It doesn't quite have the same ring as the first line of the Aussie national anthem, does it? But even though the country is younger (and perhaps freer) than many other countries, it might not quite feel the same way about itself after reading parts of the government's latest Intergenerational Report, released yesterday. You can find it here.

The burden of today's Daily Reckoning is to figure out what's going to happen when Australia's millions of baby boomers retire. From the looks of it, the stock market will crash, government finances will be stressed, and the economy is going to slow. None of that sounds very promising. But let's take a quick look to see what the best financial survival strategy is.

First though, a short look at the markets. The RBA comes out with its new interest rate decision. It's going to be spun as a positive no matter what it decides. Higher rates mean the economy is growing and it's bullish for the dollar! No change means the housing market will recover and new buyers could step in again. The market is up strongly today - mostly because it got ganked in January, falling 6.23% for the month.

One more side note. We've said all along that thousands of young Australians would come to resent the government for encouraging them, via grants, to get into the house market when prices were high and interest rates were low. It was in invitation to years of debt slavery to the big banks, sweetened with some "free" money the government borrowed in the bond market (which will also have to be repaid.

Young buyers are always at more risk of encountering mortgage stress. They are more likely to lose a job in this economy. And they tend to have less discretionary income. And today we read from Nick Gardner in the Sunday Telegraph that, "Almost half the first-home buyers lured into the market by the Rudd government's $14,000 grant are struggling to meet their mortgage repayments and many are already in arrears on their loans.

"Thousands of young homebuyers are using credit cards or other loans to meet obligations, while those in 'severe stress' are missing payments. Just weeks after the grant was officially withdrawn, a survey of more than 26,000 borrowers conducted by Fujitsu Consulting revealed that 45 per cent of first-home owners who entered the market during the past 18 months are now experiencing 'mortgage stress' or 'severe mortgage stress'".

Perhaps this is why the Prime Minister is telling everyone that re-election is not a lock. Young voters favoured Labour over issues like Climate Change, an apology, and non-pocketbook issues. Now that their pocket books have been cleanly picked, they may vote a bit differently. We'll see.

But today's episode of the DR deals with the "weight of money" argument. That argument is that the share market will make higher highs as long as compulsory super directs baby boomer funds into Australian equities. The question is, what happens to the market and the economy when the boomers shift their weight from saving and investing to consuming their retirement incomes?

Yesterday we mentioned the long-expected move to increase compulsory super from 9% of wages to 13%. But there's no guarantee this money would go to support equities. Instead, we expect a back-door transfer to pay for Australia's increasing old age and health care liabilities. It's a point made yesterday in the Intergenerational report.

The problem for Australia, like in all the Western world is that the population is ageing. You have fewer and fewer workers supporting more and more retirees. Those retirees are also drawing down their stock-market based savings vehicles. Their demand for benefits and income is increasing but their liquidating their asset portfolios to meet that demand.

This transfers the burden of national retirement from the stock market to the government. But as the government itself showed yesterday, the numbers don't add up. The ageing of the boomers leads to increased national spending on healthcare as percentage of Australian GDP. As you case see from the chart below, health, aged pensions, and aged care all expected to up as a percentage of government spending and GDP

To pay those bills, you need more tax payers and higher taxes. Or you need more productivity. That's what the government is counting on. It hopes that increases it output per hour by Aussie workers will deliver higher GDP growth and thus higher government tax receipts. But even so, the government itself projects a growing "fiscal gap", shown below as the annual Federal deficit as a percentage of GDP.

Granted, this fiscal gap isn't as bad as it is in other places like Japan and the United States. Japan's government deficits are even more pronounced, and its demographic math even more dismal. The U.S. is also in its own kind of "reality gap" in which expectations of government by the population far exceed what America can afford. The new Obama budget projects $3.8 trillion in spending a $1.4 trillion deficit. There isn't much in the way of spending cuts to programs what are considered "non-discretionary (defence, social security, Medicaid, Medicare).

You could say America itself has a kind of national "mortgage stress." The future has been mortgage for a higher standard of living today. But it was a national prosperity built on debt. It's all falling down. About the only good news is that Obama's dollar-busting budget may drive higher asset prices for gold, energy, and other commodities.

But Australia and Australian investors face a slow motion fiscal trap. The country receives a big boost from trade income with China and the rest of the commodity consuming world. The government can fund its deficits at reasonable interest rates for now. But what yesterday's report set up was a fight between two generations.

The Boomers will slowly liquidate share portfolios to meet rising health care expenses. And what they cannot pay out of pocket, you'd expect them to vote themselves. It's an effective strategy for shifting the retirement burden from the private sector to the public. We have no doubt that Super Funds will be compelled to own government bonds. And the government will sell bonds in order to finance its spending obligations to the Boomers.

But where does this leave the share market and the economy? Can the country really increase output per person and grow its way out of the fiscal gap? The highest paid and largest employing industries are financial services and resources. Are the Boomers going to migrate to those jobs?

Will you have 70-year old coal miners working in Queensland? What kind of work can an ageing population reasonably be expected to do? There are more questions to answer. But we're up against our daily deadline so we'll have to leave them until tomorrow.

Dan Denning
for The Daily Reckoning Australia

• Baby Boomers Are Ill-Prepared for Retirement
• Baby Boomers Face Early Retirement With No Money Saved
• Bernanke Calls U.S. Economic Recovery “Nascent”
• Bond Scam Perpetrated by Money-grubbing Government
• Baby Boomers Figure They Will Have to Work Longer than Expected

Meanwhile, celebrated short-seller Jim Chanos says China is going to blow up. It's going to be "Dubai times 1,000," he says.

Our old friend Jim Rogers disagrees. He thinks Chanos hasn't looked long enough or deeply enough into the China story. He thinks China is a buy.

And what do we think?

