And when we ran out of money, no problem! There was more where that came from. In one sense we couldn't spend money fast enough. As soon as it was gone, there was more suddenly available. So we just finance the house again, take out some equity (which always rises) and do one of two things - Pay off credit cards (so we can load more debt on them) or just spend the cash on things a home improvement (that is no longer reflected in the price of the home) or a vacation.

Remember how MasterCard taught us that those memories were priceless? Hope you got some good ones... because you "done bought something you can't eat," as one of my teachers used to say.

At a time when we are drowning in debt, we are also out of money.

When a debtor is out of money, he has no ability to repay. And when a creditor has borrowers who are out of money, the creditor has no income. No earnings. No power to make better loans.

So how are banks in America posting "profits"? How did Citigroup, Bank of America, AIG and Wells Fargo jump 400% in stock price? Are they worth 400% more? Are their earnings up 400%? And where in the world did all this money come from?

These companies were just bankrupt... yet found a way to get back above water. And not just above water - they are making moon-shots!

Their share price should be zero (or less, if possible!). How are they worth so much more now?

As I have written before, mark-to-market accounting rules were repealed in favor of a fictitious slight of hand. Banks no longer have to list their distressed assets at the fire sale price they should be worth. Instead they get to record their value as the price they bought them, or what they believe they will be worth in the future.

In other words, it's like me refinancing my house, but doing my own appraisal and assigning it whatever value suits me. I want cash out? Just pad the value of the house. I can't afford a higher payment? No worries, I just pad my reported income. Two years down the road I can't afford my payments anymore? Easy, just follow the same refinancing procedure all over again.

But my family and I would only have one toxic asset to deal with. The banks have them coming out the wazoo!

They are still in possession of the faulty loans and derivatives that caused this entire mess in the first place. Nothing has changed - except the accounting!

The banks always counted on that. This time, however, they are the ones left holding the bag. What are they going to do with all this JUNK? How can they unload it without attracting suspicion? How can they clean up their books without the short sellers making a profit off their downfall? They can't. It's a Catch-22.

But the real problem is that the US banking system would come crashing down in a minute if this were known and understood by the general public. The banks know it. The Fed knows it. I suspect that there are some congress people who know it.

But here's where the rubber meets the road. Government engineered a bailout. They wanted the banks to lend to Joe Consumer. But the banks didn't. And frankly, Joe Consumer didn't want it. He was too busy trying to figure out how he was going to repay all the money he had already borrowed against his house. Especially with the boss breathing down his neck, threatening job terminations if he wasn't more productive than some cheap labor in India.

So the banks were sitting on a good deal of the money from the Fed in order to protect them from future losses. Some of them have even paid it back. But the truth is, from an accounting standpoint, they don't need it anymore. From an accounting standpoint, their mortgages and derivatives are all valued at a big fat surplus. Why keep federal money? Why incur interest charges when "all is well"?

If they can show a profit from an accounting standpoint... and if they can repay their bailout money (plus interest)... and if they can still service the customer at the drive-in window or the teller counter, what's the big deal? What am I crying about?

It's all because those toxicities still exist. And they all have to be accounted for, whether the government says so or not.

We should have learned, or have been reminded of, one of the greatest lessons in the world from convicted felon Bernie Madoff: "Be sure your sin will find you out."

Even the greatest engineered schemes on the planet come undone at some point. No Ponzi scheme can continue forever. But if you are very bright (as Madoff was), you can keep the game going for a long, long time.

But what if you're not brilliant? After all, I doubt the government is as smart as Billionaire Bernie. Luckily, if that's the right word, the government has another way to keep the game going, using one thing it has that Madoff didn't.

Cash.

Gobs and gobs of it.

The government's massive wad of cash is what keeps the game going. And foreign investors lending us money. And millions of pensioners happy as long as they receive their check on the first of the month. And the multitudes of purchased votes that are blissfully sitting on the dole.

But it's not just the United States. Every country in the world is in the same pickle - because every developed nation believed they could successfully manipulate the game. The problem now is that the governments are running out of money. The United States has been broke for a long time, of course, but it could still trade on the value of its good name... and it did. Other nations are not so lucky.

The United States still possesses the reserve currency status; other nations aren't so lucky. We still boast the largest GDP; other nations are not so lucky. I'm pretty sure we still have higher tax receipts, and more room to raise taxes than other nations. But somehow, I can't bring myself to call that lucky...

But as it is an "option," I have to think that whatever smarts our government does have, someone will eventually realize it. Good Lord, deliver us.

I do not honestly think that anyone can seriously contest us in the role of reserve currency, no matter how many times China rattles the saber.

Twenty years ago, China couldn't even feed its own people or keep them employed. Now it is boasting a 7% annual growth rate. Despite the massaging that may be done to the numbers before they are released, we can already see that a country growing solely on stimulus cannot grow very long. The weaknesses in China's underbelly are already becoming apparent. She is an export economy. And people are not buying.

She cannot save the world, whatever her strength might be.

There is another round of destruction coming. The banks will have to come clean. If you thought the residential crunch was stunning, wait till you see what's coming on the commercial front. It will be a tsunami of epic proportions. Banks are not lending now, and the chances of business expansion are lower than at any time in recent history. No one will be buying excess of anything except maybe food and precious metals, so businesses will not continue to post profits. Without profits you can't service the loans you have, and rolling them over will be out of the question. The day is coming... don't let it catch you by surprise.

But until that day arrives, we must deal with what we have.

Regards,

Bill Jenkins
for The Daily Reckoning Australia

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"Banks recover to their levels before the fall of Lehman," is a headline in this Monday's El Pais from Madrid.

"Public assistance enables the world's largest 15 financial firms to return to the capitalization they had in September 2008," the article continues. The largest of the largest, HSBC, is now judged to be worth $186 billion, according to the stock market. China's ICBC is on its heels, with a market cap of $178 billion. BNP Paribas is 7th at $87 billion.

We will overlook the compromising detail that banks actually lost money in the last quarter - more than $3 billion. And let's forget that China's major banks are sitting on mega-losses from more than eight years ago (to say nothing of the more recent losses). Western banks, too, still have billions in assets whose real worth is an open question...and subject to quick reconsideration...

El Pais goes on to report something intriguing: "The two big Spanish banks leave the crisis stronger."

Ah. What doesn't kill you makes you stronger. The world economy is recovering, or so people believe. Stocks are going up - led by the banks. But are the undead of the banking world really stronger?

Ha ha...don't make us laugh.

But the world seems to believe it. The Wall Street Journal reports that just five big financial stocks are behind the stock market's rally. Fannie Mae, Citigroup, Freddie Mac, Bank of America and AIG account for nearly a third of market's daily turnover. Seems everyone is speculating on the banks...and moving them higher.

You will recall, dear reader, the banks made a fortune during the bubble years. You may also recall that they made so much money that when the bubble years came to a close, that they were almost all broke. Without hasty action from the feds, it would have been the end of the road for every major bank on Wall Street. As it was, even with government help, none of them survived intact. They all either went bankrupt, were sold off, or got bailouts with strings attached.

What busted the banks was too much of a bad thing. They made their money by peddling debt. In order to move the stuff, they convinced clients that their products were good safe investments - even leveraged derivatives backed by subprime mortgages! Such good salesmen were they that they even convinced themselves. When the crisis came, they realized that they had been buyers of the debt...as well as sellers of it. What could they do with it...except sell it to the feds?

But the whole financial industry is coming back to life. According to El Pais, it's back...and it's better than ever.

But wait? How could that be? Hasn't the world entered the worst recession since the great depression? How could lending money be such a good business? People don't borrow in a recession.

Strategic Short Report's Dan Amoss is just as skeptical. "The banking system has no experience managing through the current 'negative home equity' environment," he tells us. "This is an environment in which mortgage rates are already about as low as they can get and consumer balance sheets are as stressed as ever. Due to the nonrecourse nature of mortgages, most borrowers have no financial incentive to keep paying. Many are choosing to mail the keys back to the lender.

"This problem will cap the upside of bank stocks for years to come, so the sector will offer lots of short selling opportunities."

Borrowing by households has fallen off a cliff. Instead of borrowing, they're paying back debt at the fastest rate since the '50s. No money to be made there.

