Speaking of housing, the ABS reports that building approvals fell 7% in January from December. "Experts" were expecting a one percent increase. It was the first time approvals have fallen in five months. But with the expiration of the first home buyer's grant and rising interest rates, it shouldn't be that much of a surprise.

Yesterday's news came from the world's most akwardly named bureaucracy, the Australian Bureau of Agricultrual and Resource Economics, henceforth to be called ABARE. The group published its quarterly commodity outlook. It tells you how much Australia can expect to make from selling the family: silver, iron ore, and coal. Its conclusions were kind of surprising.

The main conclusion was that Australia would see rising export earnings on higher volumes but moderating commodity prices. In other words, the China boom will drive export volumes for the next five years. But you won't see any more mammoth increases in commodity prices.

Before we dive into the data, a warning: these kind of forecasts are usually worthless. Not that they aren't carefully prepared. But you just don't know what's going to happen in the world. You can be motoring along during a big boom and whammo! A credit depression hits and reveals a 25-year misallocation of resources in the consumer economy.

But for the sake of determining if Australian resource stocks are cheap or expensive to projected earnings, let's see what ABARE thinks earnings will be like. As you'll see, the big growth will come fromm mineral and energy commodities, with base metals giving a big kicker in the next year especially.

ABARE reports that "The value of Australia's commodity exports is forecast to be around $186.8 billion in 2010-11, which is an increase of 15 per cent from a forecast $162.5 billion in 2009-10. The value of Australian commodity exports in real terms is projected to rise over the outlook period. By 2014-15, Australian commodity exports are projected to be around $211.4 billion (in 2009-10 dollars), which is 30.1 per cent higher than forecast for 2009-10."

You're looking, then, at about 7.5% annual growth in the value of Australia's agricultural and mineral exports. That's slightly less than China's annual GDP growth rate (also a suspect number). But it's certainly a lot healthier than growth rates in the rest of the Western world.

ABARE says that in the next 12 months, export earnings will be driven by 19.8% increase in energy commodities (oil and coal, but not including uranium). Metals and bull commodity export earnings will rise by 17.6% to $87.9 billion. Iron ore and coal are the big winners here. For this year, higher prices will account for the increase.

But ABARE's rather muted conclusion is that increased volumes are going to drive earnings growth, and not just underlying gains in commodity prices (which will begin to be weighed down by increasing global production). For stock pickers that means you can't just find stock that you think are leveraged to higher prices. You're also going to have to find low-cost producers. And you are going to have to find projects with the best economics.

Good thing we've got Alex on the case at Diggers and Drillers. He's been on baby duty at home with his newborn. But he continues to check in with reports and is back on the case full time next week. We'll keep you posted.

We're taking the projections somewhat seriously. That could be a mistake. For example, take ABARE's estimates of crude steel consumption and production. Both are predicated at average annual growth rates in the Chinese economy of just under 10%. And both assume China's resource-intensive industrialisation has years to run, rather than having already run its race.

It's quite possible we're much closer to the end of the China-driven steel boom than a next higher phase. But ABARE's numbers are astonishing. It predicts that global steel production will have grown by 30% between 2008 to 2015, from 1.347 billion tonnes consumed in 2008 to 1.774 billion tonnes in 2015.

ABARE is projecting a 79% growth in Chinese crude steel production during that same period. In fact, by 2015, according to these figures, China will consume 812 million tonnes of crude steel per year. That's more than the U.S., Brazil, Russia, the 27 nations of the European Union, India, Japan, and Korea combined.

This either shows how cataclysmic things are going to get in the industrial West (and Far East). Or it shows how wildly unsustainable projections of Chinese steel consumption are. How many more empty cities can you build? How long can you sustain fixed asset investment at 30%+ of GDP, especially when much of it is in commercial and residential real estate?

On the production side - and this is the part that has the most to do with Australia's iron ore and coking coal industries - ABARE estimates Chinese steel production will be 880mt in 2015. The rest of the world combined will be 712mt. This means China will be a net steel exporter, if ABARE's production and consumption figures for crude steel turn out to be right.

Our guess is that they will be sensationally wrong. China has its own credit boom malinvestments that are bound to blow up in the next few years. Precisely when doesn't really matter. And don't forget the fact that the Global Financial Crisis has smoothly shifted into a sovereign debt crisis. This too has the potential to knock out the legs from under the world economy and hugely reduce resource demand.

"'Prepare for a very difficult economic time, which you will not be able to escape,'" said Hans Hoogervorst, the Netherlands Authority for Financial Markets chairman. He was speaking at an ASIC sponsored gig in Melbourne that sounded pretty interesting.

He said that "'Even for a country that has been so soundly managed as Australia, this will have consequences...The problem is that there is now too much on the shoulders of government. They have basically taken on all the problems caused by the financial crisis, with the effect that most of them are in really, truly horrible budgetary shape."

Large government deficits usually mean slower growth. For one, government borrowing robs the private sector of the capital it needs to resume growing. Australia doesn't have a lot of surplus domestic capital to begin with. But really the problem is what it always is: a world built on too much debt. It's gotta give.

Yesterday we promised to tell you about how some Australian savers/investors are being locked out of their money for as much as four years. Look for that tomorrow. We're runing out of time and space today.

The next few days should be busy but insightful. We're meeting with all the gathered editors from Agora Financial, a sister company here in Baltimore. And later in the week, the investment board of the Bonner Family Office meets. We're on the board there and are eager to here what other investors from all over the world are looking to buy or sell right now.

In the meantime, it's amazing how cheap things are in America. Coffee...haircuts...food. The dollar really is cheap right now. If we didn't know intimately how screwed up America's finances were, we'd think it was a buy.

Dan Denning
for The Daily Reckoning Australia

• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike
• Posco’s Production Cuts May Be Bad for Australian Iron Ore
• The Future of the Australian Resource Market, Two Ways the Boom Could End
• BHP Billiton (ASX: BHP) to Report Second Half Results Today
• The Australian Resource Boom Isn’t Dead Yet

Which shares win and which shares lose the stronger the Aussie dollar gets? Slipstream Trader Murray Dawes has been on the case over the last week, looking for other tradeable trends in the ASX 200. The stronger Aussie affects the costs and export earnings of big domestic companies. That makes it a catalyst for trading ideas. And the size of the moves in these larger capitalisation stocks is kind of surprising. But for it to be profitable, you have to first sort out who wins and who loses.

GoldmanSachs had a crack at it last week. According to today's Australian, "The biggest winners include Qantas and Virgin Blue (lower fuel costs and strengthening outbound travel), Boral (lower offshore debt costs), condom and glove maker Ansell, apparel importer Pacific Brands, diversified industrial Alesco and waste manager and car importer Transpacific."

And the possible losers? The report says they will be, "Defensive stocks with an offshore earnings skew and which also are not exposed to this global growth. These include CSL, Cochlear, Resmed, Ramsay Healthcare and QBE Insurances. GSJBW cites BlueScope, Paperlinx, Caltex, Incitec Pivot and Aristocrat Leisure as other losers, but notes currency is only one of many variables affecting earnings."

We reckon it's all a bit of tempest in a tea cup. Corporate earnings have been inflated by the credit bubble and funny accounting for the last 50 years. A quarter or two of noise about earnings is not the big story, even if the currency move is substantial. There are really only two questions that matter.

The first is whether or not shares as an asset class are a good idea right now. That's a huge debate. But part of the answer lies in your views on inflation. As we argued here in July, stocks are definitely better than bonds when inflation is the big threat. The Reserve Bank seems to think that is the case. So make of it what you will.