We don't think. We listen:

"Something like 50% of Chinese economic growth - if you can believe the numbers - is based on capital investment," said a dinner companion last week. "You can't invest that kind of money without making some pretty major mistakes."

If we were forced to bet on it...we'd bet that Chanos is right. We don't know anything about China or the Chinese economy. But you don't go from third-world communist hellhole to the world's second major economy without some serious bust-ups...especially when the communists are still in control.

Barely had we touched down in the USA than we were invited to a dinner party in Georgetown. In keeping with the Chatham House Rules, we won't mention any names, but we were in distinguished company. These were America's elite of movers and shakers, ambassadors, lawyers, policymakers, people who reflect and shape the opinions - and actions - of the US empire.

We were invited to answer questions; instead, we asked them.

We began by mentioning the failure of the economics profession. Never had an unarmed group done more damage to the wealth of a society, we suggested. Economists helped create a huge bubble, ignored it until it blew up, and then gave the wrong advice about how to fix it. Bailouts and boondoggles were all they had to offer.

But wait a minute, said a fellow diner: 'I'm an economist...we couldn't let the whole banking system collapse.'

"Why not?" we asked.

'Because unemployment would go up to 14% or more...'

"How do you know what the proper rate of employment should be?" we wanted to know.

'But you can't just ignore people when they are out of work...and you can't ignore an economy when it goes into a depression, can you?'

"Why not?" we repeated our first question.

What we notice in our brush with America's intellectual and political elite is that they are very smart, very well informed, but too busy to stop and think.

They are thinkers. They are always thinking about what to do. But they cannot afford to think radically...about why they should do anything at all. If they did, they would be as marginalized as we are... How much more fun it must be to be at the center of power...pulling the levers...turning the knobs...making the world a better place!

The presumption of all elites is that they can do a better job of running things than people who are less well educated, less informed, or less intelligent. In a sense, this is obviously true. In the administration of commonly held assets, for example - such as a municipal sewage-treatment plant...or an art collection - a person with taste, culture and education is likely to do a better job than a numbskull. (We admit that even this is a dubious assertion...but we will presume it is true for the sake of this argument...)

But the elites go a major step further...they claim to be able to do a better job of administering privately held assets too...things that belong to other people.

Take the Cash for Clunker program. Auto sales went down. But so what? How many cars SHOULD be bought and sold? Nobody knows. And it's really not for anyone to say...other than the buyers and sellers themselves. But the elite think they know better.

The fellow with an old pick-up truck may have judged his truck good for another six months of service. But with the lure of a federal bribe before him, he junked the truck six months early. Any sensible person can see that this is a waste. A valuable asset has been lost - six months of truck service.

But the elite economist thinks he has saved the auto industry. Because the "demand for trucks has been stimulated." Jobs have been saved. Detroit has been given a boost.

What kind of nonsense is this? Not only have useful resources been sent to the scrap heap prematurely, but the auto industry has been given a bum steer, too. Resources from all over the economy - steel, oil, labor, electronics - have been diverted to the auto industry, on the basis of 'demand' that only exists because of federal money. The laid- off autoworker is a victim too. He might have been considering turning to another trade...instead, called back to work by the Cash for Clunkers program, he shelves his plans for retraining and relocation. He thinks Detroit is making a comeback. How disappointed he will be when the phony demand disappears!

And where did the federal money come from? It had to come from somewhere. In the event, it was borrowed from lenders who would otherwise have lent it to someone else. We don't know what the other borrower would have done with it, but no matter what it was, it could be expected to produce a net benefit, one way or another, to the economy.

Regards,

Bill Bonner
for The Daily Reckoning Australia

• A Period of Positive Collapse
• Water Usage by Big Companies
• Tackling Economic Clouds
• Dumb Money Eyes Stock Market While Smart Money Watches Economy
• China’s Economy is the Greatest Bubble on Earth

February gold futures fell below $1,100, down 2.5%. The Dow Jones Industrials fell 1.27%. The S&P 500 shed just over 1%. And the U.S. dollar rallied against all 16 currencies in the dollar index. What gives? First a chart.

Above is a three-year chart for the U.S. dollar index. We don't use charts with quite the same precision as Murray. But we did put three boxes around clusters of trading activity where the dollar index broke above or below the high 70s level.

For whatever reason, this is both resistance and support for the index. Right now, if the index can get above and 78 and hold it, you'd reckon the long-awaited U.S. dollar rally is here and it's going to do some damage to risk assets, including Australian stocks and the Aussie dollar.

This is a point Bill made when we visited him in South Africa last week. He said, "Stocks will go lower and gold will go higher, but the bear works in mysterious ways. The bear shakes out those with weak conviction. They are suckered in by rising prices and beaten down by corrections." The dollar is suckering in more suckers.

Still, it's strange to see the dollar rallying on risk aversion, as if the dollar itself wasn't the greatest risk of all. The U.S. Congress raised America's debt ceiling by $290 billion this week to $12.394 trillion and passed another $154 "jobs bill" (which shows you how effective the first one was).

These aren't the sort of things that make a currency stronger. As our friend Jim Davidson said when we visited him in New Zealand recently, "I can't think of a single example of a country that became great or stayed great because of all the money it owed."

It's hard to argue with that. In fact, we've argued before that the global financial crisis has morphed into a sovereign debt crisis. 2010 will be full of nation states discovering their funding model is broken. Yesterday, for example, ratings agency Standard and Poor's cut Greece's credit rating A-minus to BBB-plus. That is not an improvement.

The euro and the British pound and gold and nearly everything else fell against the greenback. But we would view these unusual periods of dollar strength as chances to build your position in alternative investments at a lower average purchase price. Buy gold stocks when they correct and add to your gold position at lower prices. The dollar rally won't last forever.