How about commercial and business loans? Are you kidding? Businesses are cutting back too. Businesses borrow to expand...and there is no expansion going on. This is a contraction. Credit is contracting along with everything else.

Then, how could the banks make money? Let's refer to that news item again. Oh...there are the magic words: "Public assistance enables..."

The banks are making money the same way Detroit is making money...dishonestly and temporarily. Instead of doing honest deals with willing and able counterparties, the banks are pulling a fast one. Their money comes, ultimately, from the poor taxpayer...the poor sap who funds all the government's giveaways. The private sector lived far beyond its means during the bubble years. People wasted their money they didn't have on things they didn't need. Now, they try to save their money. But now the government wastes their money for them.

Speaking of which...a quick note on the Cash for Clunkers program. Numbers to be released today are expected to show a peak in sales in August caused by the feds' incentives. President Obama calls the program a showcase, proving how effective government can be at getting the economy back on the road.

But let's go back to basics. It's a sham when people waste their own money. It's a crime when they waste other peoples' money. Prosperity comes from accumulating (saving) capital...and using it to increase productive capacity. The formula is pretty simple: Save your money. Invest it in productive business. The Clunkers program encouraged people to do the opposite - consume capital, other peoples' capital.

'Nuff said.

Bill Bonner
for The Daily Reckoning Australia

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It's tempting to think you can have a recovery in bank stocks based on one single quarter in which bank earnings were boosted by fixed income trading (front running the Fed in the bond market). But based on the action on Wall Street today (the Dow down 3.5%), investors are having second thoughts about whether the bank's have returned to profitability for good or just for a quarter.

By the way, before we go further, we should correct a mistake we made yesterday regarding Citibank's accounting. We wrote, "Or, in plain English, Citi profited because it made a bet that the cost of insuring itself against a default would go up." That is incorrect. Instead, we should have said that Citi boosted revenues by $2.7 billion using an accounting adjustment to the market value of its debt.

Our main point was that Citi's profitability didn't fundamentally increase in the first quarter. But the accounting rule which allowed the company to present investors with a profit has been around since 2007. Heidi Moore at the Wall Street Journal's Deal Journal explains in plain English, "The rule is part of the Financial Accounting Standards Board's FAS 159, which governs the rules under which banks value their debt, including everything from short-term lending to credit-default swaps."

"Essentially, the rule is a counterintuitive and confusing one. It requires banks to take a gain when the price of their debt falls. The reasoning behind it is this: When the debt declines in value, the banks have to assume at the end of the quarter that they bought the debt back and retired it. The banks would 'buy it back' at a lower price, so they get to make a profit. Here's an example: Imagine that a bank has a bond that was once worth 100 cents on the dollar and is now trading at 60 cents on the dollar. At the end of the quarter, the bank has to assume it would buy that debt back at 60 cents - which is essentially a profit of 40 cents. "

"That's what happened to Citigroup in the first quarter. Citigroup had a rough quarter in which investors showed little faith in the bank's future by widening the spreads on the bank's credit-default swaps. As those spreads widened, they sent the message that investors believed Citigroup would be less profitable. In a nice twist, the widening spreads also triggered an accounting rule that allowed Citigroup to record a profit. "

Got that? While we were incorrect to say that Citigroup profited from a bet based on its declining creditworthiness, the whole explanation shows you just how bizarre the accounting rules are, where mark-to-market accounting is used when its beneficial, but fair value accounting is used for assets that are 'impaired.' If you're keen to read more on the subject, try this. And our apologies for yesterday's error. We'll be more careful in our accounting discussions from now on.

Meanwhile, back in the world of tangible things, the National Australia Bank is worried about a fire sale in commercial property in Australia. NAB told a Senate inquiry that the Big Four Aussie banks would not be able to refinance $190 billion in commercial property debt without government help. You can find a complete list of submissions to the Senate inquiry here. Or you can just read a few highlights below.

NAB's submission concluded that, "The four major Australian banks cannot solve the problem, due to industry concentration limits, and increasing capital requirements from credit-quality downgrades...A solution for the liquidity/funding issues emerging in the commercial property industry as a result of the global economic crisis is needed promptly."

This is a far cry from the old saw that Aussie banks are well capitalised and safe enough to meet the credit needs of the Aussie economy on their own. And on that score, one paragraph that caught our eye was this one from the submission by the Treasury: "While the major domestic banks are well capitalised, they face constraints in terms of the extent to which they could offset a significant and sudden withdrawal of finance from other financiers."

"The possible shortage of finance for financially viable commercial property assets could have adverse consequences for the ongoing operations of these assets, as well as broader macroeconomic consequences. If borrowers believe there are risks they will not be able to refinance assets, they may de-leverage by selling property, which can then sharpen price falls, and trigger further sales."

Ah yes. This is the dreaded "fire sale" of deleveraging and forced asset sales in commercial property that everyone wants to avoid. After all, we've seen what deleveraging and fire sale pricing did to the stock market. It is no wonder that the submission by the Property Council of Australia is so shrill in this regard. This particular submission says that the, "property sector has a huge exposure to foreign financiers."

That's certainly true. Of the commercial property sector's $165 billion in bank debt outstanding, $30 billion (18%) is sourced from foreign lenders. But for Australian Real Estate Investment Trusts (AREITS) nearly 70% ($16 billion) of $23 billion in debt outstanding comes from foreign lenders. As we've been saying all along, Australia's property boom was bought with foreign money. And now, in a credit depression, there's a real fear that once the money's gone, prices will collapse as developers are forced to deleverage and sell.

Or, in the Property Council's own words, "The Australian commercial property market is significantly exposed to foreign banking finance...foreign banks are already exiting the Australian commercial property market...there is a high risk that foreign banks will continue to withdraw or scale back their exposure to the commercial property sector."

The submission concludes that the withdrawal of foreign finance from the Aussie commercial property market will have will impact on, "jobs, superannuation benefits, small businesses, housing and social investments, and mum and dad investors."

They didn't leave anyone out did they?

The Property Council submission concedes that real estate values are going to fall as the flow of credit to Australia is choked off by the credit depression. But it insists that RuddBank will make sure the adjustment in prices is normal and not exaggerated by forced de-leveraging. It also insists this is not an effort to use the Federal government's Triple A credit rating to funnel money directly into the property industry and the Big Four Banks. Hmmn.

It's going to sound like a broken record, but we reckon there's going to be deleveraging in the Australian property sector one way or another. One by one, the arguments about why it's different here will fade away. The property market, like the share market, benefitted tremendously from the credit boom. Now everyone wants to preserve those gains with more inflation.

And make no mistake, that's what all alphabet soup programs across the world are all about: propping up credit bubble asset valuations with the creation of new debt obligations. It takes ever greater amounts of credit to sustain the illusion that these values are, well, sustainable.

But as several readers have begun to note, there's a diminishing marginal return on each new dollar of debt added to the economy. When you sink this new borrowed money into old financial assets, it doesn't create anything new or productive. You don't get any boost to GDP from the new debt. You just get a wobbly old property market that needs ever greater amounts of credit (or a permanent first home buyer's grant) to keep the bubble from losing air. You might as well burn the money. It would at least create some heat, light, and warmth.

That's about where we are in the property market right now. In the share market, investors are trying to sort out who wins and who loses when the banks and the government cooperate to inflate. The answer: the banks and the politicians win; the rest of us lose.

The one note of interest this week is how active China's sovereign wealth fund has been in ignoring the implosion of financial asset bubbles and instead trading paper money for tangible assets. China's loan-for-oil programme was in evidence this week when it agreed to a US$10 billion loan package to Kazakhstan in exchange for a stake in a Kazakh oil producer. Chinese companies have already concluded similar deals with Brazilian, Russian, and Venezuelan companies.

An article in last week's London Telegraph speculated that Chinese buyers are using the massive commodities correction to build up large stockpiles of raw materials at discount prices. This kills the proverbial two birds with one stone. First, Chinese companies scoop up commodities at dirt cheap prices. Second, they get rid of their dollars without circulating them back into the U.S. bond market. More on what this means for Australia in tomorrow's edition of the Daily Reckoning.