What we make of it is that dividends used to account for a much larger percentage of your total return in stocks than they have in the last twenty years. Times change. There's no rule that says the future has to be just like the past. But if stocks beat inflation, should you invest in stocks for income or capital appreciation? That's the second question.

Aussie investors haven't usually had to make that choice. Bank stocks, for example, provide dividends and capital growth. But today, we reckon that cash flows are reverting back to the mean growth rate, which is obviously lower in a world that's deleveraging and relying less on credit to fuel business and consumer spending. Rather than being inflated by consumer demand (supported by credit) we predict slower rates of organic growth, across the board. This rewards investors who pay attention to how a company generates its earnings.

Kris Sayce in his work at the Australian Wealth Gameplan, reckons that now is a good time to add dividends to the mix to beat both inflation and the trend toward smaller growth in corporate cash flows. Practically, this means investing in businesses than can increase earnings in good times and bad and can do so without high capital costs which force them to borrow money. They return the excess cash to shareholders.

In cash flow growth is constrained by less credit in the system, you also want to own businesses with leverage to a rising commodity or an emerging market. This works out pretty well for a lot of Aussie firms.

Take energy. Chevron announced another major gas find off the coast of Western Australia this weekend. Chevron's $21 billion investment in the Gorgon project in WA is already the company's single-largest investment anywhere in the world, according to the Australian Financial Review.

And why? Chevron reckons LNG from WA is going to be the carbon dioxide friendly fuel for Asia's future. True, the fixed capital costs for producing off-shore LNG are high. But the whole industry is certainly leveraged to higher energy prices, which ought to translate into higher earnings for Chevron. Your risk is that oil prices crash and take LNG prices with them, upsetting the whole applecart.

So how does this all fit into an investment strategy for a world where there is no clear winner between inflation and deflation, where there is still massive leverage in the financial system, and where public finance is creating huge long-term deficits to replace (mistakenly) the missing demand from households that are beginning to live beneath their means? Good question!

You can trade the blue-chips in their ranges based on currency exposure or leverage to commodity prices. This is what Murray is up to at Slipstream. Or you can just chuck a few market-tracking ETFs in your portfolio and forget about it, in which case you can read the DR for fun and laughs rather than investment ideas. But you can also afford to be a bit more selective, and should probably consider doing just that. Why?

If the Credit Depression is going to take a bite out of corporate cash flows for years to come, focus on that risk and avoid the stocks most vulnerable to it (leveraged players in property, mortgage lenders, and banks.) But also build yourself, as Nassim Taleb says, a portfolio of risk's that's built for a world of extremes (Extremistan!).

Taleb says you want a maximum amount of zero-risk securities. Whether that is cash, bonds, dividend-paying stocks, property, or gold bullion (not really a security) is where the debate lies. He also recommends, though, that you have a small amount of risk capital in maximum risk securities. Which ones?

You want securities where you'll find low-probability but high-value events that can move the share price. This is not banking. In banking, all the low-probability (or frequency) events tend to have catastrophic consequences when they do occur. Russia defaults. The subprime market blows up. You have maximum risk. The probability is remote, but the magnitude of an occurrence is a portfolio destroyer.

But in other areas - small cap stocks, oil and precious metals exploration and production companies, for example - the low probability events are almost always high magnitude events in a positive way. You cure baldness or impotence. You find gold or oil. You invent the iPod or Google.

In these businesses, cash flows and earnings are above trend for a three to four year period in which the share price trades at a steep premium, factoring in future growth. This is the sweetest of sweet spots for growth investors. But to taste it, you have to also have a taste for risk.

That's why it's worth being in the market in a small amount of low-probability but high-magnitude type companies. You want a portfolio of risks like that. And it doesn't have to be a big one to be worth it, or jeopardise an otherwise risk-averse strategy. In fact, we reckon that this strategy is going to generate far better returns over the next ten years that the conventional buy-and-hold blue chips through your super strategy.

Dan Denning
for The Daily Reckoning Australia

• Note to Australia: Buy Resources, Not Banks
• The Problem With a Well-Diversified Portfolio
• Gone Fishin’ Investment Strategy
• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit
• Inflation is a Reality in China

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

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

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

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

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

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

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

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

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

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

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

Dan Denning
for The Daily Reckoning Australia

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

Here is a more worrisome note, though: you can't beat the market. Or at least, your actively managed superannuation fund cannot beat the market. That is the conclusion of two researchers from the Australian Prudential Regulation Authority (APRA). This is probably unwelcome news from those in the actively-managed superannuation funds business.

"On average," researchers Wilson Sy and Kevin Liu conclude," value adding from active management appears statistically to be unable to overcome higher costs associated with attempts to exploit market inefficiencies...Higher management expenses leads to poorer net investment performance of the firms."

There are at least two points worth noting in this survey, three actually. First, actively managed funds, on average, don't beat the market. Unless you know a genius manager, paying for results doesn't deliver them. Second, the underperformance (by about 0.9%) is directly attributed to the fees you pay. If you invested in a passively-managed index tracking fund, you would do just as well as the market, and not pay a cent.

But the most incriminating finding from the study is that active managers do worse in a bear market! That shouldn't be too surprising, really. Fund managers are paid to be in the market, not to be in cash. This is true even when you are better switching to a super option more heavily weighted in cash. Cash does not generation commissions!

To be fair, the study showed that half of the 115 superannuation funds beat the benchmark index (with the best fund doing 18% better). But the big question this study prompts is whether-by correctly making a few key decisions-a self-managed super investors can regularly do better than actively managed funds AND benchmark indices.

Beating most actively managed funds shouldn't be hard, we'd humbly suggest. They outperformance the index anyway, when you figure in management fees. And because the funds show a bias to shares, (these funds allocate 50% of assets to Aussie and international shares), they are likely to get clobbered when asset allocation models suggest you ought to shift to cash, fixed income, or (ahem), property.

Of course the truth of the matter is that being in the right asset class at the right time is the single-biggest determinant to how well you do as an investor. That is, you don't have to be Warren Buffet to beat the market. You just have to be in the right market at the right time. Stock selection, as much as it is touted by value investors, is simply less important than whether or not stocks as an asset class are rising.

You don't have to be a highly paid fund manager to know whether stocks are in a primary bull market. In fact, the fund managers are likely to get it wrong because they would prefer stocks to be in a bull market. It makes the job of index tracking and fee collection much easier. But the real challenge is correctly interpreting those inflection points in the market where one asset class falls out of favour (peaks out) and another, previously ignored or cheap asset (kudos to the value crew) enters into a bull market.

Those are the tough spots to pick. But we wonder why a professional fund manager is any better equipped to call those market tipping points than a well-informed self-managed super investor who cares more about his money than generating fee income. In fact, a well-informed investor who accumulates a variety of different perspectives and then reconciles that information with his own preferences, risk appetite, and judgment is just as likely to get the big calls right as anyone else. Probably more likely, considering he doesn't have any bias toward a particular asset class.

If you want to read the whole study, go here. For now, we'll quote two important pieces of it that show that making basic decisions about how you allocate your assets is the single-biggest factor in determining the performance of your super fund.

"It is seen that 38.5% to 66.7% of the cross-sectional annual returns of our dataset are explained by their benchmark asset allocations, depending on the period and depending on whether the comparison is gross or net of costs. Over the whole five-period, the cancellation of short-term noise leads to an R-squared of more than 95%. Our results are consistent with expectations from earlier research (Brinson et al., 1986, 1991; Ibbotson and Kaplan, 2000).