In fact, "When the U.S. has to fund its deficit through the combination of issuing more Treasuries and printing more dollars, it is inevitable that the dollar will continue to weaken," said Zhu Min the Deputy Governor of China's Central Bank. He's a man who'd have a lot of interest in the value of the dollar. China owns $798.9 billion in U.S. Treasuries.

Here in Australia the ASX/200 is following Wall Street's lead. But outside the market in the real economy, the energy deals keep humming along. Japan's Chubu Electric signed a $30 billion sales agreement with the Gorgon LNG project in WA, according to Matt Chambers in today's Australian. Chubu - in addition to gas for its electricity power plants in Japan - gets a small equity stake in Gorgon.

Gorgon is a conventional LNG project. Queensland has more of the "unconventional" gas. But those projects are hopping along too. Dow Jones newswires reported yesterday that "a person familiar with the situation" says Tokyo Gas would buy coal-seam-gas from Queensland's emerging LNG district, "If prices were low enough."

This is another example of substitution. "Japan uses mostly rich LNG now, and many utilities, including Tokyo Electric Power Co. (9501.TO), have said they aren't interested in coal seam gas LNG, citing technical difficulty in handling lean LNG together with conventional LNG... But sellers of coal seam gas LNG understand these inconveniences for users and are offering competitive prices."

Does that make coal-seam-gas the poor man's LNG? Who knows? But we do know that Kris Sayce took profits on several Queensland LNG shares this year. The shares went up before any of the companies ever produced gas. It might seem strange. But not really.

When projects get "de-risked", the more advanced they get. There are several factors involved: the quality of the resource and how 'proved up' it is (i.e. how much of it can economically produced at a given underlying commodity price). Then you have a company's capital structure and financing plan. Then there are labour costs, government and environmental permitting, off-take agreements, cap ex over runs, and operating expenses.

For the smaller emerging players in this space, the share prices tend to rise as these factors move from the unknown to the known category. Or, in some cases, the share prices do not advance if something that's newly known is bad. That's why the stock market is not a savings account. There is always a risk of failure.

That said, this incipient dollar rally might take the heat out of a lot of those Aussie resource shares that did the best in 2009: small cap resource and energy shares. That's why both Kris and Alex Cowie have been using trailing stops to exit positions as the market moves down, mostly at a profit but sometimes to minimise a loss.

Even if you're not a subscriber to either of those publications it's a useful idea. When capital flows are so volatile - and they're going to be in a world with sovereign default risk - you can get sudden swings in stock markets that may not seem related to underlying company fundamentals. But that's the financial world we live in (thanks Time man of the year!)

Don't be a hero and go down with the ship. Preserve your capital and live to fight another day, perhaps in the same shares. That may seem more like a trader's strategy. But a world of low short-term interest rates and easy money forces you to shorten your time horizon and more actively manage your assets - or risk getting eaten alive by inflation and/or shifts in asset and currency markets.

That probably sounds more complex than it is, though. Lock in profits. Don't take big losses. Be disciplined. And focus on the underlying trends that should drive earnings growth in specific sectors. If you do that, you'll at least know where to look in 2010 when the dollar rally ends and secular trend in tangible assets resumes. Until then...

Dan Denning
for The Daily Reckoning Australia

• U.S. Dollar Bulls Rallying Behind Fed Statement
• The Trouble With a Sovereign Debt Crisis
• U.S. Bonds Better than Greek or Other Sovereign Bonds
• Gold Ratios: Bearish for Gold Prices, Bullish for Gold Shares
• U.S. Dollar Strength or Oil Weakness?

Instead, we're going to review your 2010 asset allocation strategy in a roundabout way by exposing some of the snarky disinformation being put out by the mainstream media about gold, courtesy of Michael Pascoe at the Age.

By the way, apologies for any typos and grammar errors in today's edition. Your editor was late getting his copy to the e-mail senders who normally clean it up. We'll own up to every single error.

First though, let's just check to see that markets are still functioning normally. That is, let's just check to see that heavy government intervention is supporting house prices (by providing guarantees to home lenders), GDP growth (by spending money on infrastructure), and disguising the true state of the labour market (by lying about how many people are out of work).

Yep. Situation normal, all fouled up. The oil price, the U.S. dollar, and bond yields were all up on bullish industrial production figures in the U.S. The "recovery" meme is taking a tenuous hold. Stocks were down. Because why would stocks rise if the economy were recovering?

Ah. Well that tells you something right there. It tells you that stocks haven't risen in anticipation of a global recovery. They're just enjoying the benefits of all that monetary and fiscal smack being peddled in Washington, London, Tokyo and Canberra. It's hard to rally on fundamentals when you're already over-valued.

Speaking of value, let us now return to the question of element number 79 on the periodic table. The snarky article we mentioned at the top is this one from Michael Pascoe at the age, titled "There's more gold where that came from."

In the article Pascoe takes on the issue of "peak gold." But how well has he done in accurately stating the argument for gold? And more importantly, is he right about the relationship between market prices and gold? Well, obviously we think he's pretty wrong. But let's see what he's said.

"Part of the dogma of the less rational gold bugs is that the world is running out of the stuff. As an article of faith, it makes a pleasant change from the idea that fiat money is about to be exposed as huge confidence trick and we're heading back to the caves."

Webster's defines "dogma" as "a religious doctrine that is proclaimed as true without proof." Already you can see what Pascoe is up to. Gold bugs are nutters and zealots. Apparently 5,000 years of monetary history where gold has proven utility as a medium of exchange and store of value does not qualify as empirical evidence of gold's value. There's no pleasing some people, especially those who come to an argument with their mind already made up.

But that's fair enough. Opinion journalists get paid to give opinions. They cloak themselves in supposed objectivity because that makes their views more respectable to the mainstream. But we've never been concerned about respectability here at the Daily Reckoning. Why base your judgments on what other people will think of them?