Dan Denning
for The Daily Reckoning Australia

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So the banks have returned to profitability have they? That was the theme on the market last week. And if it were true, a recovery in bank balance sheets is just the sort of thing that might precede a recovery in the economy. But it probably isn't true. Here's why...

The big three banks reporting last week-Citibank, Goldman Sachs, and JP Morgan-all reported huge revenues from their trading desks. As we reported last week, Goldman's $6.6 billion in trading revenues was not only 70% of total revenues, but it was also a ten billion dollar improvement on a $4 billion loss in the fourth quarter.

JP Morgan reported nearly $5 billion in revenues from fixed income securities trading. And Citigroup reported $4.69 billion in fixed income trading. In fact, all of Citigroup's other major operating segments reported declining revenues for the quarter. Its global credit card revenues fell by 10%. Consumer banking revenues were down 18%. And Citi's Global Wealth Management revenues were down 20%.

But something magic happened in the fixed income trading group for Citi. This is pure gold if you like arcane financial statements packed with fictional earnings. If you dig into the quarterly report, you'll learn than fixed income trading revenues were boosted by a "net $2.5 billion positive CVA on derivative positions, excluding monoclines, mainly due to the widening of Citi's CDS spread.

That takes some sorting out. A CVA is a "credit value adjustment." As you can learn here, it's the credit risk premium of a derivative contract. Once you sort it out, you learn that Citi "made" $2.5 billion on a derivatives position designed to profit when the companies own credit default swaps spreads widen.

Or, in plain English, Citi profited because it made a bet that the cost of insuring itself against a default would go up. The credit default swap market is the place where you can bet on the credit worthiness of a firm, or, essentially, the chance that a firm might default on its bonds. Citi appears to have reported a $2.5 billion trading gain in the fourth quarter precisely because the market thought the company stood a good chance of failing (hence the widening CDS spread).

As far as we can tell, if you use this kind of perverted logic, the closer Citi gets to bankruptcy, the more money it would "make" on its derivatives. That shows you how bogus the quarterly number was. The company reported declining revenues in its core banking and lending activities. But thanks to fixed income and this handy $2.5 billion CVA, the company was able to report $1.5 billion in net income.

Also, don't forget that all of the banks benefitted from what financial sector analyst Meredith Whitney called "back door financing." Whitney described what amounts to Fed-sanctioned front-running of the fixed income market by the banks. The Fed publicly telegraphed its intention to buy $750 billion mortgage backed securities from Fannie Mae and Freddie Mac and $300 billion in U.S. Treasury bonds. And that was AFTER it announced in late November of last year it would be wading in as a buyer for all agency bonds to support the U.S. mortgage market.

Since the financial statements of the banks don't break trading revenues out a line item basis, it's hard to say how much money each bank may have made by front running the Fed's actions in the bond market. And of course, there was nothing really illegal about it that we can gather.

But from the looks of it, what we have here is a kind of back door subsidy to bank profitability provided by the Fed. First quarter earnings were strongly boosted by an increase in the valuations of mortgage backed securities that went up with Fed buying. Before you get all excited about the recovery in financial stocks, you may want to keep that in mind.

Dear Dan,

May I add an important point from the ABS Housing Finance report, which you seem to have missed? In the report it stipulated that, "In original terms, the number of fixed rate loan commitments as a percentage of total owner occupied housing finance commitments decreased from 3.8% in January 2009 to 2.7% in February 2009."

This alludes to the fact that, not only are the FHBs propping up the housing market on their own (with govt. support of course), but they seem to be doing it with variable rate borrowings. This is a recipe for disaster.

We are at or very near the bottom of the interest rate cycle, and people are taking on more variable rate borrowings? Are they mad? Wouldn't it make more economic sense to lock in a low fixed rate for the next 15 years, or more, at this time?

There is much more upside potential on interest rates than downside. Why are borrowers not using the low rate environment, currently offered, to lock in a low fixed interest loan for as long as possible? The RBA cash rate is only 300 basis pts from ZERO, and I highly doubt that the RBA is even willing to cut another 150 basis pts.

I'm sure that the IRSwap books of every major Australian Bank cannot forever suppress the upwards pressure, currently building on medium & long term interest rates. Although that will not stop them from trying. It looks like this could get very, very ugly indeed...

Cheers.
JL

---Your well drafted article on the relaxing of the FAS 157 rules on security values seems to not want to acknowledge that this latest adjustment is to actually to correct yet another stupidity. Any lender who intends to hold the security for the life of the loan and has no need to sell while those about him are scrambling to shore up their balance sheets, should in my view feel free to snub their nose at the market price and soldier on.

These almost arbitrary market values now being set are a very recent innovation and almost coincide with the magical disappearing balance sheets that have been shrinking since mid 2007.

Why not get rid of the rule altogether and let the institution make its case in the market - transparency could be in vogue and investors and borrowers alike could judge the book by its contents.

Terence B.

New Zealand

More transparency? Now there's a thought...

Dan Denning
for The Daily Reckoning Australia

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"I lived through the Great Depression. I remember people standing in bread lines. It was hard to get a job, any job, back then. But now, you see the restaurants are still full. People are still spending money. They may be worried and they may be beginning to save, but there's no sense of urgency. And there's a rally on Wall Street. You know, every bear market produces a rally. You can expect the market to retrace its steps by one- to two-thirds.

"And every bear market has a surprise. I think the surprise is that this is going to be a lot worse than people expect."

Richard Russell is 84. He's been writing his investment newsletter, Dow Theory Letters, for 50 years. This weekend a group of his admirers, including your editor, came together to say thanks.

There are a lot of people with opinions on the economy and the stock market. You can hardly turn on your computer without getting dozens of them. But there are not many opinions with the depth of experience and knowledge behind them as those of Richard Russell. He's been studying "the language of the markets" for more than half a century. Though no one ever fully masters the language of the market, Richard can at least carry on a conversation with it.

"The primary trend is down," says he. In the end, he continues, no matter what Obama and Bernanke do, the primary trend will have its way. The bear market will continue until it "has fully expressed itself."

What does that mean? We don't know...and no one else does either. But if this market has something to say, it's probably something it's wanted to get off its mind for a long time. And our guess is it's not a message that people are going to want to hear.

Richard is probably right. After so many years of watching markets, he's developed an instinct for what is really going on. This is going to be worse than people expect, he says. Because despite all the whining and bellyaching in the press, most people still do not expect the worst. Over the last quarter century, they've learned to look for bottoms...and buy. Every time it looked like real trouble was coming, the Fed cut rates...and soon, it was off to the races again. Now, they're afraid of missing this opportunity for another boom.

But Richard is old enough to be able to look back much further than a quarter of a century. He's seen the Great Depression...WWII...the bear market and stagflation of the '70s. He knows that sometimes it pays to be extra cautious. "Cash and gold," says Richard, are the only investments you should be holding now; we're a long way from the bottom.

One of the reasons we think that is because so many people are looking for the bottom. "Individual Investors Pile Into Citi," says a headline from last week.

"The old Wall Street adage about the dangers of catching a falling knife doesn't seem to be scaring individual investors away from Citigroup Inc.

"Some discount-brokerage firms report a surge of individual, or retail, investors buying shares of Citigroup during the past five months, amid the New York bank's stock-price slide."

These investors think they see an opportunity. What we see is a trap.

The Dow rose again on Friday. Apparently, this is the rally we've expected since November. It could take the Dow back to 10,000 or so - before collapsing on the heads of naïve investors.

Remember, this is a depression, not a recession. And thanks to determined government action, it is on its way to becoming a Great Depression. In a depression, you can't revive the old economy. It needs structural change - eliminating the mistakes of the previous bubble period - and building new businesses with new ways of doing things. "Creative Destruction" Schumpeter called it. Things that don't work need to be destroyed...so that things that do work can make use of the capital more efficiently.

"What would you do if you were suddenly in a position of power in the United States?" asked one of crowd at Saturday night's dinner.

"Nothing," replied Richard. "I'd do nothing. I'd let it happen. I'd let the bear market do its work."

Amen, brother.

More news from Addison and Ian in Baltimore:

"Another industry built on credit-fueled consumption, and thus, likely to get leveled during the great deleveraging, is looking a little gluttonous right about now," writes Addison in today's issue of The 5 Min. Forecast.