You read that right. Your super returns are determined by being in the right place at the right time. This is the quiet little secret of great investment returns. Getting them may be hard. But it's not impossible. But why is it true?

"These results have very simple explanations. It is clear that the greater are the differences in returns to different asset classes, the more asset allocation explains performance. Over the short-term, the asset return differences may be insignificant and may be swamped by other short-term effects of active management; asset return differences explain less of the cross-sectional variability. Asset allocation explains more of time variability because over time the differences in returns of different asset classes become more statistically significant."

Over the short-term, property and fixed income may look safer and better than precious metals and cash. But if bonds are in long-term bear market, if we are in a Credit Depression, and if fiat money is entering a permanent period of decline, then getting your asset allocation right now has never been more important. Perhaps, according to the reader below, you should consider cattle.

--Hi folks - enjoy the DR. Current topic is moot ... what is real wealth? Just one version of the answer - the age-old definition - comes from no other authority than the Bible:

QLD

Dan Denning
for The Daily Reckoning Australia

• Your Average Australian Super Fund
• Actively Managed Superannuation Funds Have Not Had a Stellar Few Years
• The Problem With a Well-Diversified Portfolio
• Mainstream Financial Press is Finally Catching on to Hedge Funds
• Equity Asset Allocation and Portfolio Rebalancing Left Out of Superannuation Review

There was quite a bit of snarky e-mail yesterday criticizing our comparison of gold to the S&P 500 over the last ten years. "Your time periods are arbitrary!" "You only picked dates that would support your argument!" "Housing has done better. So has oil. The Aussie gold price is up less than the All Ords! Why not just buy BHP and hold?"

So many critics! But a few of them may have missed the point, we'd humbly suggest. Of course you can cherry pick dates to support your argument for the performance of one investment over another. But that wasn't our point, or our intention.

Our point was that at certain moments in the life of markets, you witness long-term trend changes. One secular bull market ends while another one might begin in a different asset class. Gold began a secular bull market in 2000 just as stocks ended an 18-year bull market. That's why the trade of the decade was to buy gold and sell stocks.

Those are the kinds of sea changes you have to be aware of if you're going to make money as an investor. This doesn't exclude making money in other ways or other asset classes. But it's useful to know what the primary trends are moving the market-especially since a huge portion of your total return in any investment comes from being in the right asset class (and not stock selection).

So yes, there is more than one way to skin a bull. By all means, buy BHP if you want to invest in the long-term commodities bull. We recommended BHP shares to readers of Strategic Investment back in 2003, for example. Even then, we were a bit late to the trend. But the important thing was investing along with the big trend.

Just to be clear though, the big trends now are soaring inflation and falling financial asset prices, along with increased energy scarcity. This produces a variety of pair trades, which include: short government bonds, long energy, short residential housing, long gold, and probably short commercial real estate and corporate bonds as well, while going long farmland and agriculture. But how corporate bonds fare in the coming months depends a bit on the aforementioned government bond yields. So let's get stuck into them, shall we?

Over in America, ten-year yields advanced to their highest level since last October. It happened just as Uncle Sam was throwing an additional $19 billion of ten-years over the line and into the battle against deflation. The sale of the bonds took place at an average yield of 3.99%.

Tomorrow is the auction for $11 billion in 30-year bonds. Thirty-year yields are already as high as they've been since October of 2007. And by extension, borrowing costs linked to government bond yields will rise too. Mostly this affects the U.S. mortgage market. It means that refinancing a mortgage-providing you can find a willing lender-will get more expensive.

But we think rising U.S. bond yields indicate that the Credit Depression is entering a new phase. The cost of capital is rising, after slumping to historic lows during the credit boom. Investors-including other sovereign nations-will demand higher yields to loan to deficit-challenged governments. Or they may just dive into asset classes with better growth prospects.

For example, Russia's central bank says it may switch out of U.S. bonds and into IMF bonds. Russia's Finance Minister Alexei Kudrin says Russia will buy $10 billion in IMF bonds. China floated a trial balloon earlier in the week about buying $50 billion in IMF bonds. Brazil said it will buy $10 billion worth of IMF bonds.

This is just the beginning of the beginning. Or maybe it's the middle of the beginning. Or it could even be the end of the beginning. But it's pretty clear that the balance of power in the global financial system is shifting. It favours real resource producers and creditors. It does not favour governments with big deficits and bad demographics (more recipients of governments in retirement years and fewer workers to support those retirees).

You can see that Australia fits in both categories. It's a resource producer with high levels of personal and corporate debt. We reckon that over the coming years, government debt will grow too.

But Australia will be a target for international investment, given its resource wealth and comparatively high interest rates. That means the country shouldn't have a huge amount of difficulty financing Kevin Rudd's deficits. That doesn't make said deficits are a good thing. And it doesn't mean Aussie interest rates won't rise too, making borrowing more expensive for Aussie businesses and households. But an auction for American bonds is more likely to fail than an auction for Aussie bonds.

Aussie deficits are still wrong-headed and unnecessary, mind you. This recession (and it IS a recession, despite the statistical flim-flammery) was not caused by insufficient consumer and business demand, as Wayne Swan and others stupidly repeat. That's what all the Keynesians say. Thus, their policy prescription is for the government to run a deficit and support spending until consumers and businesses get back on their feet.

But when you diagnose the problem incorrectly, your cure will be faulty too. This is a balance sheet recession. The cause of it was the accumulation of too much leverage at the household and business level. The only cure for this kind of a recession is the write down in non-productive investment made with credit (residential housing, for example) and deleveraging (paying down of debt).

A recession that was caused by too much credit and massive bad investment is not cured by more government spending. It's like trying to cure a cold by kicking a dog. What's more, when you have over-capacity in global industrial production, lowering interest rates to try and stimulate the demand you think is missing is a waste of time. Business won't borrow at lower rates when they don't need to. Why expand production when there is already too much to begin with and demand is stagnant in most places and falling in the rest?

Besides, what does a government really accomplish when it manages to increase consumption through transfer payments? In most of the Western world, increased consumer spending primarily benefits the producers of consumer goods. Those producers are in China and the developing world, not America and Australia. It's true that local retailers may profit. But the bulk of the profits go back overseas anyway.

At the heart of this bad policy is a simple mistake (or simple economic illiteracy). This mistake is thinking that prosperity comes from consumption. Spending money doesn't create wealth. Prosperity begins with capital formation and production. You have to make something you can sell in order to earn an income you can trade for other goods. If you don't make anything, you can't consume.

For some reason, most modern policy makers have it all backward. They think wealth begins with consumption and spending. And in the meantime, they have-along with an assist from the financial industry-engineered a structural change in Western economies that favours the financial industry (which doesn't produce anything) over manufacturing or real goods production.

That's turning out to be a world historical mistake of the first order. But at least for Australia's sake, the consequences of that economic strategy will be somewhat beneficial. As America produces less and borrows more, the buyers of its bonds and dollars will defect to better investments in other places.

Australia is one of those places. So is gold. So is oil. Housing? Not so much. Government bonds? Definitely not. And common stocks? More on those tomorrow.

Dan Denning
for The Daily Reckoning Australia

• Finding Assets that Out Run Inflation as Bond Yields Move Up
• U.S. Bond Prices Rose and Yields Fell
• Lower Bond Yields by Any Means Necessary
• Choking on Debt in the Unfolding Anglo-Saxon Bond Crisis
• Look out! It’s The Bond Vigilantes!

