For most companies, changes in earnings and intrinsic value occur very slowly - much more slowly than suggested by the daily fluctuations of stock prices.

Investor emotion accounts for these fluctuations. Many years ago, Benjamin Graham characterised this emotion as 'Mr Market'. Sometimes Mr Market was very happy and positive about the future and was willing to pay handsomely to buy shares. At other times, Mr Market thought the sky was falling in and wanted to give those same shares away at bargain prices.

Mr Market's whims can have a far more important effect on a company's share price than its actual earnings. So it pays to be aware when Mr Market is strutting around town offering high prices for shares, or when he is panicking about a company's future prospects. Our aim is to take advantage of his moods.

This is how Mr Market works. Say a company is trading on a price-to-earnings (PE) multiple of 10 times (which is the same as a 10% earnings yield). Let's also assume that the share price is $10 and that this represents intrinsic value. In a rare example, investors have priced this company rationally.

Then, the central bank decides the economy needs a boost, so they cut interest rates and unleash a flood of money into the financial system. Due to past indiscretions, the banking system is not too healthy and the real economy's appetite for more debt is not so great. So instead of making new loans with the freshly created central bank money, the funds flow into asset markets. Stock markets are a prime beneficiary.

Not realising (or ignoring) the fact that the new funds are policy induced, and not the result of sustainable economic recovery, Mr Market gets all excited and starts bidding up the price of shares. In a period of 12 months, our company goes from a PE multiple of 10 to 20 times, pushing the earnings yield down to 5%. Because the economy is stagnant, earnings do not rise. But Mr Market thinks they will eventually so his optimism has caused a doubling in the share price, to $20.

The following year sees a little less government and central bank stimulus because of a slightly improving economy. Our company manages to produce a healthy 20% rise in earnings. For the sake of simplicity, lets say that the earnings increase has also produced a 20% rise in intrinsic value to $12.

Unfortunately, the earnings increase is a little less than Mr Market was expecting. Suddenly, he begins to doubt his judgement. "What if things go wrong? What if fiscal and monetary stimulus really does nothing more than create the illusion of prosperity? The news out of China is not good - their economy is slowing more than I thought it would. What am I doing in stocks, get me outta here. Who wants to buy some shares?!"

Mr Market is beginning to lose it. He is no longer prepared to put a premium on stock prices. Instead, over the course of 12 months, the earnings multiple on our company shrinks to 8 times (a 12.5% earnings yield). The share price plummets from $20 to $9.60, well below intrinsic value.

In this hypothetical example, our company's stock price has fluctuated wildly despite earnings increasing by 20%. This actually happened to many quality Australian companies during 2008/09. Earnings for the 2009 financial year showed modest increases on 2008 numbers, but the influence of Mr Market suggested anything but.

Making fun of Mr Market's apparent stupidity is easy in hindsight. But as investors, we are Mr Market too. Taking advantage of his mood swings can be incredibly difficult because the same emotions that are flowing through the market are the ones you are experiencing.

So it's best to treat Mr Market with respect, not contempt. Understand his influence without coming under his spell and you will a much better investor. You will learn to ignore the day to day noise and will not be pushed into making a stupid decision based on what everyone else is doing.

Here's another way to think about how emotion can help or hinder you. When the outlook was good, Mr Market priced stocks at 20 times earnings. Buying stocks at these levels is the same way as saying you are happy to accept a 5% earnings yield. No one in their right mind would accept a 5% return on a risky asset like equities, so the 5% now comes with the expectation of a higher yield later. Strong future earnings growth (the reason for the optimism in the first place) is meant to take care of that.

But it rarely does, which is why paying too much for a stock almost never pays off. This is why we set our discount rate (another way of saying earnings yield) at a base rate of 12%. Discounting a company's expected earnings by 12% ensures there is a reasonable risk/reward trade off. Knowing the value of a company based on a sensible discount rate helps to take the effect of emotion - the fear and greed we experience daily - out of our hands.

This is an especially important consideration as 2010 gets underway. There is a lot of cheerleading in the financial services industry about how governments or central banks won't let deflation happen or won't let economies fall into recession.

We would caution that artificial tinkering with the market only influences the short term. Long term healing and sustained economic growth can only be generated by the private sector - by profit maximising individuals. Greater government involvement in an economy will lower long term productivity. Mr Market will come to this conclusion slowly, and the price he is willing to pay for companies will decline. So make sure you're not paying too high a price now.

Greg Canavan
for The Daily Reckoning Australia

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Yesterday, the Dow fell 213 points. Oil dropped to $76. Gold lost $9.

What caused it? What sets off a crash? Yesterday was hardly a crash. But our Crash Alert flag still flies. Because this is a market in danger. It is a market looking for a reason to crash.

You never know for sure when or why markets crash. At a certain point, markets become like drunks who want to play a game of Russian roulette. First, they have to find the revolver. Then, they find the trigger.

It looked to us as though investors were flexing their trigger fingers yesterday. Some blamed China's recent move towards tighter credit (or what they thought would be a move to tighter credit)...others blamed news from the US:

"Jobless claims in US unexpectedly rise," said the Bloomberg report. Here is how the Associated Press described it:

"A surprising jump in first-time claims for unemployment aid sent a painful reminder Thursday that jobs remain scarce six months into the economic recovery.