"U.S. restaurant expansion over the past 20 years has vastly outpaced population growth."

"Since 1990, the number of bars and restaurants in the U.S. has grown 49%, to over 537,000. The American population has grown only 23% in that period," Addison continues.

"Growth in the restaurant industry has even outpaced the U.S.'s appetite for squandering money. According to the National Restaurant Association, in 1985 Americans spent around 40 cents of every "food dollar" in restaurants. Today, we're closer to 48 cents on the dollar, a 20% bump.

"Back in the 1950's, the average Joe spent just 25 cents of his 'food dollar' in restaurants. If we're to return to anything even resembling a post-Depression, post-War, way of life... tens of thousands of restaurants will go under."

Each weekday, Ian and Addison bring readers The 5 Min Forecast, an executive series e-letter that provides a quick and dirty analysis of daily economic and financial developments - in five minutes or less.

And back to Bill with more thoughts:

Many old friends were at Saturday's dinner. Analysts, writers, opinion mongers, subscribers. One fellow said he had been reading Richard Russell for the last 30 years.

"I figured I probably paid Richard more than $60,000 in subscription fees over that period," he explained. "But it was the best investment I ever made. He helped me turn a few bucks into $30 million."

"Well, what do YOU think?" asked a local reporter, interviewing your editor at the Richard Russell dinner.

"I agree with Richard," we explained. "Let the free market do its work."

"But aren't you afraid that the banking system will collapse and that millions of people will be out of work?" came the follow-up question. "Are you saying that the government shouldn't even try to make sure that doesn't happen?"

"Maybe the government should make sure there are enough parking places. It should probably make sure the grass is cut at Arlington Cemetery. But there's no way it can do a better job of getting people what they want than they will do themselves. Even in a depression.

"Here's our new motto at The Daily Reckoning. You're going to be the first to report it in the press. And when historians finally get around to discovering our oeuvre, they're going to credit your paper as the first to publish it. Are you ready?
Here it is:

"The free market rarely takes you where you wanted to go...but it always takes you where you ought to be.

"There...we think that pretty much says it all, no?"

Rick Rule was there too. Rick provides finance capital to the mining sector - among other things. We asked him what he thought of the recent run-up in stock prices.

"I'm a lender, mostly. And as a lender, I'm primarily interested in the credit quality of the people I lend to. Am I lending now? No."

Rick explains that stock prices in the mining sector are, generally, too high. Investors are betting that they go higher. That's a bet a speculator may want to make, but not a lender. And it's that kind of speculation that got people in trouble in the first place. Homeowners bet that their houses would go up in price. So did their lenders...and their lender's lenders. They were so sure they were going to make speculative gains they forgot to pay attention to the quality of their credits.

But a rally is underway...and our guess it will destroy both the bulls and the bears.

The bulls will buy stocks believing that we have another bull market on our hands. After having lost 50% of their money since 2007, they'll lose another 20%-30% when this rally collapses.

The bears, meanwhile, are convinced that there is worse to come. They think the stimulus spending programs will cause inflation. So they're buying gold and commodity stocks - sure that when inflation comes, it will cause mining and oil stocks to soar. Maybe it will - eventually. But the first big move will probably be down. They, too, will lose big.

That could be the big surprise of this depression. It will kill the stock market bulls when the bear market rally collapses...then it will kill the stock market bears when the mining and commodity stocks collapse...and finally, it will wipe out the middle-class savers when inflation increases and the dollar collapses.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• From the Gold Pan… Inflation, Deflation and Precious Metals
• Bear Market Bounce a Sure Thing
• Your Second Chance to Escape the Bear Market
• Broad Money Supply Declines by $50B in US, Fire Up the Printing Presses
• Every Major Bull Market Needs a Major Bear Market

We'll get to the details of the Geithner plan in a moment. And we also want to cover the thread that ties the Geithner plan to the Australian housing market. But first, let's look at the market's reaction to the plan and see where it takes us.

Investors appeared to absolutely love the U.S. Treasury Secretary's plan to subsidise private sector purchases of toxic bank assets. The Dow closed up nearly 500 points, or 6.8%. The S&P closed up seven percent. The move gave stocks in New York their best two-week gain since 1938, according to Bloomberg.

The futures show the Aussie market opening up big, as well it should. BHP's New York listing was up nearly eight percent. The financials should get a nice boost too. In fact, as we dissect the technicals and the performance of U.S. markets yesterday there are three things we need to mention here.

First, the Real Estate Investment Trusts (REIT) sector was by the far biggest winner yesterday. Of the five best performing sectors, four were REIT-related. And if you look at the top ten (see below) you can see all of them are finance related.

The Financial Economy Strikes Back!

Click to enlarge

Top-ten performing sectors on the U.S. market for March 23rd, 2009, source: Yahoo.com

No one stands to benefit more from government-supported real-estate prices than real estate investment trusts. Well, no one except perhaps banks who cannot currently unload real-estate related assets without making themselves insolvent in the process. This explains why the money centre banks--JP Morgan (NYSE:JPM), Bank of America (NYSE:BAC), Citigroup (NYSE:C), and Wells Fargo (NYSE:WFC) all rallied too.

The REIT performance struck us this morning because just yesterday we read a piece from Kris Sayce in which he tipped a REIT. We thought the man had gone truly mad. He is, after all, an Englishman.

But it turns out Kris is not mad at all. He's added a regular feature to the Australian Small-Cap Investigator called "Radioactive Stocks." Sounds dangerous doesn't it?

That's just the point. Kris takes a look each month at the most speculative punts on the market. And in March (the issue is due out later today) he reckoned REITs were one sector that would soar if the market rallied. We'll see if he's right today.

It makes sense that with both the Australian and U.S. governments effectively subsidising the real estate market (Australia more directly with Ruddbank than the U.S. with its new public/private plan), investors might place a higher valuation on the properties held by REITs. Not that it's a sound economic policy. But it certainly may be a tradable move for punters.

That brings us to the second point about yesterday's action. If Australia rallies in kind, how high could the rebound go? In an update sent out to members last week, Swarm Trader Gabriel Andre produced an ASX/200 chart and provided some analysis. First the chart below.

Swarm Trader Analyses ASX/200

Click to enlarge

So what does it mean? On Friday Gabriel wrote that the chart, "Indicates a potential target for the current price action at 3,600 points. That's 3.75% higher than the current level. The second objective (if the rally gains some momentum) is the second resistance oblique line that goes through the historical high of November 2007 (point A) and the lower highs of December 2007 and May 2008 (points B and C)."

"It would represent a further 30% upside move, with a potential objective at 4,500 points. However the immediate target is 3,600 points. It is more than likely that it will be hit next week."

In fact the futures indicate 3,600 will be hit today. But will it hold? And if it does, is it possible the market could really all the way to 4,500?

Well yes. It IS possible. And it would certainly be the bear market rally nearly everyone expected at the beginning of the year (the Obama bounce). It also has the look and feel of a rally. It's not so much the bears capitulating as the bulls being suckered back in.

This is what the bear does. He roughs you up. You play dead. He goes away. You think he's gone. And you can't help yourself. You get back in. That's what investors are doing. But not all of them.

This is the final point we'll make about yesterday's market action. It was an unusually large up move on the Dow given the number of shares that actually traded hands. As you can see on the chart below, volume on the Dow yesterday was just over 500 million shares. First take a look at the chart and then we'll tell you what we think it means.

You can see that most of the big volume days came on days the market closed lower (red columns). Even then, you haven't seen large intra-day moves like yesterday's on heavier volume. Last Friday saw heavier volume and a lower close, but not a big move in percentage terms. So what?

All of this is telling us that this is a paper thin rally that should be sold. The Swarm Trader concurs.

"Big moves on light volume are often tricky," he responds to our query on the subject. "Moves like this on lighter than average volume are often generated by a few big orders that, because of the little liquidity, easily move the price.

"It is not significant if only a few 'smart' players take advantage of the spike, and typically days like this are not enough to create some momentum. Volume creates price. The price is only the 'shadow' of the volume that's why it is so important to track the volume. If the volume soars, then the price will follow.

"You need some volume to push a trend up further. But when the volume stops...the momentum is over. I wouldn't say the rebound is over yet at 3,641. But a bullish trend needs higher volume to be durable."