You don't need to own subprime loans to take loan losses in a credit depression. Smith said the area that concerned him most was the surge in small and mid-size businesses simply closing up shop unexpectedly. "In the real economy," he said, "there is no evidence that the world economy is yet bottoming." Commercial property looms as the big threat to the Aussie banks this year.

The bad banking result may be enough to sink shares today. But not if they follow Wall Street's lead. Both the Dow and S&P closed up over two percent. It was a strange reaction to a do-nothing statement by the Federal Reserve.

The Fed merely reaffirmed that it would be dishing out US$1.75 trillion to buy mortgage backed securities, agency debt, and U.S. Treasury bonds, bills, and notes. What it did not say is that it would be increasing its purchases of U.S. Treasury bonds and notes. This may explain part of the rally in stocks. Why?

Well, bond prices fell after the Fed said it would do nothing. The yield on the ten-year note went as high as 3.12%. That's as high as it's been since the Fed telegraphed its intention to buy Treasuries and try and force mortgage rates down. If investors can surf higher bond prices in the Fed's wake, perhaps they are happy to rotate into stocks for a bit.

The rally certainly isn't explained by the GDP figures released yesterday in the U.S. Those showed that the economy shrank at a 6.1% annualised pace in the first quarter. That was a slight improvement on the 6.4% shrinkage in the fourth quarter. But is it the sort of thing-along with yesterday's improving consumer confidence number-that hints of a recovery? More on that in a moment.

Before we forget, we're taking applications here at the Old Hat Factory. We have several new products in development and are on the hunt for a full time commodities and resource stock analyst. Experience in the industry (mining or energy) is preferred. But if you're on the financial side of things and know your way around a balance sheet and cash flow statement and are handy with spread sheets, drop us a line at dan@dailyreckoning.com.au Serious inquires only please. Now, back to the markets...

The copper market seemed to interpret the Fed's statement that things were getting less bad as a sign that things are getting better. Copper prices were up 4.5% in New York. Copper is generally a leading indicator of economic growth because of its use in new construction (housing and commercial property).

Dr. Faber might be in agreement with Dr. Copper (as copper is sometimes called for its ability to 'diagnose' the economic conditions). Dr. Marc Faber's latest letter landed in the mailbox yesterday. There were some real gems in this month's Gloom, Boom, and Doom Report. One was this quote from Charles Kettering, "Success is getting what you want, happiness is wanting what you get."

Got it?

Dr. Faber also has quite a bit to say about whether the large rallies in global stock markets since March (and earlier in some cases) constitute a recovery in the economy or just a "bear market rally." He says that, "At least in nominal terms, the global printing presses being run by the world's central banks and fiscal deficits have begun to impact asset prices positively."

This is a concession that the big quantitative easing efforts of the Fed have found their way into bond prices and certain other sectors. Also, by trashing cash the Fed has made stocks look relatively more attractive. Dr. Faber also thinks that, "In the case of resource and mining stocks, as well as Asian equities (and, for that matter, most emerging and other stock markets around the globe), the lows that were reached between October and March of this year are likely to hold-that is, for now."

And what about Australia specifically? He did not single the country out. But he did say that, "The markets that have the highest probability of having made major longer-term lows are resource-related equities, emerging markets, and Japan."

"Conversely," he writes, "the asset market that has the highest probability of having a made a secular high (such as Japan in 1989, or the NASDAQ in March 2000) is the U.S. long-term government bond market. Despite a still-weakening economy and massive quantitative easing, long-term bond yields appear to be on the verge of breaking out on the upside."

Dr. Faber appears to be right. And we have the chart to prove it. The chart tracks the yield on 30-year U.S. bonds over the last year. We've included two moving averages (MA), a shorter-term 50-day MA and a longer-term MA of 100days. So what story does this chart tell?

Click to enlarge

Source: www.bigcharts.com

For one, you can see that when the Fed first announced its intention to buy mortgage backed securities in November of last year, it sent the 30-year yield cliff diving. And remember, because bond prices move inversely to yields, this sent 30-year bond prices up (which would have been good if you were a large holder and eager seller of those bonds like, say, China).

But at the turn of the year when the stock market swooned, thirty-year yields started creeping up again. Bond investors began doubting the Fed's resolve (or ability) to keep rates low with regular purchases (quantitative easing). The really interesting point on the chart is in Mid-March.

That's when the Fed said it would buy up to $300 billion in Treasuries. Yet from a technical perspective, this is exactly the point the short-term moving average (50 days) crossed over the longer-term moving average (100 days). In other words, when the Fed announced it would be coming into the market to buy bonds, 30-year yields experienced a bit of a technical breakout.

Now weather people began selling bonds because they thought stocks were a better bet, or for some other reason, we can't say. What we can say is that this chart may indicate the Fed's basic inability to control interest rates even with quantitative easing.

If ten-year yields keep rising too, the Fed is going to have to come back to the market with something even more jaw dropping. But will the market believe it? Or is Dr. Faber right? Has the secular bear market in long-term bonds begun at just the moment the Fed stepped in to support bond prices and try to force yields down?

We think the question is important because there is a lot of cash on the sidelines at the moment. Higher yields may suck in some cash looking for safety. But we reckon higher bond yields could just as easily trigger a bigger move into stocks. This would get a lot of people who are sitting on the fence back into the market. The rally would go even higher. And then?

That depends on the economy. And on that score, yesterday's GDP figures also revealed two important numbers. Residential investment (housing) declined at a 38% annualised pace in the first quarter of the year. It's been falling for 13 consecutive months, but this latest performance was by far the worst of the lot.

The other number that shocked was the huge decline in business investment. Business investment in equipment and software fell at a 33.8% annualised investment. Investment in non-residential structures fell 44.2%. Why does it shock?

If businesses are not investing now, where will GDP and wage growth come from later this year? We have a possible answer. But before we get to it, let's look at another chart. The chart from the excellent bloggers at www.calculatedriskblog.com shows the respective contributions of residential and business investment to U.S. GDP. So what story does this chart tell?

Click to enlarge

This chart is telling us that previous recessions, residential investment tends to recover ahead of business investment. In other words, it's telling us that households begin to spend again before businesses do. We can't quite work out why that might be (if it's actually correct, that is). It could be that at the low point of a recession, interest rates decline low enough to finally stimulate new demand for mortgages. The rates suck households in and the new housing activity stimulates the rest of the economy.

We're not saying we buy that theory. But the chart is indicating a bounce in residential investment. Our suspicion is that the bounce is re-financing activity at lower interest rates or foreclosure sales (which are doing a ripping business in California). In other words, most of the activity in the housing market is coming from market-clearing prices being reached in the most over-priced markets.

The big question is if the up-tick in home sales (and residential investment) actually stabilises house prices. If those keep falling, there could be a whole new wave of defaults and foreclosures that sweeps the U.S. market. This would have follow-on effects for the banks (more stress, loan losses, capital raisings) and for the job market (thus the economy).

It's also possible more people lose their houses anyway, even if prices stabilise. How? The economy. If the unemployment rate keeps going up, you can expect more Americans to lose their homes.

So it's a bit of chicken and an egg situation isn't it? Will housing investment lead to an economic recovery? Or will higher unemployment blow out the housing investment rebound and send us all into wave two of the Great Credit Depression?

This brings us back to the question of wage and GDP growth this year. If it's not going to come from the corporate world (still busy cutting costs and shedding jobs), is it really possible for housing to lead the American economy out of recession in 2009?