"The surge in last week's claims deflated hopes among some analysts that the economy would produce a net gain in jobs in January and help fuel the recovery.

"A Labor Department analyst said much of the increase was due to holiday-season-related administrative backlogs at the state agencies that process the claims. Still, economists noted that that would mean claims in previous weeks had been artificially low. Those earlier declines had sparked optimism that layoffs were tapering and that employers would add a modest number of jobs in January.

"The January employment report will be issued Feb. 5. But the surveys used to compile that report were done last week, so economists are paying close attention to the jobless claims figures from that week.

"'The trend in the data is still discouraging,' Diane Swonk, chief economist for Mesirow Financial, wrote in a note to clients. 'Hopes for a positive employment number in January...are rapidly dimming.'"

Anyone who was 'disappointed' by the jobless numbers hasn't been paying attention. Consumer and business credit are falling. That means businesses are not expanding. They're contracting. And that means they need fewer employees.

People without jobs can't shop like they used to...and they can't pay their bills. One out of 4 mortgaged houses is underwater. One in 10 is in foreclosure. Many more will probably go into foreclosure as the depression continues and default becomes more socially acceptable. Previous generations regarded default and foreclosure as a disgrace. Lenders priced this aversion into their lending rates. But now, default is just a shrewd financial move. When the financial costs of defaulting are lower than the costs of paying...that's what borrowers will do. Just like Wall Street.

As the depression continues, attitudes will change... Voters will probably want real change in Washington; that's what the Massachusetts election may be telling us.

But back to our story...

This morning, we see another itchy trigger finger. Stocks are falling in Asia. This time it's blamed on Obama's pledge to punish the banks with higher taxes.

But the real cause of the wobbles on Wall Street is the economy. Trillions' worth of fiscal and monetary stimulus aren't stimulating at all. They're just shifting control of the economy to the feds...and shifting the debt bubble in their direction, too.

Does that make a nation more prosperous? Of course not.

The stock market has been ignoring the fundamentals. It's priced dozens of big companies over 50 times last year's earnings. Overall, stock prices are closer to a top than a bottom. And yet, a depression brings a bottom, not a new top.

We say this with caution. A few years ago, we might have said it with reckless confidence, but we were smarter back then. Now, we even place our breakfast order with caution. You just never know...

No one ever knows exactly what Mr. Market will do. If he wants higher stock prices, he'll get them - no matter what the fundamentals tell us.

But we have to stick with the fundamentals anyway. That's all we've got. And they tell us to watch out. In a 'normal' recession, businesses would be re-hiring by this time in the cycle. They're not doing so. Why? Because it's not a 'normal' recession. It's something quite different. Something we haven't seen in the last 50 years. Something we never wanted to see again. But here it is - a depression. That's what those higher unemployment figures tell us. People who own and run businesses aren't hiring. They know the jig is up. The insiders who own businesses are selling 24 shares for every one they buy.

Unemployment is over 10%...and it seems likely to stay there for a long time. Consumer and business credit are declining - for the first time in half a century. And those trends too seem likely to continue. There are still beaucoup mistakes to correct and a long way down to go.

So relax. Buckle your seat belts. Sell your stocks. And enjoy the show.

"I spent some time driving around over the weekend," began an Irish colleague. "The Irish property market is a disaster. Over in Cork is the highest residential building in Ireland, the Elysium Tower. It was begun a couple of years ago. They have something like 300 units. But they've only sold 7. And now the owner is trying to buy back those 7 properties. It costs him so much to keep the lights on and to maintain the building, he figures he would be better off buying back the 7 units he sold and shutting the whole property down.

"If you wanted to buy something in Ireland now, you could get a very good deal..."

Uh oh. Both good and bad news on our new Trade of the Decade. Japanese shares were rising, last time we looked...because the falling yen makes Japanese exports more attractive.

But to whom are they going to sell? US consumers look like bad prospects. Their real, disposable incomes have gone nowhere in nearly 40 years. In the last two years, household net worth and incomes have been falling. Credit is falling too. The young have no jobs - even the ones with college degrees. One out of 5 defaults on his college debt. And the old have no money. Seniors are holding onto jobs as long as they can...trying to make up for years of failing to save.

China is another big customer. And the Chinese economy is about ready to blow up. Some luxury properties in Shanghai rose 100% last year. And now the authorities are tightening up on credit.

What happens to an export economy when its major customers go broke? We're going to find out... Japan's business leaders sense trouble. Business borrowing is collapsing. It's at its lowest point in 5 years.

This Trade of the Decade could be in for a rocky start.

Bill Bonner
for The Daily Reckoning Australia

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Andre Diederen is a senior research scientist at TNO, in Holland, a sort of think tank aiming to apply scientific knowledge to industry and government. Diederen argues in a recent research paper that we face a "looming metal minerals crisis."

"During the next few decades," he says, "we will encounter serious problems mining many important metal minerals at the desired extraction rates. Amongst them are all precious metals (gold, silver and platinum- group metals), zinc, tin, indium, zirconium, cadmium, tungsten, copper, manganese, nickel and molybdenum."