We're entirely subjective in our views. But at least it's transparent. And at least we base our conclusions on facts and arguments. And we've not once argued here - although perhaps some gold bugs have - that the world is running out of gold. That is not what "peak gold" means at all.

The first step in any debate is to define your terms. So we will do so here and say that "peak gold" mean's declining annual gold production. We'll prove that in a minute. But just so it's clear, no one in this space is saying the world is running out of gold. But gold IS getting harder to find and more expensive to mine. And the supply of paper money continues to grow faster than annual gold mine production.

We won't dwell on the subject of paper money too much longer, except to say Pascoe's dismissal of the current status quo is nearly as laughable as it is naive. He says 'peak gold' "makes a pleasant change from the idea that fiat money is about to be exposed as huge confidence trick and we're heading back to the caves."

Seriously. How can any objective observer take a look at fiscal and monetary of the last three years and assume that central banking and fiat money are not a giant con job on the general public? Fiat money allows the government to create money backed by nothing. Not only does decrease purchasing power - especially hurting savers and those on fixed income - it accelerates the misuse of real resources.

When it comes down to it, it's a kind of theft. The government prints money and gets the benefit of using it first before purchasing power is diminished. It trades paper money for real goods and services - things which take labour and raw materials to produce. The systematic inflation inherent in fiat currencies IS theft of real labour and resources.

As long as that inflation makes house prices and stock prices go up, it appears to please everyone. But it's the argument of this publication that the monetary regime in place since August of 1971 - when Richard Nixon took the U.S. off the gold standard - is a) a fraud, and b) in the process of disintegrating. It's disintegrating because, at it's heart, it's based on the idea that money doesn't have any real tangible value.

Gold does, of course, have tangible value. To the extent that it's intrinsically valuable, it's valuable because it's physical properties - relatively scarcity, durability, transportability, divisibility, homogeneity - make it particularly useful as a monetary unit of exchange. To suggest it has no inherent value is to misunderstand the qualities that make money useful, and more importantly, sound.

But back to the issue of production. It's not just the nut jobs in the newsletter industry warning that gold production is falling. It's the gold miners. Of course you have to discount what they're saying to the extent that they're talking their own book. But they do know their own business and they are saying that 2009 could be the last year for some time that gold production rises.

Omar Jabara, the spokesman for Newmont Mining in the US, says that in terms of production, "2009 is the outlier as far as the trend. The trend is that production has been in a general decline since 2000. Why does that matter?

Pascoe says, quite correctly in theory, that price discovery and market mechanisms help ensure that supply grows when prices rise. Or, in his own words, "The 'peak gold' story isn't quite as dodgy as some of the 'peak oil' scare mongering the more sensationalist media have trotted out over the years - we'll never run out of oil as the market mechanism very successfully rations it and because, at a price, we simply make the stuff. Shell, for example, is spending $20 billion building a gas-to-diesel plant in Qatar."

Running out of gold? Don' worry!! We'll just make more of it!

It's hard to reconcile this with the fact that the gold price has been rising since 2000, but gold production has not. In late 1998 the gold price was in the mid $200s and annual global production was just under 2,500 tonnes per year. Since then, the gold price is up 340%. Yet production this year is set to be just over 2,400 tonnes. That's an increase over last year, mind you. But still down from the production level over ten years ago. So why aren't higher prices attracting new producers?

Well there are a couple of factors here. First, a lot of the big mines that were producing in the 1970s - especially in South Africa - are seeing production declines. That's not say all the mines are played out. But they're having to dig deeper and pay more for labour and energy, all of which leads to rising production costs.

That is, despite the rising price, production costs are rising faster for some companies. Those companies are making less money from the price rise, leaving less to invest in new exploration and production. Besides which, surely Pascoe would know that there's no such thing as just-in-time gold production.

You have to find the stuff. And it has to exist in an ore body that's economic to mine at current gold prices. And you have to get permits to mine it. All of that takes time and money - usually years - during which central bank printing presses are busy churning out new paper notes at a much faster rate. The supply of paper money is growing a lot faster than the annual mine supply of gold, which does not look like growing much at all in the coming years.

Barrick Gold's Vincent Borg says that, "it's a fact that gold production form mines has been in decline since 2001 and has gone from 85 million ounces to about 75 million ounces a year...It sort of goes down about one million ounces every year and or forecast is that it will continue to decline despite the higher price."

In most markets, higher prices to attract new producers. But as we've said before, quoting our friend Doug Casey, gold mining is a lousy, capital-intensive, highly-regulated business. It is not like opening a lemonade stand. Therefore gold production does not automatically increase because prices are higher. That's a fact, not a dogma.

Yet Pascoe persists. He quotes StandardBank analyst Waler de Wet, who, presumably because he has a South African sounding name, must be right about gold. De Wet told clients that, "Given that the US gold mine production is 10% of global mine production, if you assume gold resources are proportionate to current mine production, global resources could be 330,000 tonnes. That is another 137 years of production."

The argument here is that higher gold prices turn more resources into proven reserves. That is, marginal gold projects become economically viable with higher gold prices. But the reason that these projects were marginal to begin with is that they were more expensive to bring into production (away from infrastructure, lower ore grades, smaller ore bodies). If the margins don't improve on the projects, there's no guarantee anyone is going to bother producing them, especially if the cost of production is rising as much or more than the gold price.

Further, why would anyone assume that "gold resources are proportionate to current mind production?" It seems like a rather large assumption to make. As anyone who's spent any time analysing resource stocks knows, a resource is not the same thing as a proven reserve.

The energy market is fortunate that higher oil prices make other sources of unconventional more economically viable. That's why Australia's LNG and coal-seam-gas industries have done so well this year (a trend Kris Sayce profited from in Australian Small Cap Investigator and Alex Cowie is bullish on in Diggers and Drillers.)