Or maybe it needs more money. The last two weeks have been punctuated with big commitments by the Feds to inject money into credit markets and, indirectly, on to bank balance sheets. First Bernanke commits to buying $300 billion in U.S. Treasuries and $750 billion in mortgage backed securities and the market goes up.

Now, along comes a Geithner with as much as $1 trillion in tax payer funds to dole out to his private equity and hedge fund buddies and we get another rally. Really...who doesn't like free money to you change your life? No wonder Wall Street is partying it up.

By the way, Bank of America's Richard Bernstein rained on the parade at the end of the day, telling clients to sell bank stocks after their two-day, twelve percent rally. "The history of bubbles shows quite well that financial sector consolidation is inevitable," Bernstein wrote. "Financial stocks will be attractive when the government tries to speed up that inevitable process. However, to the contrary, the government continues to attempt to stymie that inevitable consolidation."

Not exactly a ringing endorsement of the rally from an insider working for one of the firms at the heart of the crisis. But the man has a point. And we'll get to the Geithner plan in just one quick second.

First, we need to correct an error. Last week we wrote that the global economy would not recover this year because, in part, "You still have massive over capacity in global production (demand far in excess of supply)." A few alert readers pointed out that we meant "supply far in excess of demand."

Sorry about that. We sit corrected. Incidentally, the outlook for the global economy hasn't improved much for last week. The World Trade Organisation is predicting a nine percent contraction in global trade this year. Its report doesn't come out tomorrow, but if global exports shrink by nine percent, it's not going to be good for Aussie exports.

In fact, Dun and Bradstreet's Global Economic Outlook released yesterday says Australian GDP will shrink by 0.2% in 2009 instead of expanding by 0.5% as it previously expected. "A collapse in world trade, particularly in the Asia-Pacific region, and a sharp drop in economic growth for China have significantly heightened the downside risk to Australia's outlook."

You can say that again. But please don't.

The more frightening projection from the D&B report is that it reckons Chinese GDP will come at just 3.5% in 2009, a full six percent lower than the 2008 growth figures. "While there are a number of concerns for Australia, the most significant will be the decline in forecast economic growth for China, which has fuelled much of Australia's growth over the last decade."

Much lower Chinese growth will have social implications for china. But it also has budget implications for Australia. With Aussie exports to China falling, tax and royalty revenues decline further. Perhaps that's why Treasurer Wayne Swan is already preparing the public for a $50 billion budget deficit and another stimulus package.

All of this adds up to a very contrarian idea: this rally may be your last best chance to sell stocks this year before the market tests new lows. Your risk, the bulls will tell you, is that the Geithner plan put a bottom under stocks and the recovery can now begin.

If the rally continues, it's going to severely test the resolve of those who are paying attention to the economic trends that lead corporate earnings. But hey...that's why they call them markets. There are always two sides to every trade. Someone is going to win and someone is going to lose.

Speaking of losses, how about another quick foray into the Australian housing market? Could it be we have been wrong in predicting a house price correction/crash for two years now? Is it possible that Australia's bubbliest days are head? Is it possible that Australia is just now repeating the very same mistakes that led the U.S. into such a mess in 2004-2007?

Yes. It is possible.

"Australian housing market holds sub-prime danger," write Glenn Milne and Nick Gardner in the Sunday Telegraph. "Australia is facing its own version of the US sub-prime housing crisis, with thousands for young homeowners risking bankruptcy as a result of Kevin Rudd's stimulus package," they write.

The article goes on to feature the work of Dr. Steve Keen, whose work we've published here before at the Old Hat Factory. The argument is simple to understand, too. The only way to keep house prices abnormally high is to suck ever larger numbers of borrowers into the market.

The government is doing just this with the first home buyers grant (FHB). It's doing so under the guise of "affordability." But in fact, it could turn out to be the worst financial decision many of these couples in their mid-twenties ever make. Why?

They will have borrowed a huge amount of money at just the moment when home prices in Australia are reaching their peak. What's more, these are the most marginal borrowers left. They are the most vulnerable to losing their jobs. And because they're just getting started in their careers, they are likely to be under the most mortgage stress of any borrower (paying the largest percentage of disposable income to the mortgage).

These new homebuyers face a dual risk. It's hard to say which is more dangerous right now, unemployment or higher rates. Most of these new buyers are getting into the market at the low point in the interest rate cycle. Because Australians favour the adjustable rate mortgage, these new buyers will have maximum exposure to rising interest rates.

The more you look at it, the more it looks like the government is doing its best to saddle a generation of young Australians with a lifetime of debt they can never hope to repay. Sure, it's good for the banks. They can grow their loan book. And because most home loans in Australia are "recourse" loans, the banks don't have to worry about being saddled with a bad debt.

This is a key point. Many Aussie analysts highlight the "non recourse" nature of the U.S. market as one reason why house prices can't crash in Australia. They say that in the U.S., the borrower can simply walk away from the loan if the market value falls below the mortgage. You get "jingle mail" where the borrower-who has no interest in continuing to pay on a property that's worth less than the mortgage-sends the keys back to the lender and moves on.

You can't do that in Australia. In Australia, the bank can do more than just seize the collateral (the home) put up for the loan. It can come after your personal assets too. The bank has "recourse," the borrower does not.

Some have argued that in the 1990-91 recession, unemployment rose but house prices did not fall. They cite this as evidence that Australians "fight" to stay in their homes even during tough times and this puts a floor under house prices. But this is nonsense.

Whether you can afford your house is not a question of how bad you want to stay in it. It's a question of whether you can really afford your mortgage payment. As the chart below from the Treasury shows, interest rates were already on the decline in 1991. This meant that those people who did lose their jobs in the recession at least found some relief in lower mortgage rates as the rate cycle headed lower.

The Interest Rate Cycle and Aussie Savings Rates

Source: www.treasury.gov.au

Today's first home buyers get a big fat government check to help cover stamp duty. And they get one to two years of fixed interest rates on a massive loan. And after that? They are fully exposed to rising interest rates. They have little in the way of savings or other assets for the banks to chase after should house prices fall.

So yes. It's true. Australia does not have a sup-prime problem. But by incentivizing the marginal buyer to come into the market just now, the government may be sowing the seeds for first a spike in home prices and then later, the inevitable correction. The credit boom made Australia's houses some of the most expensive in the world. For now.

The other nasty side effect of the credit boom is the high household debt to income ratio. The boom suckered people into taking on big mortgages at ever greater multiples of income. Now, these borrowers face the prospect of losing their come in a recession.

Australia's Household Debt to Income Ratio

Source: www.treasury.gov.au

But won't this all be fine if the government sends another stimulus check to these households? And won't it all be fine if the RBA cut rates at its next meeting? After all, it looks like rates are headed lower, not higher, and the government is there to hand out money to anyone who needs it.

Well, all of that is wishful thinking. A one-off payment of $900 is not enough to bail someone out of a $450,000 mortgage (the median home price in Australia), especially when the bank can come after your personal assets.

We meant to take a closer look at how to structure your assets for falling property prices. But we've run on long enough already. We'll save that-and a fuller breakdown of the Geithner plan for tomorrow. For today, let's consider the possibility that the first home buyers in Australia, at the encouragement of the Federal government, are walking into a lifelong financial nightmare from which their credit ratings might never recover.

Dan Denning
for The Daily Reckoning Australia

• Geithner and His Toxic Asset Bailout Plan
• Geithner Reassures China that America Takes Financial Obligations Seriously
• Geithner to Explain to Congress How US Bailed Out AIG
• The Plan that Prevents Plans
• Plan to Survive 2009

We're going to take our "Crash Alert" flag down for a while. Finally, the Dow shows signs of life. We won't know for a few days...but we'll take a guess: the rally will continue.

Stocks in the United States have lost $11 trillion in value - more than cut in half - without a single major bounce. We expected one after Obama was elected. All we got was a 15% ricochet. Then, after he announced his major stimulus/bailout/boondoggle program...we thought, surely, stocks would rally then. Nope. Instead, globally, stocks are down 20% since Obama office.