Diederen advances in this forecast because many of these metal minerals have relatively low reserves. As we've mined much of the high-grade ores, we now have to dig deeper and process more rock to get a given amount of metal. Lower grades require exponentially more energy, as Diederen shows. So he believes that the "decades-old paradigm of increasing reserves as demand rises" is no longer valid without cheap and abundant energy. The bump up in costs will be so great, in fact, that much of the known mineral resources will never become economically viable reserves.

By his estimate, the planet holds less than a 50-year supply of a number of essential metals and minerals.

More importantly, we reach peak production of many metals well before the 50-year period is up. For example, the remaining lifetime reserve of zirconium is 19 years, but peak production is well behind us already (1994). Referring to the chart below, Diederen writes: "Although exact data fail, the elements strontium [Sr] through niobium [Nb] will soon reach their peak production or have already passed their maximum extraction rates."

All the elements here face stiff headwinds as far as increasing extraction rates. Some of the more interesting ones - from left to right - include silver (Ag), gold (Au), molybdenum (Mo) and niobium. The latter is worth highlighting because Capital & Crisis recommendation, IAMGOLD (IAG:nyse), owns a niobium mine that is something of a wild card to value, but throws off significant cash flow. It is also one of only three such mines in the world and produces 8% of world supply. It's a nice little bonus you get for owning IAMGOLD.

Diederen also makes the case that many metal minerals have no acceptable substitutes for their major applications. And finally, even where we have plenty of proven reserves, we may still face supply constraints because so much of the resource is in one place that is not easy to access. An example Diederen uses is chromium, which is mainly located in Kazakhstan and southern Africa.

Common ideas people put forward that would avert the Diederen thesis include recycling and technological progress. As to the former, Diederen makes a good case that even with more intense recycling, we'll need more primary production to meet growing needs. As to the latter, he cites the Jevons Paradox: that when we use something more efficiently because of technological progress, we wind up using more of the resource in absolute terms. Certainly, you can see that with oil over the long term.

Car engines and all kinds of applications are more energy-efficient than ever, yet our oil usage in absolute terms has gone up materially over the years.

The developing supply crunch in these metal minerals sets the backdrop for a major, long-term bull market.

Molybdenum is one of the most interesting metal minerals from an investment standpoint. That's why I have recommended Thompson Creek (TC:nyse), a major miner of molybdenum, to the subscribers of my investment letter, Capital & Crisis. I've stuck with this story despite a gut-wrenching, hair-whitening ride. Over the last two years, the stock has traded as high as $25 per share and as low as two dollars. It currently sits at $11.70. The story here is all molybdenum, the price of which has drifted down to about $11 a pound from prices around $35 in the middle of last year. So if we don't see a rise in moly prices, TC isn't going anywhere.

But longer term, I see good reasons for moly to rise, mostly tied to the story of steel demand, against a rather tighter supply of moly. But for now, the company had $262 million in cash last quarter end. It also raised another $200 million after the quarter ended. So the market cap is now about $1.6 billion and the company has practically no debt and nearly $500 million in cash.

Thompson Creek could be acquired by a copper miner, such as Freeport- McMoRan, looking to boost its exposure to moly. More likely, I think, is that Thompson Creek uses its cash hoard to buy a more-cash-strapped competitor. We'll see. But the stock seems ripe for M&A with all that cash.

Detour Gold (DGC:tsx; DRGDF:pink sheets) is another ripe takeover candidate. In a world where the gold majors are struggling to increase production, Detour has the largest deposit not already owned by one of the biggies.

As metal minerals prices slowly rebuild their momentum, I would expect to see a large number of takeover deals in the sector. Place your bets now.

Regards,

Chris Mayer
for The Daily Reckoning Australia

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That's fantastic! Just 18 more months before we can put all of this behind us. Why didn't they aim to overcome the crisis a year ago? Oh well. Better late than never.

Of course, it is possible the leaders of the APEC nations have no idea what to do, and certainly don't agree on how to manage their currencies. The Journal reports that everyone is badgering the Americans and the Chinese to quit their cozy currency arrangement. America has effectively devalued the dollar with low interest rates, and the Chinese have matched the devaluation because of the semi-formal currency peg.

The results is a global race to the bottom, otherwise known as competitive currency devaluation. Exporting nations must mimic the Fed and keep rates low (or sell their own currencies and buy dollars) to stay competitive. It suits China and America for different reasons.

America's weak dollar hasn't exactly helped exports like everyone expected. In fact, the trade deficit widened last month on a weaker dollar, mostly due to huge oil imports. But as long as U.S. interest rates are kept low, the housing market will not implode. The weak dollar suits the Fed.

And a weak Yuan suits the Chinese for now. They remain the world's low cost producers. And their goods get even cheaper when the Yuan declines with the dollar. More market share is good for Chinese producers. But it doesn't make any other exporters trying to compete in manufactured or consumer goods very happy. About the only people, or metal, made happy by the current state of affairs is gold.

The weekend edition of the Australian Financial Review has gold on the cover, incidentally. You can see a picture of it a few paragraphs down. Underneath the giant golden letters it reads, "Why you shouldn't laugh about gold hitting $US2000 an oz." But if anyone's laughing, it's a nervous laughter.

Why? Well, the fact that the gold made the cover of the AFR confirmed our view that it was an excellent month to research uranium stocks. That's just what Diggers and Drillers editor Alex Cowie did. He published his first report as the full-time editor of Diggers and Drillers on Friday. It was on uranium, including one specific recommendation.