But you can't just "make more" gold the way you can make more energy. The world doesn't need oil. The world needs fuel and the work that fuel can do when you burn it. Thus, high oil prices lead to investment opportunities in oil and other energy sources, which eventually brings down the price of energy.

The funny thing is that the last time we checked, the oil prices is above $70. This confirms the peak oil thesis. The age of cheap energy is over. Oil is still out there. But it's getting harder to find and more expensive to produce. The cheap stuff is going fast.

With gold, of course there is more gold in the ground waiting to be mined. But who's going to mine it? And at what cost? It's an expensive business. And even if exploration spending boomed and turned up even more gold, it will take years to bring into annual mine supply.

You could argue that the rising gold price is only a function of scaremongering by newsletters like the Daily Reckoning - or that it's being ramped up by speculators and fund managers. This would explain why gold producers didn't increase production to meet rising prices. They saw the price rise as fictional or fundamentally unsound.

We wouldn't agree with that argument, mind you. But it's one way to explain why gold production isn't more price sensitive. The other is the simpler one: gold production is hard to increase, no matter what economic theory or Michael Pascoe says.

But by the end of the article you can see that Pascoe doesn't really have his head in the argument, just his heart. "The gold price's recent stall thanks to the Greece and Dubai-inspired up-tick in the US dollar demonstrates just how much of the gold rally has really been a currency story rather than anything intrinsically valuable about the yellow metal.

"It's just another alternative to greenbacks, one that doesn't do much productive or pay dividends but relies purely on speculation for any non-currency price improvement. The unkind might think that's why the gold bugs keep the scare campaigns coming - that and the need to sell more internet newsletters."

He's partially right and mostly wrong here. Yes, the rising gold price is a function of the bear market in paper money. Gold is better money than paper, if you're a gold bull. That makes gold stocks a leveraged speculation on higher gold prices. We don't have to say any of that to sell newsletters. After all, this one is free.

But we keep saying it because it continues to be important. Only a numbskull would ignore all the warnings about paper money coming from the markets in the last two years. Rising fiscal deficits...insolvent banking systems...the re-monetisation of gold by central banks as a reserve asset. These aren't articles of faith. They're facts.

Of course gold isn't an investment panacea. But it's something you should take a lot more seriously than Michael Pascoe does. Unless you're worried about being respectable amongst those of your friends who thought that a currency crisis was something that only happened in history books, and not something you ought to prepare for.

Dan Denning
for The Daily Reckoning Australia

• Australia Presents Investors With Great Portfolio of Energy Choices
• Aussie Gold Price Moves Up
• Gold is the Oldest Form of Wealth
• Sustainability of U.S. Deficits Reason Why Investors Own Some Gold
• Gold, the Dollar and Inflation

The first is that Abu Dhabi extended a $10 billion in financing to debt-distressed Dubai. Hossanah! Remember, Dubai is not Lehman. It's Bear Stearns. It's merely the reminder that there are lot of leveraged investors in the world who've used borrowed money to buy assets that aren't very productive. They'll get theirs soon enough.

The second bullish item is that ExxonMobil (NYSE:XOM) made a US$41 billion all stock bid for Houston-based natural gas company XTO. This sent Exxon shares down 4.4%. Thus the Dow's rally was a bit tepid (XOM is a Dow component).

By the way, we've probably mentioned it before, but it's normal for the shares of the acquiring company to fall on an acquisition announcement. The shares of the company being acquired, obviously, usually rise to near the price per share indicated by the value of the bid. You can engage in this kind of arbitrage trading...if all you do is sit around at a desk all day and figure out who's going to be acquired and who's going to do the acquiring.

Exxon is either getting a bigger foot in the U.S. natural gas market or hedging against cap-and-trade legislation, or both. We vote for both. No one is in a better position to know about the constraints on global oil production and discovery of new reserves than a major company like Exxon. And Exxon has seen firsthand that unconventional natural gas can be a lucrative little market.

But are those two bits of news really enough to send the market higher? Probably not. Who knows why the market goes higher? It does what it does. There's an alternative explanation.

The alternative explanation is that the Copenhagen climate talks look like they're collapsing into confusion and President Obama's legislative agenda is in tatters. The private sector absolutely loves this.

Mind you we're not addressing any public policy issues here. We're not that smart. But politics has an effect on markets and lately one of those effects has been a huge increase in uncertainty...uncertainty about the cost of carbon dioxide emissions...the cost of health insurance...the size of government deficits...and more regulation in all aspects of corporate and private life.

Good policy? Bad policy? Who knows? All we know is that the more uncertainty you introduce into the markets, the more conservative and defensive investors are going to get. It's hard (and unwise) to make long-term plans when short-term laws and regulations are always changing. No wonder bond yields are so low. A near-nothing return on cash is still much safer than taking your chances in the equity market.

That's not to say that a deal won't come out of Copenhagen. Maybe the planet will be saved. Or maybe Copenhagen is the sell signal for global warming as a big idea/moral issue with which to bash the public. But either way, we reckon the stock market actually likes the idea that no climate deal is imminent and that healthcare legislation in the U.S. Senate can't seem to get 60 votes.

Dan Denning
for The Daily Reckoning Australia

• Messages from Copenhagen Climate Change Conference
• One of the Biggest Humbugs in Capitalism is Private Equity
• Aged Pension MkII
• An Old Friend With a New Idea on Global Warming
• A Trader’s Market or an Investor’s Market?

China is a country of hyperbole. There's scarcely anything you can say about it that doesn't end with 'est.' In some ways, it is the world's oldest society. In other ways, it is its newest. It is the world's richest - with more than $2 trillion in reserves. It is also the world's poorest, with some 200 million people who get by on less than $5 per day. It faces the world's biggest problems too.