The only way we can see that happening is if the Fed is even more massively involved in supporting the mortgage backed securities market than it already is. It's committed $1.25 trillion to the market already. This backing could make it possible for millions of homeowners to refinance into new fixed rate 30-year loans this year. And if that happens, then you might see that housing-led recovery.

Don't hold your breath. Goldman Sachs reckons the U.S. government will have to raise $3.25 trillion in the debt markets this year to make up for the Federal budget deficit of $1.75 trillion and to fund the Fed's various credit-easing operations. And if the Treasury can't raise the money for the Fed on favourable terms, what do you think the Fed will do?

More on that tomorrow.

Dan Denning
for The Daily Reckoning Australia

• A Period of Credit Contraction, De-leveraging and Depression
• The Credit Depression
• Copper, the Metal with a Ph.D. in Economics
• Global Credit Shortage is Over According to European Central Bank
• 40 Years of Inflation, 80 Years of Dow/Gold

The total value of the deal is $30 billion. Chinalco gets a minority stake in some of Rio’s crown jewels, including the iron ore project in the Pilbara. It’s not cheap. Chinalco is paying a US$12.34 cover charge to get into the Pilbara, according to today’s Australian. But it’s oh so worth if it if you’re looking to source your steel industry’s long-term ore requirements.

You know for a fact that Rio’s directors did not wake up in July of 2007 and ask themselves, “How can we destroy shareholder value, imperil our jobs, and transfer ownership of our prized assets to our customers today?” Nobody entrepreneur waked up in the morning wanting to make the biggest mistake of his life.

Rio got caught in what Murray Rothbard called the “cluster of errors” that appears at the end of a credit boom. Normally, entrepreneurs make their mistakes discretely, in an uncorrelated fashion. One man correctly reads the emerging need for overnight transport of goods (FedEX) while another man opens a steakhouse in a neighbourhood full of vegans.

But in a credit boom, the abundance of money causes everyone to miscalculate at the same time. Entrepreneurs—who as Rothbard points out are in the business of forecasting future demand and meeting it with new supply—misread the market based on demand that has been falsely stimulated by the availability of cheap credit. When the credit goes, the businesses find they’ve expanded for a demand which was never really sustainable.

Of course it’s easy to say all that with the advantage of hindsight. If they knew then what they know now, Rio’s directors probably wouldn’t have saddled the company with $40 billion in debt on the eve of a credit depression. But then, we can never know then what we know now. As investors, all you can do is look for management team’s whose assumptions about the future are not “excessively forward looking.”

Rio will just be fine, one way or another. What’s really disturbing at the moment is how many economic mining projects are in danger of shutting down because finance is drying up altogether. And we’re not talking about greenfield mines or exploration projects. We’re talking about mines that are already mining ore or have completed all the necessary permitting.

Financing is now a critical problem. Hmm. Do you think there’ll be a government bailout for miners with economic projects who simply can’t refinance their loans? Probably not.

Over in New York, the Dow Jones did its best Lazarus imitation and rallied nearly 200 points in the last fifty minutes of trading. It still finished about seven points down on the day. But that’s better than 200 points down.

Is it over yet? No. Not yet. The Financial Times reports that, “Almost half of all the complex credit products ever built out of slices of other securitised bonds have now defaulted, according to analysts, and the proportion rises to more than two-thirds among deals created at the peak of the cycle.”

“The defaults have affected more than $300bn worth of these collateralised debt obligations, which were built from bits of other asset backed securities (ABS) such as mortgage bonds, other CDOs and structured bonds, or derivatives of any of these, according to analysts at Wachovia and Morgan Stanley.’

What about the other half? Uh oh...

Our old London desk mate Adrian Ash at Bullion Vault writes in...

Hey Dan loved your man's story about the Kiwi gold dealer who went bust in the late '80s. GoldCorp cost some 1,600 private buyers their entire "investment" after BNZ demanded (and was awarded) what little gold there was.

Like several other local titans blown up by the '87 crash, Ray Smith the man behind Gold Corp even wrote a book about it in the mid-90s, trying to downplay his role in the scandal, entitled Where's the Gold? Must've had balls of brass. Try blaming the private-investor losses on BNZ instead, I'm told. But the key point for gold investors came right at the top of your reader's story, when he refused to accept Goldcorp's certificate in lieu of gold.

Your reader said the secretary told him, “Oh no. Nobody does that nowadays [takes physical delivery]. It's much too risky. We store all our customers' gold in our vault. And it's a free service".

Everything you needed to know about Goldcorp's business and risks was spelled out right there:

#1. Title was vested in that piece of paper "your proof of ownership" rather than in the gold. That's the problem, legally speaking, with certification. The more persistent risk, physically, lies in over-issuance...selling more certificates than there's gold in the vault [ed note sounds like fractional reserve banking]. Which is why, here at BullionVault, we publish a central register of all customer property instead. Anyone visiting the site can then prove it against the full list of all gold bars held by our vault operators.

#2. The gold "sold" to the buyer wasn't necessarily in the vault anyway. That's made clear by storage being "a free service". Because just like several of the leading gold programs running today, storage can only be free to the buyer if the gold doesn't actually belong to him or her. It's what's known as "un-allocated" making the buyer an unsecured creditor, in the same way that cash depositors are unsecured creditors of commercial banks.

The final judgment in the Goldcorp case realized this, over-turning a previous decision that said non-allocated gold could be subject to a proprietary claim by unsecured creditors. But it can't, firstly because it won't necessarily exist (!) and secondly because that free storage proves they don't actually own anything.

Goldcorp was no more a custodian of physical property than your bank when it accepts a cash deposit. So whatever gold might have been in the vault could then be lent out or sold with or without the customer's explicit knowledge because s/he was only an unsecured creditor, not an owner of physical property left in safe-keeping.

The moral? Always take DELIVERY if you want to get yourself off risk. Possession, on the other hand along with all the extra costs, hassles and lack of liquidity is another matter entirely.

And finally, this conversation from the pokey in the hotel we’ve been staying at this week on the Gold Coast. It was the end of a long week and your editor sat down to finish a glass of red wine over a bizarre looking game that had a giant red kangaroo on it. It was called “Big Red.”

“How can three eagles not win a hand,” we asked the stranger to our right, trying to figure the game out?

“I don’t know. What kind of eagles are they?”

“I don’t know. I think they’re brown eagles. There’s no gold on them.”

“Maybe it’s a sea eagle.”

“Maybe. But...shouldn’t three eagles win something.”

“Not necessarily. It looks to me like you’ve got eagles there. But you’ve also got crocodiles...boars...let’s see...I think that’s a dingo...some gum trees...a queen...and a king. So they have to fit together somehow, or else you don’t get anything.”

“It sounds like a synthetic CDO?”

“Pardon?”

“Nothing...really. Nothing. Never mind.” And off to bed we went.

From Dan Denning on the Gold Coast
for The Daily Reckoning Australia

• Rumours Swirl Over Chinese Equity Stake in BHP Billiton
• A Pivot Point
• Chinese Foreign Mining Acquisition Equal to All of 2007
• Qatar Relies on Natural Gas Reserves While Dubai Leans on Trade and Finance
• A Gold Standard, Without Gold

The week begins with a bang, according to the Financial Times. The FT reports that, "The Obama administration is gearing up for a 'big bang' announcement within the next two weeks that will combine a bank clean-up with measures to reduce home foreclosures and probably steps to kick-start credit markets."

Obama as Prime Mover will have to turn the chaos in America's housing and mortgage market into harmonious order. Then He has to singlehandedly leap a tall legacy of toxic assets in a single bound, freeing up banks to lend by buying all of their dodgy assets.