We talked with Alex about whether to write about gold this month or uranium. Trouble is, he'd already written about gold in October. We've been getting a lot of questions here at the DR about gold. The gold price is making new highs in U.S. dollars ($1,123.40 in the futures market last week), but hasn't carried over into Aussie dollar.

The strong Aussie dollar has capped the Aussie gold price for now. You can read what Alex has to say about it here. The short version, though, is that Aussie investors looking for leverage to higher gold prices ought to look at producers who incur cash production costs in U.S. dollars. This keeps costs under control, but ought to benefit share prices (all things being equal) if gold continues to make new highs.

November 2009	Winter 2006
Source: The Australian Financial Review	Source: Diggers and Drillers

By the way, a report predicting $2,000 gold was the very first letter we mailed when we began our financial publishing business in 2006. The prediction seemed a bit crazy back then. And truth be told, the report bombed. That is, very few readers took us up on the offer to subscribe to Diggers and Drillers and see what else we had to say about gold stocks and the resource industry.

And to be fair, the prediction hasn't come true...yet. Most Aussie gold stocks have lagged the move in bullion prices. And some people still think that gold itself as a genuine asset class is a crazy idea.

The author of the AFR's piece, Robert Guy, is grudging in his recognition of gold's recent performance: "Often dismissed as cranks and conspiracy theorists, true believers may have found vindication in gold's record-breaking run, which has underscored the migration of the mainstream to the long-held world view of these fringe dwellers."

And then he can't help himself. "Gold bugs' dystopian vision of debased currencies, enfeebled banks, debt-burdened governments resorting to the printing press, coupled with the menacing spectre of inflation, presents a worrying analogue to reality," he adds.

An 'analogue to reality'? Last we checked, all those things Guy mentions weren't just prophetic visions. They ARE reality. The real vision - in the sense of a something that appears in fevered recesses of the mind but has no existence in the physical world - is that government-led efforts to revive the economy by taking on more debt have actually worked and that everything is getting better and better.

But then, the idea that investors who buy gold are crazed believers is a convenient way of dismissing monetary history. Close your eyes and pretend everything is all right!

To understand the investment benefits of gold, you don't have to "believe" in gold in the way that, say, you have to believe in the Virgin birth or the resurrection to call yourself a Christian. You just have to understand how gold has always been part of a sound money system and how it promotes responsible government and personal liberty. It is not an act of faith. It's a rational conclusion.

Further, gold's physical attributes - durability, divisibility, transportability, relatively scarcity, and its sameness in all places - make it such a useful medium of exchange. To the extent that those qualities make for really useful money, gold does have an inherent value. Gold is very good money, which is why it's being remonetised after years in the Keynesian wilderness.

But we've written so much about gold in the past you are probably sick to death of it. So we'll conclude with two points. A sovereign debt crisis is brewing because Western Welfare states refuse to live within their means and are increasing public sector debt. This makes their currencies dangerous to own and their bonds subject to default. At the very least, most paper currencies face major devaluations.

The second point is that gold bullion is not a panacea for the problem of fiat currencies. It's a good start. But if you think the monetary world will somehow muddle through, then gold stocks give you leverage to a higher gold price. As eye-catching as gold's recent gains have been, we reckon most investors haven't begun to stock up and gold.

While the easy money in gold has been made, the big money has yet to be made.

All that said, we think Alex's timing on uranium is good. Turning to your attention to those asset classes that no one wants to touch is hard to do. For one, you have to be conscious that what everyone is talking about is either fully priced or over-priced. Secondly, it takes some courage to step into a market that everyone hates, or finds so uninteresting that it's not worth the time.

Granted, uranium does not exactly constitute a hated asset. But it hasn't been in the limelight lately, has it? There was a small story in this weekend's Australian, though. Energy Resources Australia's CEO Rob Atkinson says the pieces are in place for a uranium shortage down the track.

He cited three factors. First, the GFC cut off the capital for new mine development. This happened with oil and gold, too, both of which were facing production peaks anyway. But in the uranium industry, you've had major interruptions of mine supply from two sources that were expected to be a lot more productive, BHP's Olympic Dam and Cameco's Cigar Lake mine.

On the demand side is the resurgence in the world's fleet of nuclear reactors, which use uranium as fuel. Of course nuclear power remains controversial in some places (like Australia) even as it figures prominently as part of the energy portfolio in other places (like China and India).

No matter how you "feel" about it, it's pretty likely that nuclear will emerge as the clear winner as an alternative to hydrocarbons. Who knows what kind of madness the world's leaders will agree to. The idea that the world can give up burning coal and still maintain a comfortable standard of living is belly-laughable.

But even if next month's climate change summit in Copenhagen fails to produce a breakthrough (and it already looks like that may be the case), uranium should come out of the summit...er...glowing. And don't get us started on that summit. We've heard the interviews and read the articles. It does indeed look like a massive power grab. But that is a subject for another day.

As an investment issue, uranium stocks present better value right now than some other commodity stocks. One reason is that prices in the spot uranium market have trended between US$40 and US$50 all year. They soared to US$140 along with oil in 2007, but have since fallen, stabilised, and consolidated.

