Our Chairman, who art at Goldman
Blankfein be thy name
The rally's come
God's work be done
On earth as there's no fear of correction
Give us our daily gains...

Poor Goldman Sachs. Everyone is on its case. Criticizing. Carping. Jealous. Envious.

So, today we rise in defense of the Wall Street giant. Yes, the Goldmen may be shysters. But they are honest shysters...

We pick up sword and shield, ready to fight for Goldman, after reading The Financial Times. The FT has devoted a whole page to Goldman bashing. It's time someone stood up to say a kind word for the firm.

Besides, Lloyd Blankfein said he was sorry. That's right. He announced that the firm regretted its role in the world financial crisis. And if that weren't enough, he pledged half a billion dollars to helping small business through tough times.

In his apology, Blankfein mentioned that he thought Goldman was doing "God's work." That is what prompted humorists to make up the "Lloyd's Prayer," we have republished above. On the surface of it, it does seem absurd. If any group of people ever worshipped Mammon, it is the bunch that works at Goldman. Money is what makes that mare run; no one doubts it.

In 2008, the average compensation of the average Goldman employee averaged $364,000 - or more than 6 times the earnings of the average American who was not employed by Goldman. Naturally, the widespread publication of this fact caused a surge of envy. Now comes news that the average Goldman man expects to make about twice as much this year - or about $765,000. As you can imagine, this did nothing to soothe the jealous spirits. Instead, it inflamed them.

And now, everyone has Goldman in his sights. Newspaper editorials kvetch and moan. Union-organized yahoos demonstrate in front of Goldman's offices. Cartoons make fun of Blankfein. Commentators say the Goldman crew is greedy. The Rolling Stone magazine described Goldman as a "vampire squid." Saturday Night Live mocked the company. Stand up comics stock up on Goldman jokes. Even priests criticize the firm's claim to be doing 'God's work.'

The regulators cannot be far behind. It is illegal to trade on "inside information." So, when a company targets the shares of a rival, and passes its buy orders through a Wall Street firm, the traders are forbidden from trading the shares on their own account. They cannot profit from 'front running' shares, based information not yet available to the public.

Goldman clearly profits from front running. But it does it by aggregating information from clients rather than using the inside information from a single client. This gives them a "market color," rather than precise trading targets. In other words, if you have a client who sets out to acquire Acme Cement Company, you can't buy up the shares yourself in anticipation of the rise in the share prices. That information is "protected, inside information." But suppose you have two clients, each of whom targets a cement firm? You quickly get a "market color," don't you? You put two and two together. If they're both after cement makers, probably, the whole cement sector will go up. You buy cement makers, though not those that your clients are buying.

This aggregated inside information gives Goldman a big advantage. So do its close contacts with the feds. Goldman has its former operatives in key posts throughout the government. It knows what the government is doing; it has a fair idea of what the government will do next. In trading US government securities, the biggest business in the financial world, this "insider" knowledge is no doubt a handy thing to have. It doesn't hurt either that the Fed is making money available to Goldman at practically no cost. Nor, that the Fed is buying its mortgage backed securities - perhaps even ones that would be hard to unload on the private market.

These contacts and sources of 'insider' information are what George Soros has called the "hidden gifts" that Goldman enjoys...and that contribute mightily to its success.

But so what? As far as we know, Goldman holds no gun to any counterparty's head. Nor does it lie...unless you call saying things that aren't true "lying." Goldman merely says the same falsehoods as the rest of the financial industry...the things people want to hear...which almost everyone believes anyway. And is there anything wrong with taking money from the US government? Doesn't every retiree do so? Doesn't every larcenous Congressman and every conniving contractor and every shiftless welfare addict aim to do the same thing? Isn't the whole idea of government to take from someone and give to someone else? Then, why not to those who are most able to claim it? The swift...the strong...the smart...the Goldmans!

No, dear reader, we cannot criticize Goldman. Instead, we admire it. Goldman took advantage of the financial boom by selling debt and derivatives all over the world. Now, it takes advantage of the 'recovery,' by trading on its client information. And who can blame it for wanting to do business with the richest and dumbest client of all, the US government?

In God's plan, at least as we see it, the lowly are raised up. The rich...the proud...and the foolish are brought down. God deals with the meek on his own. Goldman helps him bring the boom down on the others.

