a new or higher quality good (2) the introduction of a new method of production (3) The opening of a new market, (4) The conquest of a new source of supply of raw materials or half-manufactured goods, (5) a new way or organising an old industry.

Dan Denning
The Daily Reckoning Australia

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