Even in its calamities, China is second to none. People inside the Great Wall were about as rich as people outside it, man for man, until the 19th century. Then, China missed the industrial revolution. Nearby Japan missed it too, but quickly corrected its mistake. It kept the barbarians at arms length, but still managed to pick their pockets. The Chinese, on the other hand, played it cool. The barbarians had nothing to offer, they believed. They still think so. Said Xue Chen of the Shanghai Institute of International Studies, just last week: "The US has a lot to ask from China. On the other hand, the US has little to offer China."

In the early 19th century, traders from Britain and America bought porcelain (china), silk and tea. Trouble was, they could find nothing to sell in exchange. The trade balance with China went negative, with China building up substantial monetary reserves (in silver). In 1830, a Chinese merchant, Hao Gua, who enjoyed a near monopoly on trade with the gweilos [foreign devils], was said to be one of the richest men in the world. Then, the English found something the Chinese would buy - opium. The fruit of the poppy was popular in many countries but, as usual, the Chinese over-did it. First, it was a favorite of the leisure classes. Then, it trickled down to ordinary workmen. Soon the coolies were neglecting their labors and China was in crisis. When the authorities tried to stop the drug trade, the English opened fire, humiliating the government and almost bankrupting it. People lost confidence in Manchu rule. By mid-century, nearly half the country was in open revolt. A Christian revolutionary had set up the "Heavenly Kingdom" in Nanjing. He raised armies and challenged the Qing Dynasty to battle. For a time, it looked like he might win.

In the north, meanwhile, infanticide of female babies had become common in Nien territory - a reaction to famine and scarcity. By mid-century, one out of four young men in the region couldn't find a bride; "bare branches," they were called. By 1855, these bare branches were ready to break. They armed themselves and organized. They drove out government forces and controlled a large part of the country before they were finally put down. Between natural calamities and war, some experts put the 19-century death toll at an unimaginable 200 million. And then came the 20th century! The Middle Kingdom staggered forward, from error to accident to catastrophe! From the Taiping insurrection to Mao Tsetung. Then, 30 years ago, Deng Tsaoping announced the new line: "To get rich is glorious," he said. Suddenly, the Chinese began saving every penny. Building factories. Cutting prices. And beating the barbarians at their own game.

Again, they exaggerated. While Americans built too many shopping malls, the Chinese built too many factories. Then, in 2008-2009 came the "greatest collapse in world trade in history," says Nobel-winning economist Paul Krugman. Americans - their biggest customers - rediscovered thrift. You might think China would realize it had too much capacity and back off. Instead, it rolled more steel. It built more factories and offices...entire cities.

If stimulus spending is a measure of stupidity, the Chinese are three times as dumb as Americans. Both governments respond to correction by doing more wrong than they did before. Loans in China are rising by about 40% of GDP annually. The money supply is soaring at nearly 30% a year. "We estimate that [fixed capital formation] accounted for 70% of China's growth in 2008 and close to 90% of China's first half of 2009 growth," says a report from Pivot Capital.

It is just a matter of time until this capital spending bubble blows up. But China is full of bubbles. In another example of its central planning, it made the ancient practice of infanticide state policy. One couple/one child was the rule. Missing girls was the result. Then, when the boys grew up, they discovered that their brides were missing too. The working age population of China is collapsing. There were 7 workers to every old person in 1990. Now, there are barely 4. By 2035, there will be only 2. What happened to the workers? They are the missing children of the missing girls who then became missing mothers. And by 2040, 397 billion old people - more than the total populations of France, Germany, Italy, Japan and the UK combined - will be missing the support of those missing workers.

Where this leads, we don't pretend to know. But bare branches bend...and then they break.

Regards,

Bill Bonner
for The Daily Reckoning Australia

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But the proper question - if you're sitting on the fence about this move - is how broad the rally is. Are all stocks rallying? The other day, 29 of the 30 Dow components were up. Kraft was not. By the way, Kraft has gone hostile in its bid for Cadbury. This partly explains why its shares were down.

When a company makes a takeover bid, what usually happens is that the bid places a premium on the shares of the company being sought. Those shares rise.

The shares of the seeker (in this case Kraft) often fall. There's a whole school of trading (and even some hedge funds we've heard about) who arbitrage like this on takeovers. They buy the shares of the company being acquired and sell the shares of the acquirer.

That seems like a lot of work, even though it might turn a profit. You could hardly call it a long-term wealth building strategy. Anyway it's certainly not the same as looking for capital efficiency or firms with high net tangible assets selling at a discount. It's a trading strategy.

But then, that brings us back to the question. Is this a trader's market or an investor's market? One way of knowing what's really going on is looking at measures of breadth and volume. A big day in a small number of stocks can move a whole index higher. But that doesn't tell you how most stocks are travelling. So how are they travelling?

Have a look the chart below, and especially the lower part. The top part is the S&P ASX/200 over the last year. You see the market within kissing distance of a new 52-week high. But how broad is the participation? That's what the advance/decline line below shows you.

Bigcharts.com says, "The Breadth Advance/Decline Indicator is the number of advancing issues divided by the total number of both advancing and declining issues. Readings above 0.5 are considered 'bullish' while readings below 0.5 are considered 'bearish.'"

By that definition, the market action would look pretty bullish. But it also looks like the a/d ratio is just as about as high as it has been at any time in the last twelve months. And each time it is neared .75, a big correction has followed. Hmmn.

We asked our technical wizard Murray Dawes to tell us how broad the participation is in the Aussie market rally. Is it just the banks and the miners, or is everyone getting in on the action? Stay tuned for his report. And incidentally, yes, the charter offer on Slipstream Trader has now expired. But that doesn't mean membership is closed. For details, go here.

Dan Denning
for The Daily Reckoning Australia

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So we're moving. And we're moving people. We're moving.

But where are we moving to? It looks like another mini-bubble. The market seemed prime for a fall in conjunction with a U.S. dollar rally. That could still happen if the U.S. employment report tomorrow is a shocker.