Until next time,

Bill Bonner
for The Daily Reckoning Australia

• Meredith Whitney and the Buy Recommendation on Goldman Sachs
• China’s Economy is Now Freer and More Competitive than the United States
• Warren Buffett is Buying Four Percent of Goldman Sachs
• Who Was the SEC Harassing Instead of Madoff?
• JPMorgan and Goldman Sachs Making Billions in Profits

According to Goldman Sachs, robust 2010 oil demand growth will deplete these inventories over the next 12-to-18 months and diminishing production rates in key areas around the world will create a supply/demand imbalance.

The top portion of the nearby chart shows the decline in production from the world's top 230 projects. After peaking in 2009, production from these projects is set to fall for the next several years. Excluding OPEC countries (bottom portion of the chart), the decline rates will likely quadruple from 2007 to 2012.

Over that time period, non-OPEC production is expected to fall by 2.5 million barrels per day. Only Brazil, Canada and the former countries of the Soviet Union are expected to see production growth.

One of the largest contributing factors for this is chronic decline rates from some of the world's top mature fields. Mexico's Cantarell field, one of the largest oil fields in the world, produced 30 percent less oil in 2008 than it did in 2007 - a trend that's expected to continue.

Norway, the world's 11th largest oil producer in 2008, saw its oil production peak in 2001 and is down 27 percent since. Another big producer, Venezuela's state-owned oil company PdVSA has seen annual decline rates of more than 25 percent in certain fields according to the Energy Information Administration (EIA).

Adding to the dilemma, many countries without decline-rate issues have been holding out production increases until projects become more cost effective; this is why we recently saw Russia overtake Saudi Arabia as the world's largest oil producer.

The Saudis have been content to sit on the sidelines while awaiting the return of higher prices. The same goes for other OPEC countries; PIRA, an oil-industry consultant, says the cost of oil will have to rise above $80 per barrel in order for the cartel to increase production.

With oil prices currently hovering around that $80 level, OPEC officials have recently hinted that production increases aren't off the table for the cartel's upcoming December meeting.

But even if we see a production increase out of OPEC, decline rates from maturing fields and high barriers of entry to bring new fields online should keep the supply/demand balance tight for years to come.

Regards,

Evan Smith and Brian Hicks
for The Daily Reckoning Australia

• No Spike in Oil Price Following IEA “Third Oil Shock” Announcement
• BHP Billiton: The Oil Company That is Not an Oil Company
• Where Will Future Oil Production Come From and How Can Investors Profit Today?
• Oil Price Chart Shows Slight “Correction” in Near Future
• OPEC Agrees Not to Cut Oil Production Until it Meets in May

And don't forget the foreclosures. They're running 23% ahead of last year...even though they weren't as bad last month as last month.

Associated Press:

"The number of households caught up in the foreclosure crisis rose more than 5 percent from summer to fall as a federal effort to assist struggling borrowers was overwhelmed by a flood of defaults among people who lost their jobs.

"The foreclosure crisis affected nearly 938,000 properties in the July- September quarter, compared with about 890,000 in the prior three months, according to a report released Thursday by RealtyTrac Inc. That puts foreclosure-related filings on a pace to hit about 3.5 million this year, up from more than 2.3 million last year."

What an economy!

The Dow is now back over the 10,000 mark...just where it was in March 1999 - 10 years ago. Is that progress...or what?

During that time, the dollar has lost about a quarter of its purchasing power. That means stock market investors have lost only about 25% or their money over the decade. Not too bad, huh?

And, oh yes...they've lost their jobs too...

AP continues:

"Unemployment is the main reason homeowners are falling into trouble. While the economy is likely out of recession, the unemployment rate - now at a 26-year high of 9.8 percent - isn't expected to peak until the middle of next year."

But hey...we're not going to complain. We've got a job - trying to figure out what is going on. And that is a job that is recession-proof. Everyone wants to know what will happen next. When times turn tough they want to know even more.

So, will someone please tell us what is going on...we want to know too!

"What do you think?" asked a friend at dinner last night. "The way I see it, Obama's goose is cooked. He's stuck. He can't go forward and he can't back up. He can't back away from all those promises - including his promise to rescue the US economy. If he does, the voters and his own party will revolt. On the other hand, he doesn't have the money to go forward. He has to borrow it. And if tries to borrow much more, the Chinese will revolt.

"His only hope is that the economy revives...so he doesn't have to do anything. And that's not going to happen."

Why not? Wait a minute...you already know the answer to that question. Because it's a depression. It's the end of the road for the consumer credit economy. Consumers did their best. They borrowed as much as they could. They spent like there was no tomorrow.