In other words, uranium is one of the assets to resist the rising tide of global liquidity. That doesn't mean it's coiled like a spring and will inevitably rise. But there are some good reasons to take a closer look at it now. And Alex pointed out an important fact in his November article: future uranium producers will have to produce above a certain number of pounds per year for at least ten years in order to enter into agreements with the utility companies that buy uranium for fuel.

That means that not just any explorer or developer is going to win the uranium sweepstakes if prices begin to rise in the spot market. And, of course, if global GDP and industrial production again collapse because of a second credit crisis, demand for electricity - including future projections - will go down. Maybe the world will build fewer nuclear reactors than planned, needing less uranium than expected.

Dan Denning
for The Daily Reckoning Australia

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First, Goldman's buy on the banks seemed to buoy the market. The Dow finished up 112 points and is just under 9,600. Meanwhile, Aussie stocks shrugged off that sense of impending doom and rallied 43 points yesterday. The ASX 200 is at 4,622 and thoughts of 5,000 by the end of the year must surely be dancing like sugarplums in the heads of some investors.

Ho! Ho! Ho!

But seriously. The banks? Really? Aren't you the least bit suspicious that Goldman is talking up the banks? Doesn't this mean Goldman is probably already short on the banks?

We have been hanging out at what we now call the "Trading Nebula" in our new offices. Our research department is growing, so we like to drop by and see what the traders think is happening. Often, it seems nebulous to us, given the peculiar vocabulary of indicators and charts the guys are using. Hence the "Trading Nebula."

But Murray Dawes was especially clear this morning when he told us that his screens are producing all sorts of warning signals on the banks. He is obviously running a different trading algorithm than Goldman. But then, he's producing trading leads for our new Slipstream Trader, which is designed to produce long and short ideas on ASX 200 stocks. In our chat this morning he told me that two banks showed up, although neither were part of the big four.

If Murray is suspicious that the banks can lead the market to higher highs, at least he's in good company. Bear heroine and noted financial analyst Meredith Whitney wrote in the Wall Street Journal over the weekend that, "Anyone counting on a meaningful economic recovery will be greatly disappointed. How do I know? I follow credit, and credit is contracting."

You don't say?

"Access to credit is being denied at an accelerating pace," Whitney adds. "Large, well-capitalized companies have no problem finding credit. Small businesses, on the other hand, have never had a harder time getting a loan...In the U.S., small businesses employ 50 percent of the country's workforce and contribute 38 percent of GDP...Without access to credit, small businesses can't grow, can't hire, and too often end up going out of business."

What then, has the regulatory and policy reaction actually produced? It's propped up large institutions that still have heaps of bad assets and have used the last six months to increase their leverage. But at the regional and local level, real businesses with real customers and real capital needs can't get credit.

To summarise: We have saved the zombie companies with zombie assets at the expense of the living, breathing engine of the free market; the small business. This leads Whitney to conclude, that "We are only in the early stages of the second half of this credit cycle...I expect another $1.5 trillion of credit-card lines to be removed from the system by the end of 2010."

What will happen to the economy then? And what will happen to Australia then? Will it matter? The ability to extend credit to small businesses and households is concentrated in the hands of the Big Four. Does that make us safer? Or does it concentrate the risk in a few major players, jeopardising the whole system of credit?

What's clear is that the supply of commercial credit is more concentrated now than ever before. Will the Big Four shun risk and build a capital cushion by cutting off small business credit? Will they double down on their housing lending in order to support house prices; a scheme which supports the value of the assets the banks carry on their balance sheets?

If we're making it sound like the market and the economy are at a critical inflection point, it's because they are. The complacency of the last six months is giving way to some real questions about what to do with troubled assets that are still troubled and bad debts that are still bad. Can a global economy really grow when the financial system is weighed down by so much debt?

Professor Michael Hudson is coming to Australia and he says "No!" If you're interested in hearing what he has to say in person, check out his schedule here. You can RSVP for the event near you, provided seats are still available. If you can't make it, there's a good You Tube video of his ideas here.

We're not familiar with everything Dr. Hudson has to say. We're planning on catching up for lunch and will report back to you how it goes. In the meantime, he gave an interview with the folks over at Business Spectator and put his views lucidly: "There's a basic mathematical principle; a debt that can't be paid won't be paid."

Talking about the explosion in consumer debt world-wide, including here in Australia, Hudson says, "These debts are beyond people's ability to pay and so we're going to see breaks in the chain of payment and this means that a lot of debts are going to go bad. It means that people are going to hesitate to realise that they can't pay, a kind of cognitive diffidence [sic] that people have about the fact that they really can't pay their debts."

"They're willing to run down their savings, they're willing to sell off their assets and do everything, but in the end they default and this is what breaks the back of an economy. The houses are defaulted on, they're put up for sale, that crashes real estate prices all the more and, again, the commercial real estate is even in more serious condition than residential real estate right now."

Coming back to Barofsky and Goldman then, and if Hudson is right, is this the time to buy the banks? Barofsky's report concluded that not all nine of the banks that received $125 billion in capital infusions from the U.S. government here as "healthy" as Ben Bernanke and Hank Paulson made them out to be.

The nine institutions combined had over $11 trillion in assets. But Paulson made it sound as if the capital infusion would not only stabilise the banking sector, it would prompt the resumption of credit flows in the economy. That turned out to be...not true.