A negative employment will remind everyone that this recovery (if it can properly be called) that is still largely a jobless one. The process of reducing household debt is going to take years and not months if households can't grow their incomes. Real wage growth (adjusted for inflation) is pretty hard to come by in most of the Western world (unless you run a bank).

All this adds up to lower household spending ahead. How much further ahead can stock prices get of corporate profits that may never materialise? We'll see. But valuations are already stretched. Investment advisor Jeremy Grantham reckons fair value on the S&P 500 is around 860 - or 24% lower than yesterday's close at 1,066.

But whether the market breaks up or down here (something Murray has been looking out with his technicals) is up to investors. There is a huge cash position on the sidelines that's still worried to jump back into markets. For the bear to really do his work, he's got to convince these people to get into the market. The Fed is helping by making cash a wasting asset (when you figure in inflation).

Thinking out loud, then, you could make a case for new highs on the market as this cash mountain moves into equities. We saw a chart on Sunday at the opening of the conference hosted by the Gold Standard Institute which showed that the amount of cash on the sidelines exceeded the total market cap of the Wilshire 5,000 (a broad measure of the market value of all U.S. equities).

In layman's terms, it means there is more money in cash right now than there is equity in U.S. companies. Now, there is a very good reason investors are reducing their allocation to stocks. As we've said before, we think the equity premium - what people are willing to pay for stocks - is regressing to the mean. It was so high for so long because corporate cash flows in the second half of the last century benefitted so much from low interest rates and globalisation.

But even if the equity premium is collapsing, it wouldn't take a small change in that cash position to power equities much, much higher. In fact, if the investors holding that cash realise that inflation is a bigger risk than over-valued stocks, they may decide to get out of cash anyway, despite the risk of being in the market.

In any case, we are not suddenly becoming bullish. But we are suddenly thinking that the next phase of this GFC (other than the sovereign debt crisis) is to lure investors back into an equity rally. Whether they are prodded by negative real interest rates on short-term deposits, or lured by equity markets lurching ahead with the backing of the dollar carry trade, well that doesn't really matter.

It could all be moving on up.

What's really worth watching is how the commodities behave in this market. They are moving on up too. This means gold is shedding its image as a risk-aversion asset and becoming something that people want to own. Its allocation in household and institutional portfolios is going up too. And of course, trading cash for things is probably a good trade these days, no matter whose cash you have in your wallet.

We'll have to cut it short today as other deadlines press. But beware. The bear is afoot and he is making mischief. He is doing is devilish best to convince investors that he's hibernating. After all, the November to April period is usually when stocks do their best.

This year has been unusual because, thanks to the Fed, stocks had a great six months during a time when they generally don't do much. It's unnatural you might say. But so are current fiscal and monetary policy, we might say.

We might also say that there is something tawdry about insisting that modern living standards are not negotiable and must be preserved with high public sector debt. In effect, today's policy makers are saying to the future, "Our current well-being and comfort is more important than any debt you may have to repay. We refuse to live within our means because it would inconvenience us to do so. We are too lazy and selfish to recognise our financial mistakes and pay for them. We're going to leave that to you. Suckers!"

It's not very nice. It's not very moral. But it is what it is. And right now, it gives you the chance to prepare your portfolio for the consequences of bad policy (fiscal, monetary, climate...take your pick!) More on all of it next week. Until then!

Dan Denning
for The Daily Reckoning Australia

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One day does not a trend make, dear reader, but it does us give pause for thought. What if we dollar bears are wrong about the greenback's fate? What if all these column inches spent bashing the buck - and the frauds at the Fed in charge of protecting it - all come to naught?

"Nonsense!" we say.

Mankind will eventually bury the greenback in the cold, hard ground, alongside every fiat currency that ever went before it. The only question, it seems to us, is when the first shovel of dirt will be thrown. Traders from New York to New Delhi are gathered around the open pit, but they may have to wait, at least for a while. Just to be on the safe side, we've bought a golden shovel, but for now we're content just leaning on it.

Here in the Far East, the dollar is a particularly curious entity. Once upon a time, the mighty greenback was the best show in town, the "must have" ticket for the rocking Asian economies. China, Korea and Japan all amassed gargantuan stockpiles. The three hold about US$4 trillion (with a "T") in foreign reserves, much of it in US Treasuries. Even Taiwan - an island one-third this size of Tasmania but with a population equal to Australia - has stashed away the equivalent of US$332 billion in foreign reserves.

But that was then. This is now. And now everyone knows what all those dollars - and the men who stand behind them - are really made of...paper and promises, promises and paper. And now that the game is up, everyone is betting on a dollar collapse. But that presents a problem, and an opportunity, in itself...

"Whenever you find yourself on the side of the majority," Mark Twain once observed, "it is time to pause and reflect."

Right now, every necktie on television is betting against the dollar. The Powershares DB US Dollar Index Bullish and Bearish Funds - which measure the sentiment for and against the greenback versus a basket of six major currencies - are showing dollar bearishness in the extreme. But what if this "recovery" is not all it's cracked up to be? What if equity markets suddenly start resembling reality - even for a short while? If risk appetite contracts, even marginally, might we see a rally in short term Treasuries...just like we did last time? And just how quickly will currency traders be able to cover their short dollar positions if such a scenario unfolds?

We don't know the answers, dear reader. We only observe that the larger the mob, the more likely it is to be galloping in the wrong direction.

So are we dollar bears, or bulls? The answer, dear reader, is both - the former over the long haul...but the latter before then.

Dan Denning, our friend and colleague on our Australian DR desk, puts it thus: "Though we are confirmed US dollar bears, the dollar is looking oversold. Stocks are looking overbought. And frankly the reflation of all asset markets (bonds, stocks, commodities, and real estate) is looking over cooked... Watch out!"