It's a big ask. But if anyone can do it, He can. Especially when He's got America's credit rating to abuse!

Reordering the financial universe is not cheap. It takes a lot of energy and a lot of matter in the form of new U.S. dollars. Reuters reports that, "Goldman Sachs estimated that it would take on the order of $4 trillion to buy troubled mortgage and consumer debt. That number could shrink if the program were limited to only certain loans or banks, but it could also grow if other asset classes such as commercial real estate loans were included."

How much is $4 trillion? "At $4 trillion, that would be the equivalent of nearly 1/3 of U.S. gross domestic product. If the government had to fund that amount by issuing additional debt, it would intensify investor concerns about massive supply scaring off demand."

Yes. You can imagine the world's main owners of dollar-denominated reserve assets (China, Japan, the Petro states) would be intensely concerned about a $4 trillion increase in dollar denominated debt. But wait a tick...

It's one thing to say you might need to float as much as $4 trillion in debt to fund your bad bank. It's another thing to sell that debt? Who will buy it? Even these days, $4 trillion is a lot of capital to loan. Maybe that number has been floated to make a smaller number, say $2 trillion, look small by comparison.

Good news everyone! The Bad Bank is going to cost us half as much as we thought!

If the 'big bang' goes off this week, what will it mean for Planet U.S. Dollar? Or Planet Gold? Well, as our friend Steve Belmont in Chicago reported on Friday, gold is moving toward a day of reckoning after trading in a range for the last ten months. It will either break out much higher, Steve says, or buckle. We'll be watching.

While investors hoard cash, companies are looking for capital. Rio Tinto admitted over the weekend that it might sell more of its London-listing to current equity partner Chinalco. Rio can do a rights issue. But it appears to prefer asset sales as a method to retire its $38 billion debt associated with the Alcan acquisition.

Chinalco is in the catbird's seat, able to cherry pick assets from a distressed seller. This is not a bad position to be in if you're Chinalco, or if you're an individual investor who can pick and choose between great Australian resource projects. It's less good for Rio, which is now in the position of selling the family silver to keep the roof over its head.

Finally, did you notice the obnoxious change in political rhetoric this weekend? You knew Barrack Obama was going to give it to Wall Street, calling executives "shameful" for getting bonuses while their firms received TARP money. Remember, by the way, the TARP money was forced on some firms in an effort to boost confidence in the overall plan.

We normally try to keep a reserved, ironic, and sceptical air when reading the statements of politicians. Most of them are not worth taking seriously. But every once in a while, you get the scent of something so noxious and dangerous that you have to put aside humour and call it what is. Today is one of those days.

Now, the populist shame game is to be expected. That's not a big deal. What's more alarming is the bilge and claptrap spilling from Kevin Rudd's gob and what it may mean for your ability to preserve and create wealth in the coming years.

In The Monthly, Rudd plants a Neo-Marxist flag in the ground of the current debate with the kind of jargon-laden elitist preening that makes academic critics of the free market (who've never spent a day in the business world creating value) so nauseating.

Specifically, Rudd writes that, "The time has come, off the back of the current crisis, to proclaim that the great neo-liberal experiment of the past 30 years has failed, that the emperor has no clothes. Neo-liberalism, and the free-market fundamentalism it has produced, has been revealed as little more than personal greed dressed up as an economic philosophy."

Why not proclaim, since he is apparently in the position to make such proclamations, that the experiment in paper money and the deliberate policy of inflation it implies is theft? It is bureaucratic lust for power and authority disguised as monetary policy? It's also, at its heart, the belief that one or a few people in government know better than you how you should lead your life.

Leave it to Rudd and the resurgent global Left to use the present crisis as an occasion to expand their political ideology of government power and wealth confiscation. Despite the fall of the Berlin Wall in 1989, Marxism never really went away. It ensconced itself in Western universities and colleges, and in the careerism of the political class, which believes it is entitled to govern by virtue of its intellectual superiority and the moral justness of its anti-market position.

Their strategy, as always, is to control the rhetorical high ground by framing the discussion in populist terms and making an enemy of "greedy capitalists." Don't get us wrong. There are plenty of greedy capitalists to go around, or to go to jail. In fact, many more of them would be going out of business if the government would quit propping them up with taxpayer money. This generation of corporate executives shares plenty of blame for playing fast and loose with the corporations they were supposed to be stewards of. They over-levered, over-speculated, and over-paid themselves.

But Rudd is an ignoramus of the lowest order to say that current events somehow negate the last thirty years of globalisation, or three hundred years of economic growth and the division of labour. Tens of millions have been lifted out of poverty. Hundreds of millions have more economic and political freedom than ever before.

These results can only be the product of a system in which risk taking entrepreneurs have access to capital and savings, allocated through competitive markets where firms that deliver real value to consumers thrive and those that don't fail. That system has worked for 300 years of Western history to create wealth, choice, and opportunity.

Shame on Kevin Rudd for calling that "market fundamentalism", as if belief in the institutions that create wealth and liberty is akin to the same kind of religious fundamentalism that permits suicide bombing. If there is a more offensive use of rhetoric to equate two vastly different things, we haven't seen it.

But the Neo-Marxists are back on the march. And they are probably coming for your wages and pension sometime soon. Make no mistake about it. 2009 is the year the Neo-Marxists have been waiting for.

It is their chance to undo all the perceived evils of Thatcher and Reagan. There would be plenty of those to undo, of course, not least the idea that deficit spending is morally permissible. But the real push by the Neo-Marxists is to use the present occasion to expand the scope and reach of government power into your private life, so they can tell you what to do, what to watch, what to eat, what car to drive, and ultimately, what to think or say.

This will be disguised as better more "parental" regulation to achieve more equality and social justice. But behind the false populist outrage and the elevated language of idealism, it's just another push for government elites to expand their ability to compel you to live the life they think you should lead.

The simple regulatory response to all this is to reduce the amount of leverage available to financial players. Reduce margin lending in shares. Let bankers get back to making prudent loans in the housing market based on what a buyer can actually repay, rather than letting the government subsidise subprime lending because it's politically desirable.

There are other sensible regulatory responses to the mess. But they will be discarded in favour of grandiose and over-reaching plans to redesign the entire world in some utopian image. A 'big bang'? Really. Does that mean they're going to blow things up and call it a "fix?"

What we're getting at is that it's going to be a tremendous challenge to withstand this push in the next few years, mostly because it will have so much popular support from people with no brains who believe in fine sounding speeches and appreciate getting tax rebates/credits/handouts from the government. The first battle in the war on wealth creation is wealth redistribution, whether you like it or not.

It would be more honest if the Left just came out and said something like, "The last ten years have been a huge wealth transfer from the middle class to Wall Street and from the developing world to the developed world. We're going to try and reverse all that now because we know it's our best shot in the last thirty years to get some back. So here we come! Open your wallet and shut your mouth!"

Neo-liberalism isn't the culprit in all this. What does that word even mean? Isn't Rudd using it because it sounds like Neo-Conservatism? And everyone knows that Neo-conservatism is evil, therefore Neo-Liberalism must be evil too!

The real evil of the last thirty years is the vast expansion of credit in the world that changed personal and corporate incentives. The plunge in the cost of capital-encouraged by governments and Central Banks-set of an orgy of bad risk taking, quietly condoned by regulators and politicians who all benefitted in some way from housing/commodity/trade booms.