So what is the truth? Well, as we suggested at the time, the TARP was just a massive delaying tactic. The capital infusions (putting aside that it wasn't really capital but money the Federal government borrowed that must be repaid) were designed to prevent the banks from going insolvent on further asset write downs. But the whole logic of the deal was that asset values would stabilise and even improve, meaning the banks wouldn't have to take losses or raise more capital.

Give it time baby. Time heals all asset values, right?

No. It all goes back to what you mean by "troubled." And this is the real heart of the issue behind our mistrust of the stock market rally. There has been no real improvement in the quality of troubled assets in the last year. In fact, they are more troubled than ever. The financial system remains troubled, and not much in it has really changed.

This leaves the highly-leveraged banks in the same precarious position as they were before, albeit with slightly more confidence from a gullible public. But at the balance sheet level, have things really improved? And more importantly, have the trillions in assets in the financial system related to residential and commercial real estate really become more valuable in the last six months? Or is just a Ponzi Finance pyramid of junk waiting to go up in flames?

In our view, the last year has been a policy and regulatory sham to cover the retreat by bankers. The people heavily invested in the old system of debt-based asset appreciation are stalling for time. They hope that the passage of time will improve earnings for a quarter for two.

And if they are the religious sort, they pray that some other scheme will be established to take the troubled assets of their hands. But time cannot heal troubled asset values. Faith healing doesn't work in financial markets. We'd humbly suggest that the day of reckoning is still out there, hiding somewhere on the calendar, waiting to rise again. Until then...

Dan Denning
for The Daily Reckoning Australia

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• Is the Macquarie Model Dead?

Will the Amero replace the dollar? Not at all...this myth has already been debunked online. If there were a new currency we also wouldn't expect to see it any time soon, that's our guess. We're in a depression. Maybe it will become a Great Depression...or a Greater Depression, we don't know. But it is a time of credit contraction...not credit expansion.

For the moment, prices are falling. The dollar is safe...at least, for now.

We paid a visit to France over the weekend. No one knows how France stays in business. Everything is very expensive and very difficult. Half the population struggles to earn a living. The other half struggle to stop them. But more about that later....

What caught our eye, walking down the street near the Communist Party headquarters, was a clothing shop. A few blocks away, you will pay $100 for a pair of jeans. But in this sidewalk shop, you can get a pair for $10. Shirts for $5. Jackets for $8.

The store is owned and run by what appears to be a Chinese family. They probably skirt French employment law by keeping the entire operation in the family. Then, rather than an expensive store, they have a cheap storefront in a bad part of town and put everything out on the wide sidewalk. Even in bad weather, they stretch out a tarpaulin over the clothes racks.

A $3 shirt? A $10 pair of jeans? That's deflation. A few months ago, these same clothes may have had designer brands on them - alligators or polo players, perhaps. But upscale sales are falling. So the factories take off the brands and dump their excess production onto the low-rent market.

We don't know that for a fact...we're just putting two and two together.

Excess capacity was built with excess credit. That's what happens in an expansion. Entrepreneurs borrow to increase production so they can sell more products to credit-addled consumers. Then, the excess capacity dooms them. They put out too many goods and too many services. When demand falls - along with incomes and housing - prices fall too.

Yesterday, the dollar held steady. The yield on the 10-year T-bond fell to 3.69% after reaching up toward 4% a few days ago. The rise in bond yields (with falling bond prices) was probably the most interesting story in the financial world...until they stopped rising.

What's going on?

As we explained, there is no real economic recovery taking place. In fact, there is a lot more risk and mayhem on the horizon.

And with no real economic recovery, don't expect a real bull market on Wall Street. Or real pressure on bond yields. (Of course...there's much more to the story...so stay tuned.)

In the meantime, yesterday, the Dow dropped 200 points. It looks to us as though the rally is coming to an end. If you're invested in U.S. stocks now, sell them. They could go higher...but it's not worth the downside risk. In the meantime, check out the 'millionaire's market'. It may be your best bet for turning a profit in this environment.

Some things are obvious and predictable. Other things are not. And, of course, we always have to remember that we don't know what we are talking about. As colleague Alex Green's delightful new book reminds us, "the only certainty is surprise." More later...

What is more or less predictable is that a severe depression is developing. Our iron law puts it this way: the force of a correction is equal and opposite to the deception that preceded it. The Bubble Epoque was extraordinary in practically every way - with illusions, frauds and absurdities galore. Ergo, so must be the Bust Epoque that follows.

From the housing sector comes news that even though houses are much cheaper they are not necessarily much more affordable. While prices are falling so are incomes and employment. Mortgage lenders, meanwhile, learned that they needed to be more careful about whom they lent money.

In 2007, the banks were so loose their arms practically fell off. If they had been young girls, you would have found short poems about them in the boys' toilets. They weren't prudent lenders; they were promiscuous ones. But now house prices are falling and lenders say 'no' to everyone. But unfortunately, that won't undo the mistakes of the past - the mistakes that are deciding the future of the US economy. The lax lending standards caused the first wave of loan defaults that rocked the banks to their core...and now the second wave is headed straight for the United States.

So the poor lumpen are trapped between falling incomes and rising lending standards; they can't buy a house even at a much lower price.