Asian and European markets largely floundered overnight after Wall Street's lackluster session yesterday.

Here in the Far East, Japan's Nikkei 225 dipped 1.35% by the close while Hong Kong's Hang Seng and the Aussie All Ords ended down by 1.85 and 1.45% respectively. China's CSI index was the only major measure to buck the trend. It finished higher by 0.45%.

Back to the European measures and London's FTSE, Germany's DAX and France's CAC 40 all finished lower by around 1.3% for the day.

In the commodity pits, crude had slipped back a bit last we checked. A barrel of the world's goo was down about 60 cents to just shy of $79. Gold was hanging on around $1,036 per ounce...but looking a little punch drunk.

Until next time...

Cheers,

Joel Bowman
for The Daily Reckoning Australia

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Look. Skeptics can say what they want; it does not change the fact that our world is struggling to maintain daily flow-rates. Whether you agree with us or not, the energy reality is that the supply of conventional crude oil is very close to its peak and no other fuel source can easily fill the supply gap.

Yes, various governments are now promoting alternative sources of energy and over the following years, we expect this drive to intensify. But those sources will provide too little, too late. So there remains, today, an unbelievable degree of denial when it comes to 'Peak Oil.' Most people simply dismiss it as a conspiracy. Others gleefully point to alternative sources of energy, whereas some believe that the vast improvements in oil drilling technology will save the day. Do not be seduced by these delusional hopes.

Remember, crude oil is the lifeblood of the global economy and roughly 70% of it is used to power transportation. Moreover, a vast amount of crude oil is also used up by agriculture (production of fertilizers, pesticides and irrigation systems). In fact, modern-day agriculture can be best described as a process of converting hydrocarbons into calories. Without cheap energy, the world would certainly have trouble producing half of the current food supply and the result could be far worse.

Thus, crude oil is a key ingredient in two of the most critical processes which make modern life possible - transportation and agriculture. And shortages of this vital natural resource will result in extreme pain. In the initial stages, the price of crude oil will rise remorselessly and eventually, we will face rationing.

Now that we have established the importance of crude oil, we will explain why new drilling technology and alternative sources of energy will not make this problem go away.

First, as far as drilling technology is concerned, it is worth noting that America is home to the best oilfield technology on this planet. However, its oil production peaked in the early 1970s and has been in a relentless decline. Furthermore, apart from America, other technologically advanced nations in the world have also failed in maintaining their daily flow-rates. For instance, after exporting crude oil for over two decades, Britain is now a net importer and its production is in a state of permanent decline. Hard data confirms that two of the most advanced countries in the world now live in a post 'Peak Oil' era, so what are the odds that other less fortunate nations will succeed in averting 'Peak Oil'?

Secondly, as far as alternative sources of energy are concerned, they represent a drop in the energy ocean and will not be able to offset the depletion in crude oil. Despite all the euphoria surrounding renewable energy, the 'sources' like ethanol and solar panels are net energy losers. In other words, it takes more energy to produce ethanol and solar panels than the energy you obtain from them. For sure, hybrid and electric cars will help us to some degree but you must keep in mind the fact that electricity is not a source of energy; it is a carrier of energy. Even if electric cars become popular, how will we generate sufficient electricity?

Elsewhere in the alternative energy patch, a lot of hopes currently rest on unconventional sources of oil (especially tar sands and shale oil). Once again, this optimism is misplaced, as the increased supply from the unconventional sources will not even make a dent in the overall energy picture. The nearby chart confirms that our world currently produces roughly 85 million barrels per day of total liquids and out of this gigantic sum, only 13 million barrels per day of oil is derived from unconventional sources. So, when the production of conventional crude oil finally declines due to 'Peak Oil', it is extremely improbable that unconventional supply will be able to rise to the challenge.

As far as Canada's tar sands are concerned, Alberta currently produces roughly 1.4 million barrels of oil per day and under the best case scenario, this figure is expected to rise to just 3.5 million barrels per day by 2020. To complicate matters even further, the tar sands require huge amounts of water and natural gas. In addition to this, the mining procedure is extremely polluting. For example, the process of extracting 'oil' from bitumen releases at least three times the amount of carbon dioxide emissions as regular oil production. Accordingly, we have no doubt in our minds that Canada's tar is not the Holy Grail.

Finally, the new oil shale discoveries in America are not going to help us either because the 'oil' trapped in the shale is in fact kerogen - a precursor to oil. So far, all major oil companies have struggled to convert the kerogen into usable oil and it will be interesting to see whether any of them succeeds in the future. In any case, this conversion process is extremely expensive and we can assure you that shale will not be producing any oil at today's prices. Recent studies reveal that the price of oil will have to rise to several hundred dollars per barrel to make this process economically feasible.

Well, now that we have covered the supply side, let us briefly discuss the demand side of the equation. According to the IEA, global oil usage in 2009 will amount to 84.4 million barrels per day and it will rise to 85.7 million barrels per day in 2010. This means that oil demand will rise by 1.5% over the next twelve months which is in line with the growth rate over the past two decades. If this growth rate continues over the next 4-5 years, there is no way our world will be able to ramp up production.

Unfortunately, positive thoughts and wishful thinking will not change the equation. Precious time has been wasted and we have no margin of safety. We must prepare ourselves for sky-high commodity prices and periods of acute shortages, which will make wartime conditions seem rosy. In fact, we believe we are already a decade into this painful transition but let us warn you that we have seen nothing yet.

If our assessment is correct, it seems prudent to make a sizeable allocation to the energy sector. However, given the realities of 'Peak Oil', we do not recommend exposure to the oil majors, as their reserves and production are in decline. On the contrary, we urge you to invest your capital in quality upstream oil/gas companies and businesses involved in the energy services sector.

Regards,

Puru Saxena,
for The Daily Reckoning Australia

• Peak Oil – The Rewards
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