But now the credit cycle has turned. The Credit Depression is upon us. And Comrades Rudd and Obama will try and use it for the next great push in the Neo-Marxist dream, one world government with one world currency. More on that tomorrow!

Dan Denning
for The Daily Reckoning Australia

• Does it End With the Bang of Inflation? Or the Whimper of Dying Prices?
• U.S. Government Must Roll Over $3.4 Trillion in Debt Over Next Four Years
• Obama and the $3.8 Trillion Budget
• U.S. Government Spending $13 trillion to ‘Fix’ Problems
• Is Kevin Rudd Planning to Steal Your Superannuation and Bankrupt Your Retirement?

Stocks in the U.S. were up overnight. The only really positive news on the day was that existing home sales in the U.S. were up 6.5%. It was unexpected news. A lot of short sales and foreclosure sales boosted the market.

See. Markets work if you let prices function. Median house prices have fallen over 15% in the U.S. in the last year, according to the National Association of Realtors. The median price of US$175,400 is obviously starting to clear some of the inventory over-hang. If prices fall even more, you can expect more buyers to come in off the sidelines and back into the market.

The alternative is to keep those new buyers out of the market by propping up prices through various government-backed lending initiatives. If you want to make homes more affordable, you should let home prices adjust lower, to a level that reflects tighter credit. How hard is it to figure out that if you take away copious amounts of credit from the housing market (in Australia or America) prices are going to fall?

But is that such a bad thing? Well, it is if you own a house and have a large mortgage on it. But let's consider a new study on global housing affordability by Performance Urban Planning. The report concluded that Australia has the most unaffordable housing of all the nations surveyed. Not only that, but according to the report, Australia doesn't even have a single urban area in which housing is merely "moderately unaffordable."

Now before you write in defending the honour of Australia's housing market, let's be clear what the survey's designers consider unaffordable. They use a ratio of Median House Price to Median Household income. A house is "Affordable" if the ratio is 3.0 or less. It's "Moderately unaffordable" if the ratio is 3.1 to 4.0. It's "Seriously Unaffordable" if the ratio is 4.1 to 5.0. And it's "Severely Unaffordable" if the ratio is 5.1 or more.

Australia sports a ratio of 6.3, which is both "Severely Unaffordable" and "Seriously Daloob." New Zealand comes in next t 5.7, followed by Ireland at 5.4 and the U.K. at 5.3. Owing to its large number of metropolitan areas in which there is a wide variety of median prices and incomes, the U.S. nationwide ratio is just 3.2.

Part of the problem in the other countries is that national median incomes and house prices are derived from just a small number of densely populated urban areas. It's a pretty common occurrence in America to pack up your car, change states, and change jobs. You trade lower wages for a lower cost of living. That may be harder to do in more homogenised labour and housing markets, like, say, Australia.

So is today's ratio any higher than historically? You bet it is! According to the study, "In recent decades, the Median Multiple has been remarkably similar among the nations surveyed, with median house prices being generally 3.0 or less times median household incomes."

"This historic affordability relationship continues in many housing markets of the United States and Canada. However, the Median Multiple has escalated sharply in Australia, Ireland, New Zealand and the United Kingdom and in some markets of Canada and the United States."

There are other ways to measure affordability, of course. But it really comes down to the mortgage payment. Looking at house prices in terms of household earnings and income, then, is the method that makes the most sense to us. And by that measure, Australia has some of the most expensive housing in the world.

In fact, according to the table below, Australia has over a third of the sixty housing markets ranked "Severely Unaffordable" by the survey. Two of the top three "Severely Unaffordable" markets are in Queensland. And eight of the top twenty "Severely Unaffordable" markets are in Australia, according to the survey.

Source: 5th Annual Demographia International Housing Affordability Survey

If you're in the market for something "Seriously Unaffordable" you should try Bendigo (4.8), Wagga Wagga (4.9). or the goldfields in Ballarat (5.0). The other 24 major urban areas surveyed are either prohibitively expensive, or overvalued, depending on your point of view. So why haven't Aussie house prices fallen more?

"Unlike the other national markets in the Survey," the survey surmises, "Australia has thus far been able to avoid material house price declines. It seems likely that, sooner or later, the inherent instability and unsustainability that characterizes bubbles will lead to house price declines in Australia. However, were it possible for Australia to retain its highly over-valued house prices, there would still be a significant cost. Future generations would pay far more for housing than in the past, and Australia's relative standard of living would decline."

Far be it for us to suggest that Australia's love affair with homeownership could be financially ruinous at these prices. Besides, we don't have to say it when you can see it for yourself in the image below. But the generation psychology of getting rich in property is hard to break. It's worked for the Boomers. Now everyone thinks it will work. Hmmn.

Source:5th Annual Demographia International Housing Affordability Survey

The other side of the affordability ratio is household incomes. And if the job market data from the U.S. on Monday is a preview of what's ahead for Australia, median incomes are going to decline for the people who got fired. In the U.S. alone, over 79,000 pink slips were handed out to start the week.

Maybe it will be remembered as "Pink Monday." Corporations are hoping to stem the rising tide of red ink by slashing jobs. Caterpillar is cutting 20,000 people loose. Sprint Nextel fired 8,000, Home Depot, 7,000. Pfizer is laying of nearly 19,000. And American Express, after reporting an earnings drop of 79%, is sacking 7,000 workers too.

It's a lot of bad news. But the Amex news shows just how bad things are getting in the real economy. "Our fourth-quarter results reflect an operating environment that was among the harshest we have seen in decades," Amex CEO Ken Chenault said. Card member purchases declined by ten percent, year-over-year. Amex reported rising late payments, delinquencies, and is expecting larger default rates by its customers.

Do you see what's happening? Consumers are cutting back their use of credit cards. But even so, they are having trouble servicing their outstanding credit card debt. Households have a cash-flow problem too. They too, are overleveraged and have to reduce the amount of debt they are carrying.

The only way to do that is to cut spending. Thus a double whammy for the retail economy. With one hand, households cut spending, damaging business profits. With the other hand, businesses lay off workers, further reducing household income. And on the cycle goes.

The cycle of rising unemployment, negative earnings news, and recession is obviously a big downer for the stock market. Of course, as we write that, stocks are up on the day. But in a credit depression, asset values fall faster than government efforts to reinflate the money supply.

As we pointed out last week, the value of credit outstanding dwarfs the patchwork efforts of various government spending programs to prop up banks and house prices. We'd expect weaker stock prices, falling house prices (yes, even with interest rate cuts from the RBA), and the build up of a big inflation trade. More on that tomorrow.

Dan Denning

for The Daily Reckoning Australia

• American House Prices Continue to Fall While the Same Can’t Be Said About Australian House Prices
• Are Aussie House Prices in a Bubble?
• House Prices in California and Las Vegas Hit Hard by Wave of Foreclosed Properties
• Majority of Australians Believe House Prices Will Rise in Next Twelve Months
• House Prices Always Go Structurally Higher in Australia

This is very good news. It means you will have a chance to buy gold at lower prices before it goes up higher later this year. Much higher, in fact, according to the 2009 forecast made by Diggers and Drillers editor Al Robinson. Look for Al's special gold forecast issue later today in your in box.

Not everyone agrees that gold is going higher, mind you. "The deflationary scenario is still incredibly intact, even though the government has thrown trillions of dollars at it," one Leonard Kaplan told Bloomberg. Kaplan is the president of Prospector Asset Management in Evanston, Illinois. "Gold has a long ways to go down," he added.

Daloob. Seriously daloob. Daloob is a word that means whatever you'd like.