The retailers are trapped too. They leased huge spaces to sell their wares; now they have no one to sell their wares to.

Sales go down; so do earnings. Bloomberg reports that business executives see what is coming. They look at the figures and see their businesses trapped between high output capacity and low pricing power:

"Insiders Exit Shares at the Fastest Pace in Two Years," begins the headline.

"Executives are taking advantage of the biggest stock-market rally in 71 years to sell their shares at the fastest pace since credit markets started to seize up two years ago.

"Insiders of Standard & Poor's 500 Index companies were net sellers for 14 straight weeks as the gauge rose 36 percent, data compiled by InsiderScore.com show.

"Sales by CEOs, directors and senior officers have accelerated to the highest level since June 2007, two months before credit markets froze, as the S&P 500 rebounded from its 12-year low in March. The increase is making investors more skittish because executives presumably have the best information about their companies' prospects."

Even governments are trapped. Yesterday, Nicolas Sarkozy told the French that he wasn't going to follow the 'austerity policies' urged on him by the European Central Bank. "Austerity policies never work," he said.

The French deficit is more than twice the levels permitted by the European Union's economic guidelines. But at 7% of GDP, it is still barely half America's government deficit.

And over on America's left coast, the government of Arnold Schwarzenegger is faced with the same crisis - only worse. The New York Times tells us that states, led by California, are putting government employees on forced furloughs, releasing prisoners early, closing parks and reducing education budgets. They need to watch out; citizens might notice that they never needed to spend so much money in the first place.

Speaking of prisons, for example, the states could save a fortune simply by getting rid of the jailbirds who never really did anyone wrong. By that, we mean the people who didn't harm anyone but themselves...and arguably, not even themselves. There are hundreds of thousands of people in prison for drug crimes, for example. Let them pay a fine and turn them loose.

(If we were running things, we'd legalize drugs and make alcohol and cigarettes compulsory. TV, rap music and Barbra Streisand performances, on the other hand, would be outlawed.)

"France is rotten," said a dinner guest on Saturday night, recalling de Gaulle's famous warning that Vietnam was a "rotten country"...and that Americans should stay out.

"I'm fed up. You can't do anything in this country without either getting permission or getting a fine. You can't drive fast...even though the highways are made for much faster traffic. You can't smoke. You can't start a business...or sell one...or hire anyone. The way these employment laws work it's safer to murder a bad employee than fire him.

"Someone is always telling me what to do...and it wasn't like that a few years ago. I'm old enough to remember what it was like in the '60s and '70s. France was still a free country back then. You could do pretty much what you liked. You could ride down the road without putting on a seat belt. You could smoke in bars. If you didn't like your job you could tell your boss to go to hell. Then, you'd just look in the paper...there were always hundreds of jobs. People changed jobs. If one didn't work out...they tried a different one. Now, if they don't like their job they go to court and the employer is really in trouble. The whole process is rotten.

"What I'm really surprised about is the way the French have gone along with all this bossing... They're sheep."

"Wait a minute," another guest challenged her. "France is still a great place to live. The food is good. The weather is usually pretty good. The health service works. The trains run on time...at least, when the workers aren't on strike. It's pretty to look at. I don't know how much you've traveled, but compared to the places I've seen, France is way ahead. Besides, if you don't like it so much, why don't you just leave? Find some other country you like better..."

"Ha...I'm too old now...and besides...they're all rotten."

Bill Bonner
for The Daily Reckoning Australia

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This definitely sounds like a spurned lover. But what will the revenge be? Let's hope she doesn't have a knife. Or a blue water navy. Or an inter-continental ballistic missile.

Alas, for the new capitalists of the Chinese state this is a lesson that capitalism is not a romantic business. It makes for realistic bedfellows, not true love. Chinese deal makers may currently view the Australian resource sector has a harlot or a shameless "lady of the night" that has turned down a helpful offer the minute something more lucrative came around.

But that is assuming Chinalco's intentions with Rio were always honourable. And that is ignoring the fact that the "white knight" offer, made in Rio's hour of need, was also extremely favourable to Chinalco, given Rio's weakness at the time. But let's not take sides in this lover's quarrel, shall we?

And let's not lay blame, either, except, perhaps, with Tom Albanese, who deserves it. We suspect realism will prevail in the future relationship between China and Australia. A "let's-still-be-friends relationship makes sense for both parties, one of which has resources, the other of which needs them.

Time and necessity heal all wounds. But in the meantime, don't forget the flowers Mr. Rudd!

By the way, no one should assume that Australia will always have China to fall back on, whether it is for capital in a pinch, or long-term resource demand. China's apparent economic recovery is "mild" and "unstable" according to a study from The Development and Research Centre of the State Council in Beijing. "Although the economy has bottomed out, it was touching a flat bottom, instead of a V-shaped bottom," says the Centre's deputy director Zhang Wenkui.

With our unseemly interest in bond yields lately, we've completely neglected the idea that China may not inevitably rise to replace America as the world's dominant economic power or Empire. Its possible China itself could collapse. More on that subject tomorrow.

Dan Denning
for The Daily Reckoning Australia

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If you were drawing up a plan for your dream economic recovery, this is how you would draw it up. The weakness emerging in the Australian housing sector (the fastest decline in prices in six years) would be made up for by resurgent Chinese demand for Aussie resources, led by the first growth in China's manufacturing sector in nine months.