But a rally in a bear market is one of the surest phenomena investors can count on. After so many years of rising prices - the bull market began in August 1982 - investors have learned to 'buy the dips.' Now, they're looking at a Grand Canyon of a dip; many can't help themselves. All they need is a little encouragement.

Yesterday, the encouragement came from Citigroup - which said it had made money in the first two months of '09 - and from Ben Bernanke, who said we needed to regulate the financial sector better.

The rest of the news is terrible, awful...revolting.

Unemployment in the United States is up over 8%. A Bloomberg survey says it will go to 9.4% before the end of the year. Our own guess is that it will top 10%. By summer, one out of every ten people in the 'workforce' will be out of a job.

There are always some people living on the margins...hand to mouth...paycheck to paycheck. The trouble is that the margins are getting wider. "24 Million Go from Thriving to Struggling," says a headline at USA Today. Not hard to see why. When you live from paycheck to paycheck, losing a job is a disaster. And in February alone, 651,000 jobs were lost.

Obama says he's going to put millions to work with his spending proposals. He pointed to 60 new jobs in Maryland, on a highway-paving project:

"That's how we're going to get this country back on its feet," he said.

When we lived in Maryland, the only people who worked on paving crews were immigrants from Latin America. No one else wanted the job. But maybe things have changed.

Meanwhile, Congress has gotten into the spirit of the Boondoggle Age. It sent a $410 billion spending bill to Obama for his signature. Included in the bill were 7,991 "earmarks," or pet projects that didn't make it into previous bailout, stimulus and boondoggles programs. Included in the spending bill, for example, is a program to pay for eyeglasses for people who are supposed to be blind...and to increase funding for Amtrak. The passenger train system has been losing money for as long as it has existed. According to classical economics (and plain good sense) Amtrak makes us all poorer. It takes valuable resources - labor, steel, electricity and so forth - and turns it into a service - transportation - which consumers judge to be worth less than the resources that went to provide it. Yet, that is the whole theory of the Obama stimulus program! Spend money on things that are unprofitable. (If they were profitable, they wouldn't need public funding.) Somehow, wasting wealth is supposed to make us all better off.

As we think we reported yesterday, the bill for all these crisis- related boondoggles (including financial guarantees) is headed towards $12 trillion. And Paul Krugman, Nobel Prize-winning economist at the New York Times, believes even that is not enough!

"Many economists, myself included, actually argued that the plan was too small and too cautious. The latest data confirm those worries - and suggest that the Obama administration's economic policies are already falling behind the curve.

"To see how bad the numbers are, consider this: The administration's budget proposals, released less than two weeks ago, assumed an average unemployment rate of 8.1 percent for the whole of this year. In reality, unemployment hit that level in February - and it's rising fast.

"Employment has already fallen more in this recession than in the 1981- 82 slump, considered the worst since the Great Depression. As a result, Mr. Obama's promise that his plan will create or save 3.5 million jobs by the end of 2010 looks underwhelming, to say the least. It's a credible promise - his economists used solidly mainstream estimates of the impacts of tax and spending policies. But 3.5 million jobs almost two years from now isn't enough in the face of an economy that has already lost 4.4 million jobs, and is losing 600,000 more each month."

Yes, dear reader, looked at individually, each spending project may make us poorer - but we'll make it up in volume!

But here at The Daily Reckoning, we always look on the bright side. Yes...you know what we think of bailouts, rescues, and stimulus packages - they're all claptrap, eyewash and bamboozle. And they'll delay the restructuring that the economy desperately needs. But looking at the part of the glass that is half full - at least they make it easy for us to carp and criticize.

*** Poor Bernie Madoff is going "up the river." The expression "up the river" refers to Sing Sing Prison, 30 miles up the Hudson River from New York City.

How much time will Bernie do? "Life," said one report. "For up to 150 years," said another - perhaps over-optimistically.

Bernie has copped a plea. When his attorney is asked the question, he is expected to reply: "Guilty as charged."

Meanwhile, poor Martin Armstrong rots away in a New Prison. We will tell Armstrong's story when we have more time. It has all the ingredients for a great conspiracy story - the CIA...an omniscient computer program...money...power... you name it.

Martin Armstrong was once the highest paid economist in the United States, as head of the Princeton Economics. At least, that's what the papers said. He developed an elaborate cycle theory, which was said to predict major market turns. Now, poor Martin is a convict...serving out a five-year sentence, after having spent eight years in jail for contempt of court, on charges related to an alleged Ponzi scheme. "Alleged" is an important word, because Armstrong was never tried or convicted on the original charges. But we'll leave that for another time....

Even from his jail cell, Armstrong still keeps up with the economy. His 8.7-year cycle theory predicted a downturn would begin in the summer of '07 - which it did. But now...get this...he says the recession will last for 23-26 years! Why so long? Because the feds won't allow the economy to heal itself, he says.

We don't know if he'll be right or wrong. But it is a shame to keep people like Armstrong and Madoff in prison - at taxpayer expense. Both could make valuable contributions to society in order to compensate for their alleged crimes.

We have previous suggested that Madoff be tapped for Secretary of the Treasury. The United States is running the biggest Ponzi scheme of all time, paying off old loans by taking out new ones. Why not let a real pro run the program?

And surely some under-secretary post could be found for Armstrong. In the news over the weekend came word that Geithner was working 'night and day'...and alone. He is supposed to have a full complement of hacks and functionaries to help him; but they haven't been appointed or approved yet. So Geithner sits at his desk and talks to himself. What a pity! Destroying a major economy is not a job for a single man. Even Alan Greenspan had a crew of apparatchiks to help.

Free Madoff! Free Armstrong! Let the pros do the job!

*** And a note from our intrepid correspondent, Byron King, on why all of the cool kids own gold - and you should too:

"I'm recommending gold because it's one way - and an ancient and established way - to preserve your wealth and purchasing power over time, especially during uncertain times.

"Gold has history. Gold is to wealth as Sun Tzu is to the art of war. Gold is real. Gold is solid. Gold is nobody else's liability. Gold is quiet. Gold can be your own little secret. Many people even believe that gold is money! Archaeologists tell us that for about 8,000 years of human history, if you had gold, you could buy stuff. And if I owned a restaurant and you wanted to pay for your hamburger with a $50 U.S. Gold Eagle, I assure you that I'd take the coin and find a way to make change."

Although gold may be in the midst of a correction due to this bear market rally, the long-term outlook for this precious metal is very, very good. Take advantage of this dip in the price and buy some of the yellow metal to pad your portfolio. You'll be happy you did.

Bill Bonner
for The Daily Reckoning Australia

• The US Dollar Showing Signs of Life
• Obama’s New Stimulus Program
• How the Stimulus Works
• Signs of Life
• Madoff Astonished SEC Didn’t Verify His Claims

Besides, stocks have been a bad bet for the last 12 years. They're now back to '97 levels...meaning, investors have made nothing for a dozen years. Stocks for the long run? How long do you have to wait?

And now, the stock market is breaking down...again. Dow Theory has given a Bear Market Signal. What that means, exactly, we don't know. Stocks will go down until they stop going down, we guess.

Citigroup is moving "closer to toast," the New York Times reports. The market cap of Citigroup has fallen by more than 50% since Monday. "I think it is going down," writes old friend Jim Davidson. "My best guess, it will be nationalized...on a 'temporary' basis."

Many are the economists urging the government to nationalize the big banks. People need confidence in the banking system, they say, or we'll all be toast.

Among the big names in favor of nationalization is Nouriel Roubini, one of the few economists who seemed to know what was going on. He saw the crisis coming and said so. Now, he's practically a media star.

Of course, we saw the crisis coming too...here at The Daily Reckoning. We said something too... But we're still waiting for the press to call...just so we can hang up on them. The worst thing that can happen in this trade is success. It makes you think you know what you're talking about. The next thing you know, you're giving advice to central bankers and major corporations. Then, the gods get their backs up. Everyone starts believing what you say...even you.

If we were in charge, we'd get out the toaster. But nobody asks our opinion. And it's probably a good thing. Because when people come to think what you think, what you all think is probably wrong. At least, that's the way it tends to work in the financial markets. As soon as everyone gets on to a trend, it is soon over. Back when the going was good, for example, everyone thought it would be good forever. Naturally, it stopped being so good soon after.

Now, what does everyone think? Hard to say. We read the headlines and try to figure it out.