But what does it mean to say that the deflationary scenario is "incredibly" intact? Does this mean that the scenario is "not credible?" Or does it mean the scenario explains and predicts what's ahead? The statement is incredibly opaque.

Either way, the deflationary scenario that Kaplan refers to is worth a few lines. The scenario is one where commodity and stock prices fall as the credit depression gets its hands around the neck of the economy and squeezes. Under that scenario, gold would fall. And under that scenario, the cost of paying off debts would rise massively as cash gained value. Old debts would become economy-killing burdens for households, businesses, and, dare we say it, governments too.

In fact, the real economic consequences from this kind deflation are so destructive that we would bet our left big toe that the Federal Reserve is going to do everything in its power (and perhaps some things not in its power) to prevent it. It's not a risky bet. The Fed is firmly moving down the path to monetary weirdness. We are well and truly down the rabbit hole in 2009.

In the meantime, falling commodities prices are telling you that the forecast for the economy in 2009 is not good. Gold, oil, metals, and grains all moved down yesterday while the U.S. dollar moved up. It will be worth watching if commodity shares follow commodity prices down. Commodity shares, as we know all too well, were decimated in 2008.

But based on some analysis from our old friend Dr. Marc Faber in his latest Gloom, Boom, Doom report, commodities as an asset class are about the only stocks actually in a similar position to where stocks found themselves in 1987. That is, while the entire market was savaged last year, commodities may be the only sector worth taking a punt on in 2009, based on Dr. Faber's analysis of previous bull and bear cycles in various asset classes.

What cycles? Faber says that the length of the cycle immediately preceding a correction or crash has a lot to do with what you can expect next. "If an up-cycle was brief," he writes, "the down-cycle is also likely to be brief. If the up-cycle lasted a very long time and was accompanied by huge excesses, the downturn from the peak of such a cycle is likely to be lengthy-as was the case for gold after 1980, and for the Nikkei and the Japanese economy post-1990. Similarly, if a down-cycle lasted a long time (20-30 years), the up-cycle is also likely to last for an extended period of time."

The bull market in commodities began in 1999 and was preceded by an infamous 20-year bear market. Equities, on the other hand, enjoyed an 18-year bull market from 1982 to 2000, but have been in a bear market since then (with a robust, credit-induced bear market rally from 2003 to 2007).

By that logic, the down-cycle in equities should be a lot longer because the up-cycle preceding it lasted so long. On the other hand, the down-cycle in commodities should be shorter because it was preceded by a much shorter up-cycle and a very long down-cycle. Stocks down. Commodities up. Got it?

But is it right? The reasoning makes sense, especially if you compare it with the historic numbers Dr. Faber presents (which we will not replicate here for the sake of space). But there is a simple objection that must be dealt with. What if the commodities cycle is itself a function of an even larger cycle, namely the credit cycle?

If you argue that the bull market in credit began in 1973 and a world of floating exchange rates and competitive currency devaluations (or 1913 when the Federal Reserve was founded, or 1694 if we want to go all the way back to the Bank of England again), then the direction of asset prices would be dictated by whether credit was in an up-cycle or down-cycle.

It's pretty safe to say that credit appears to be in a down-cycle, starting in August of 2007. What's more, it was preceded by a massive "up-cycle" in which the supply of money and credit grew globally. That "up-cycle" drove up all assets in all countries simultaneously. We will find out this year if another "up-cycle" can be artificially by Obama and Bernanke.

But if we are now in the "down-cycle" for credit-the Credit Depression-then how can commodities possibly outperform equities and rally while stocks fall?

Well, the only possible way for commodities to go up in price during a credit depression when global economic activity shrinks...is if we experience massive, central-bank backed money printing and the inflation that ensues. Not that this is an outcome we find desirable. But it's clear as day from the Fed's actions and words that it will produce inflation at any cost to prevent being crushed by debt and deflation. For all its real wealth destruction, the Fed appears to prefer hyperinflation to credit depression.

And don't worry that the Fed is out of interest rate bullets in its pursuit of reinflating the credit bubble. There are other weapons. It will mail checks directly to people or buy assets directly on stock markets. You can expect the debt-to-GDP ratio in the United States to approach and exceed 100% before Obama's first term is over. You can also expect to see more direct government asset purchases and intervention in markets.

How can we be so sure that we're on the verge of a brave new world of government-managed markets and economies? It's simple. Central banks and national governments the world over face an existential crisis-the loss of public confidence in paper money. Action must be taken to restore confidence or real economic activity (lending, borrowing, spending, and investing) will grind to a halt.

Perversely, the monetary authorities will destroy public confidence completely through massive inflation. It will also unleash a great deal of social and political disorder. But the authorities appear to prefer this chaotic result (which they can then police and manage with new rules) to another Great Depression characterised by too little money and price deflation. The excesses of the credit bubble will not be liquidated. Instead, they will be perpetuated and subsidised. The resulting economic and social disorder will be met with more State activity in your personal and economic life.

All of this is a long way of explaining why the current lull in the gold price is a great buying opportunity. You know the tactics and strategy of the central bankers. And you have a pretty good idea that any rally in the stock market is a fake out rally, not sustainable based on the economic forecast OR previous cycles (where markets are coming off 20-years of rising prices). What you don't know is if gold prices are going to fall further before eventually heading higher.

To find the answer to that, you can consult 1974. At that time, stock markets looked oversold and gold had begun to move and was on the verge of a correction. "If someone really felt that the similarities between the 1974 low and the current market conditions are overwhelming," Dr. Faber adds, "he should consider purchasing gold and oil rather than U.S. equities (and also shorting U.S. bonds)...Gold corrected between the end of 1974 and the summer of 1976 by 40%, while the stock market surged. But from its August 1976 low, the gold price increased eight-fold."

"If we are really in an environment such as we were in at the 1974 lows (and I have serious reservations about this assumption), then we should expect some further weakness in gold prices when equities rebound. Such weakness would then provide an excellent buying opportunity."

"However, keep in mind that even if you bought gold at its 1974 high at US$196 per ounce, by 1980 you would still have quadrupled your money, which was far better than the return the stock market provided. So even if you endorse the view that we are in a similar situation as in 1974, I would be reluctant to stay out of the gold market entirely in the hope of buying it at lower prices."

"Another reason why gold may not sell off as much as it did between 1974 and 1976 is that governments' interventions with monetary and fiscal measures around the world are unprecedented. ..Therefore, based on my time/cycle analysis above, commodities and commodity-related shares would also seem to be in a far more favourable position to resume their up-trend than broad U.S. equity indices, which (a sharp rebound aside) are unlikely to enter a sustained longer-term bull market."

If Faber is right, what will it mean for Australia's broad equity indices? Well, you'd expect them to go higher as commodity prices react to the increase in global money supply. It certainly seems like most of the deleveraging is done in commodity stocks, meaning it would take something monstrous for mining shares to retest the 2003 lows.

Monsters are real though, so we can't completely discount the possibility that 2009 will be worse for resource shares than 2008. However, one needn't be a raging bull on Aussie resource stocks to see that the case for gold looks good. It's distressing that gold looks so good because the outlook for the economy is so bad. More on that tomorrow.

Dan Denning
for The Daily Reckoning Australia

• Krugman Warns That the Run-up in Stocks Can’t Be Justified By the Fundamentals
• Oil Was Down and the Banks Were Up
• Less Gold is Being Sold by European Central Banks
• Why the Bull Market in Commodities Isn’t Over
• A Worst-Case Commodity Scenario