Of course it may not be quite THAT simple. Australian data sent mixed signals yesterday. House prices fell in the first quarter despite the flood of first home buyers in the market. In fact, you could say it's the worst of all worlds in the housing market. At the low-end of the price spectrum, the grant is driving prices up, essentially wiping out the benefit of making prices more affordable. At the high end, prices are falling anyway as investors keep their powder dry (and realise that interest rate will rise again).

Prices at the lower-end of the market rare rising. "New figures from property analysts Residex show that 57 per cent of suburbs with average house values below $350,000 experienced a price increase of more than $7000 in the six months to March," reports the Sunday Age. "A similar rise was recorded in almost half the suburbs with house prices below $500,000," in the Melbourne property market.

"Average prices soared by $30,500 in Werribee South, $26,500 in Kilsyth South, and by $24,000 in Broadmeadows and Albion - all of which are suburbs with house prices at the lower end of the market favoured by first home buyers." Hmmmn.

Should it surprise anyone that housing values in these places have already grown to exceed the value of the first home buyers grant? It wouldn't surprise anyone who knows how markets (and real estate agents and mortgage lenders) work. And to be frank, state governments that generate income from stamp duty probably have no problem with higher home prices, even if the simple price inflation leaves new home buyers with a more unbearable mortgage and a less affordable home.

So how will the RBA wade into this morass of data today? It would have learned that job advertisements have fallen by 49.9% in the last year and 7.5% alone in April, according to a survey by the ANZ Group. If businesses aren't hiring now, won't it lead to higher unemployment later (which would put even more pressure on mortgage owners?) We'll have a better idea on Thursday, when the 'official' employment numbers come out from the ABS.

In the meantime, the TD Securities-Melbourne Institute Monthly Inflation Gauge says inflation is up just 2.1% in the last year. Couple that with the rise in the Aussie dollar lately as the "yield trade" is back in vogue, and you can make a pretty strong case for the Reserve Bank cutting rates when it meets today. Why?

The RBA doesn't have to defend the dollar. The markets are doing that. With inflation seemingly tame, the Bank can give mortgage owners more relief until the employment situation improves in Australia (if it does so this year, that is).

What do we think? Central Banks always overshoot in both directions. It's ridiculous to think that a small committee of men and women know exactly what the price of money and credit should be at any given moment. However, since the mandate of the bank is both price stability and growth, you can expect the bank to over-stimulate now, leading to much higher inflation later.

But really, who is worried about such things today? The S&P 500 has entered positive territory for the first time since early January. According to Swarm Trader technician Gabriel Andre in Money Morning, the Aussie market (measured by the S&P ASX/200) is now entering the second wave of a rebound rally up from last year's 48% decline.

S&P ASX/200 to Embark On Second Rebound Wave?

Click to enlarge

Source: www.moneymorning.com.au

Gabriel says wave one of the rally took the index from around 3,100 to around 3,700. It ran into resistance at 3,800. But it seems to have smashed through that this week. The second wave, he says, could take it up to 4,500. That would constitute a 50% rebound from the total decline between the 2008 high and the 2009 low.

We'll leave the technicals to Gabriel. But at the fundamental level, you'd certainly think the postponement of the government's Emissions Trading Scheme (ETS) is a breath of fresh air for the energy and mining stocks that would have been hit hardest by it. LNG producers and miners may see an especially big tailwind, especially when you factor in the idea that China's $781 billion stimulus is leading to a recovery in that economy.

So is it all over? The crash? The depression? The credit crisis?

Well, no. We wouldn't expect the banks stress tests to reveal anything at all later this week. If bad news is already priced into bank stocks, less than bad news coming from the stress tests might even lead to a rally in financials. The market anticipated that result today, driving the financials up on the S&P. And in the end, perhaps the stress test was Tim Geithner's way of forcing the banks to raise capital more quickly than they otherwise might.

But in a lot of ways, this feels like a "catch up" rally, where timid investors "catch up" with the trend buy getting off the sidelines and into the market. Or should we say "ketchup" or perhaps "catsup?" It's the kind of rally that makes things seem (or taste) better than they are (like a meat pie at the footy). And it's driven by people who are afraid of missing out on an even bigger rally.

If that's correct, then it's exactly the sort of convincing move that the insiders would ride early while selling into retail strength. Get everyone back in the game, sell for a tidy 35-40% profit on a short-term basis, then hunker down to see what the second half brings.

After all, the old trading adage is to "Sell in May and go away." It's supposedly based on the idea that the stock market generates its biggest returns between November and May on the calendar. The gap between May and the last quarter is a kind of no man's land for investors. We have no idea if that's true.

We do know that there's more than one second wave out there, though. A second wave rally in the ASX is a great time to make trades and take some profits on recovering shares. But let's not forget the second wave of bad housing debt in the U.S. (Alt-A mortgage) and the second wave of real estate losses coming from commercial property.

Those losses are going to further impair bank capital, put pressure on lending, and lead to larger declines in employment. Economies that live and die by credit growth and residential real estate still have some dying to do, we reckon. But for us the living today, the rally is something to enjoy while it lasts.

Dan Denning
for The Daily Reckoning Australia

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