"In Gold We Trust," says a headline at the Wall Street Journal. Gold fell back below $1,000 yesterday. The yellow metal seems very popular. Maybe too popular. But does everyone think gold is going up? We hope not; if they did, we'd have to sell.

Still, most people still think gold is a little kooky...the kind of stuff that grumpy old men bury in their back yards. And most professionals, too, still think gold is weird - an investment for grandpas. 'Worried about inflation?' they ask. Then, solving their own problem: 'Just buy TIPS. You know, government bonds indexed for inflation. You'll collect some interest...and you'll be protected against inflation. These bonds are indexed to the CPI.'

TIPS are cheap. That is, you don't give up much yield to get the inflation protection. But if investors can get protection from inflation for only, say, 1% of yield...what does that tell us? Well, it tells us that investors think the rate of inflation over the next 10 years - TIPS are equivalent to 10-year notes - will be only about 1% per year.

People don't call an exterminator when they have no pests. Gold is protection against inflation. They don't usually buy gold when they don't fear inflation. The TIPS premium - the extra that investors pay (or the yield that the give up) - is so low, it tells us that investors aren't afraid of inflation.

What are they afraid of then? Why is gold going up? What is it that everyone thinks?

Our guess is that people don't know what to think. Some - and only some - are hedging their bets by buying gold. Something funny is going on, they must think. They don't know exactly what it is, but they're sure it won't end well. They buy gold...just in case.

We continue to hold gold because we know it is the ultimate store of wealth... Think about it this way. No paper currency has ever stood the test of time. They've all eventually become worthless pieces of paper. But gold has not, and will not. This is why it is the ultimate hedge against inflation...against uncertainty in the markets...and is the anti-paper. This is why we hold it...and why you should do the same. Find out how you can get the precious metal for just a penny per ounce. See here.

So, the major trends continue. Stocks go down. Gold goes up.

*** The S&P 500 took quite a beating last week. After breaking through near-term support at in the 804 area - the bottom of the market's intermediate trading range - stocks are now poised to test November lows at 741 on the S&P. But Easy Money Options' Wayne Burritt thinks, if history is any guide, that the market may be poised for a bull run.

"The recent technical action is shaping up much like the market's recovery after the dot-com fiasco. Back then, the S&P tested the 769 to 789 level three times in the eight-month period between July 2002 and March 2003. Each time the levels held and after the third was over, the market commenced a spectacular bull run.

"In fact, from its jump-off point of 783 in March 2003, the market didn't stop until it reached 1576 in October 2007. That's a staggering 101% gain in just over four years.

"Today, the markets are wrestling with similar lows in the 741 area. It made its first test in November and succeeded. It's now in the midst of a second test. If my thinking is right, it will test that low, recover and then test it once again. After the third, a new bull run could be in the cards."

Wayne does admit that the fundamental pressures of today are much worse than following the dotcom bust...and that means the market bias going forward is certainly to the downside.

However, Wayne has his sights set on a handful of companies that are prepared to move up - no matter what the broader market does.

*** Looks like Paul Volcker is channeling Gloria Gaynor...

Volcker, former head of the Fed and hero of the inflation fight of the '80s, says of capitalism: 'I will survive, I will survive.'

We did not read Mr. Volcker's speech. But we can imagine it. Capitalism, in its various forms, has been around for a long, long time. It is unlikely to go away, simply because everything else is a fraud and a scam.

What a delight to see Mr. Volcker rise to defend capitalism. The old creed needs a lift. Every crackpot and malcontent on the planet is gunning for it - including Danny Ortega, here in Nicaragua.

What is capitalism, after all? It is not a system...not a plan...not a program. It was not decreed by any half-wit tyrant...nor written into law by any earnest assembly. It has no constitution...and no boundaries. It is merely a recognition of basic principles. 'Thou shalt not steal,' it says in the Bible. Capitalism recognizes other peoples' property. The baker has a right to his oven. The farmer has a right to his land. The capitalist has a right to his money. What they do with these things is up to them.

Will they make mistakes? Of course they will. Will they do evil and obnoxious things? No doubt about it. Will they occasionally lose their heads and overprice their assets...or run the whole economy into too much debt...or blow themselves up in a bubble? You bet.

As Adam Smith described, they will also bumble along to create the wealth of nations.

But larceny wasn't invented in the 21st century either. Naturally, people want what the capitalists have. Everywhere and always, the thieves will find reasons why they should be able to take it from them. They will respect the environment better, they say. They will invest in 'socially responsible' projects, they claim. They will heal the lame and make the blind see. If only they get their hands on your money!

• Stocks and Gold Are Going In Opposite Directions
• The Stinging Reproach of a Former Fed Chairman
• The Correction in the U.S. Housing Market Made Its Sharpest Move Ever
• Consumer Price Inflation has Spooked Investors Everywhere
• Gorbachev and the Most Complete Test in Economic History

The rally was a no-brainer. There is a strong line of support at $700, which was resistance during 2006 and the first half of 2007. Moreover, the market was, and is, oversold.

The catalyst was news that the U.S. government had to bail out Citigroup, the world's largest bank by revenues. The event has given way to new concerns about the economy, which weighed on stocks and gold this week, or at least provided an excuse to take some profits in the latter.

The big question now is whether it was just a retracement rally that ultimately gives way to new lows or whether we have seen the bottom in gold, with this rally being only the first of many to come.

I don't think the chart can answer that question alone. Technically, the structure of the market is healthy now, and as far as the fundamentals go, gold should not remain under $1,000 for very long.

Indeed, I sense the market is building up for a very bullish move.

Allow me to touch on some of the bullish factors coming into play.

"Notwithstanding the many developments on the bailout front during the past six weeks, The New York Times, like other media outlets, continues to quote Wall Street insiders who report" [that] "'You have a market that is frozen.' What planet do these guys live on? It certainly is not the same one to which the Federal Reserve's data apply. I've been singing this song for many weeks, but I'm going to keep singing it until somebody in the news media wakes up and realizes that these 'frozen credit market' tales are pure hooey. Look at the data, for crissake."

- Robert Higgs, author of Crisis and Leviathan, in a recent essay on the bailout programs

The fundamentals are significantly bullish for gold. I'd like to say they are bearish for the dollar, but in truth, they are increasingly bearish for all paper currencies. Outside of the Bank of Japan, everyone is inflating madly. In the G-7, narrow money (M1) is growing at 7-10% on a year-over-year basis in the U.S., Canada, the U.K. and Australia - more in developing countries like China. And this rate is picking up now.

October's data are not in yet for the ECB. Its balance sheet increased by some 400 billion euros during the month, which is the first big change since the second quarter, and will probably reflect in M1. The Bank of Japan started inflating M1 again in September too, after holding it steady for most of the year.

The broader monetary aggregates (i.e., those determined by the banking system at large) are growing briskly everywhere but in the U.S. and Japan, though even the latter are still growing.

Broad money in the U.S. is growing between 5-10%, depending on whether you rely on TMS or MZM or higher, if you like M3 (I don't).

The U.S. data are good through October. Up till the end of September, as far as we are updated, the year-over-year growth rate in broad money approached 20% in Australia, its highest rate in almost 20 years. In the U.K., the broader monetary aggregates are growing at close to 14% on a year-over-year basis, which is its highest growth in almost a decade.

These growth rates are almost as bad as China's, which is approaching 20% year over year too, again. Given these numbers, it is no surprise to me whatsoever that the yen is the strongest currency, followed by the U.S. dollar, or that the Aussie and the pound are taking the greatest beatings, along with all the other riskier currencies.

The actions governments are taking now are bearish for stocks and bullish for inflation. But they are not just bullish for inflation - they are remarkably bullish.

I don't mean to sound happy about it. It's just an observation that the market has yet to come to terms with. Since September, the Fed has expanded its balance sheet a total of $1.3 trillion. Of that total, it has created about $600 billion in reserves out of thin air.

Most of that is not counted in money supply, because it excludes deposits held by depository institutions. Total money supply is about $6 trillion, if you rely on the Austrian School definition (I do). It has, nevertheless, translated into growth of about $100-200 billion in new money created by the banking system since September already. Deflation is a no-show so far, and I don't think it will arrive at all. I think history will see this as just another scare.

The Federal Reserve just announced two new programs that commit it to another $800 billion, and that is even before President-elect Obama puts his stimulus package together.

Reuters cited Wachovia's chief economist:

"Some, however, are worried the mounting costs of the measures, which have the potential to reach several trillion dollars, could eventually fuel a troubling inflation.

"'It may mean (a) longer-run issue with inflation and inflation concerns,' said John Silvia, chief economist at Wachovia Securities in Charlotte, N.C. 'It may be too much of a good thing is a bad thing.'"

Ya think?

Even more inflationary, in my opinion, is the fact that the talking heads think the Fed's latest facilities are simply not enough. They are complaining the programs do not include direct purchases of credit card debt and mortgages in the secondary market and that the Fed isn't going to buy mortgages with maturities of more than one year. Not long ago, the Fed never bought anything but Treasury notes.

Gold bulls are going to attempt to raid Comex's vaults by forcing delivery on their December futures contracts (Dec. 19). Who can tell how that will go? I can't. But it'll be interesting to watch.

Facts: The open interest in futures contracts on the Comex has fallen to its lowest level since summer 2005, breaking a general uptrend in place since 2001. From a contrarian standpoint, the short-term bottoms in these data tend to favor the buyers over the sellers. However, the statistic went into orbit during the last half of 2007 - it broke away from the upper channel on the charts, creating a bubble in appearance. The current extremity could simply be a symmetrical reaction to that extreme.

Nevertheless, this is a bearish fact, technically speaking, if it represents a lasting new trend.

It is tempting to suggest that the threat of a raid in futures contracts is causing a short squeeze.

It is true that the commercials are liquidating their short positions promptly. But the funds are increasing their short bets, and the liquidation of longs is such that the net short ratio has hardly budged off its mid-September low - which, incidentally, is a level that has coincided with strategic buying points at seven other junctures since the bull cycle began in 2001.

However, the record of this statistic in gold is unique in that during bear markets, the commercials tend to be net long (wrong) most of the time.

So the fact that they are covering their short interests on net does not necessarily presage a rally if a bear market has set in. A bear market would mean that gold prices could fall as far back as US$500.

Fundamentally, the conditions just don't look ripe for a bear.

I don't believe the COTs (Commitment of Traders report published by CFTC) have any real predictive value. They tell us only whether the market is too much extended one way or another; they don't tell us how long those conditions will last. Right now, the structure of the market is healthy. The commercials are covering their shorts, the funds are getting short and the numbers basically favor the bulls. The contraction in open interest worries me a little, but it could be explained in terms of a collapse in spread trades linked to various index products.

In its most recent report on gold demand, the World Gold Council said as much in trying to explain the drop in the gold price in the context of soaring physical demand. In its third-quarter report on gold demand, the WGC noted growth in both jewelry and investment demand across the spectrum relative to both the last quarter and the year-ago quarter. I don't want to go into a critique of the method here, except to point out that it chronically understates investment demand and overstates jewelry demand.

The inclusion of ETFs all but proves the point.

In just one year, investment demand has grown in importance from under 15% to over 30% of total gold demand, causing the deficit (supply shortfall) to grow nearly tenfold. The WGC interprets this deficit as supply coming from speculative sources, like futures trading or changes in inventories at the various exchanges - like at Comex. Thus, it calls it "inferred investment." Formerly, it called this the "balance." But as it grew, the WGC decided it meant something. What is causing it to grow, aside from growing demand in general, is that while the WGC is "identifying" new kinds of demand, it has not kept up with the various sources of supply. Gold bugs have argued for years that the supply of gold is not limited to mine production, officialdom or scrap...that it is not like other consumable commodities.

It is more useful to assume that most of the gold ever produced is held as a reserve, or store, aboveground. And if this is true, then investment demand must be much larger than the WGC calculates, or the price would, frankly, never go up. If the WGC is smart enough to include producer hedging (or dehedging) in the equation, it should also include a measure of demand that expresses itself through all the exchanges and bring itself up to speed on all the sources that supply the market. It assumes that jewelry demand dominates the market, which is incorrect, but even if it were, it still has the wrong idea.

Jewelry demand may be price sensitive in the short term, yet it has grown every year, at successively higher prices, since the bull market began. Despite my objections, however, I am in total agreement with the council's explanation why gold prices have fallen despite the evidence of soaring gold demand:

"Notably, the selling captured by the [inferred] investment category was mainly by investors with a short-term focus. It largely reflects the fact that gold was caught in the downdraft of other commodities and other assets - it does not reflect a questioning of gold's value or role as a safe haven. The strong buying in the ETF and bar and coin markets during the quarter, which reflects investors with largely a longer-term focus, suggests that investor belief in gold's role as a safe haven and store of value is stronger than ever."

No wonder the commercials are covering. The establishment is getting hot for gold.

JP Morgan's gold analysts "urged" investors to stock up on gold this month, citing counterparty risk and tight supplies.

Citigroup's foreign exchange group also put out a bullish tout.

Well, that's an understatement, actually. "[Gold] continues to look like a bull market to us. We continue to believe that a move of similar percentage to that seen in the 1976-1980 bull market can be seen, which would suggest a price north of $2,000," Citigroup's FX group said last week.

What I found particularly intriguing, besides the timing of these calls, was that they both discounted the dollar. That is, they noted, as I have in the past, that the foreign exchange value of the dollar may not be important at this stage. Morgan said, "It is not an absolute given that a rally in gold means a falling U.S. dollar," while Citigroup pointed out, as I also have, examples of just such a situation during the 1970s.

Anyway, it's not a sure thing yet, and it all makes great fodder for the bull market in gold.

Good Trading,

Ed Bugos
for The Daily Reckoning Australia

• Today’s Current Gold Price
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• Demand for Credit is Growing Less Fast
• Gold Price Outlook – the Long and Short of it
• Gold Ratios: Bearish for Gold Prices, Bullish for Gold Shares

Worse for the bank and those investors brave/oblivious enough to recapitalise it is that you could not pick a U.S. bank more exposed to the housing and retail busts unfolding. Citigroup has reported some US$40 billion in losses already, more than even the bumbling UBS in Switzerland.

One begins to wonder how Citigroup-faced with mounting losses and forced to beg for new capital to stay above regulatory requirements-has lasted this long. Investors with deep pockets-at the prodding of the U.S. Treasury Department-have been happy to give the bank big new chunks of capital, which just as quickly go down the housing black hole.

How many lifelines does a bank get? When it's as big as Citigroup... probably as many as it needs. Citigroup is America's Northern Rock, much too big to fail. But that doesn't mean we'd want to be a shareholder.

Keep an eye on the existing and new U.S. home sales data that comes out this week, too. A parade of CEO's on Wall Street took to the airwaves last week to announce the end of the credit crunch. But then you'd expect them to say this, considering it's their credit (and assets) that are getting crunched.

Home sales can't have improved by much in the U.S. And if they are worse than expected, the turnaround investors who are loading up on home builders, banks, and brokers may be in for a rude surprise.

This is how it has to be in a bear market. Buyers have to have enough nerve and optimism to buy in the face of an obvious decline in business conditions. Only when they capitulate will it be time to buy, and that could be years.

The U.S. dollar was slightly up against the euro and the yen to close last week. But pay it no mind, we reckon. The dollar had just made a record low against the euro at US$1.59. European money many Jean-Claude Juncker warned market participants that the G-7 was serious last week, really really serious, when it talked the dollar up.

Seriously. We're serious. We mean it. Really.

Market participants showed what they thought of that by bidding oil up to US$116 on the NYMEX. Oil will correct sooner or later. And the dollar will rally some against the Euro. But in the grand scheme of things, investors still consider tangible assets and resources as superior alternatives to owning particular national currencies (especially dollar-denominated stocks and bonds).

That can change for two reasons. One, traders in oil and real assets will take profits and sell. The second reason is that the "authorities" will eventually do everything they can to punish investors who put their money in commodities. Raising margin requirements in the futures market is one way to do it. Another way is to raise the political heat on hedge funds, which will probably be blamed for rising food prices. Hedge funds don't kill people though. It takes a government to do that.

Dan Denning
The Daily Reckoning Australia

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