But now, it IS tomorrow. And now, they've got to settle up. So, boo hoo...no more wild parties. Daddy took the T-bird away. Get over it.

What should Obama have done? Nothing. But the last chief of state to do that in a time of financial crisis was Warren G. Harding - one of America's best presidents. That's what he did in the panic of 1920. How come we don't hear much about the crisis of 1920?

Because Harding didn't do anything; it went away.

But that was a long time ago. Now, presidents are expected to do something. They have too many people around them who stand to make a buck out of it.

Yesterday, Goldman announced its quarterly earnings. Goldman, you'll recall, is the firm that former Treasury Secretary Henry Paulson (a former Goldman chairman) called 13 times before breakfast during the financial crisis of last September. And Goldman is also the firm with its men in key posts in Washington, helping the feds figure out what to do with trillions of dollars in bailout funds (TARP, TALF, Fed's buying toxic assets, etc.)

Well, what a coincidence...now the firm says its latest profit is four times what it was a year ago.

The firm's "activities have become more profitable after the crisis reduced competition and governments injected funds in the banking system," says The Financial Times.

Goldman can borrow the funds at almost no cost. Then, it can use the money in a variety of ways...such as lending it back to the government for guaranteed profits...or speculating on oil or gold, or whatever. Not for nothing is gold is up 17% in the last six months. If you can borrow at zero cost you can do a lot of speculating. Many speculators are using the government's money to bet against the US dollar - and making a lot of money.

The US government has put $13 trillion of the nation's money and credit on the line. That's how much the feds have at risk on all their toxic asset purchases, loans and guarantees. Apparently, Goldman gets its share.

What can the feds do? Everyone is telling Mr. Obama that he must do something...now! So what does he do? Something stupid, of course.

Yesterday, poor Mr. Obama did something stupid. He said he wanted to send 78 million American seniors a check for $250 each.

What a nice Christmas present. But wait. Even Santa doesn't have that kind of money. The feds are already running a deficit somewhere close to $15 billion PER DAY.

But heck, who keeps track of these things? And who quibbles about a few billion more or less?

Not us. Not here at The Daily Reckoning. We've got other things to quibble about. In fact, we've got so many things to quibble about we hardly know where to start.

So let's just pick a news item at random and we'll begin our quibbling there. Here's one:

Social Security recipients are not going to get a COLA. A COLA is a "cost of living adjustment." It's what Social Security recipients get when prices go up. It adjusts their payments to inflation.

COLA seemed like a fair idea when it was put in place. That was when prices were going up. The old folks were getting a raw deal and people felt bad about it. We remember those years. There was a report in the press in the late '70s that old people were "forced to eat dog food" to survive. We suggested that the government allow people to use food stamps to get pet food. But that was greeted like so many of our attempts to be helpful.

The trouble with the COLA is that there is no UN-COLA. When prices fall, there's no way to get the money back. The adjustments only go in one direction.

And prices ARE falling. US import prices roes only 0.1% last month...down 12% from a year ago. Take out energy and they're still down 4%. And that's with a dollar that is losing value at the same time. Imports should be going up in price. Instead, the downward tug of deflation is so strong that they are pulled down...even with the dollar buoying them up.

So, imagine that the United States slips into a Japan-like slump...a long slump with off-and-on falling prices. The government's budget projections call for a rapid return to growth. Even then, they expect trillion-dollar deficits until the end of the next decade. But if the economy does not return to rapid growth, the situation gets much worse - fast. Tax revenues don't go up...and spending continues to mount. There's no way to reduce payments to Social Security recipients. And imagine the poor sap who proposes it. Or who suggests that maybe government salaries don't have to be twice as high as private salaries. He wouldn't last long.

This leaves the feds in a tight spot. They won't have trillion-dollar deficits...they will have multi-trillion-dollar deficits. They won't have just a little trillion-dollar hole to fill; they will have a Grand Canyon.

How to fill it?

Ain't no way... Ain't no way... At a certain, but unknown, point the whole thing falls apart. The feds can't raise enough money. They go broke.

Now, hold on...the US federal government can't go broke, can it? Those fellows have a printing press. They can print their way out, no?

A very, very good question. Why would a government with the power to create money at will ever go bust? And yet, they do. Why? Because it is cheaper.

But this is far too large and important a subject for a Friday. This is a subject for a Tuesday. Maybe even a Wednesday. But Friday? Nope. God didn't make Fridays for this kind of thing. We'll have to come back to it next week.

Can anything stop the Chinese?

"China consolidates its lead in world trade," was a headline in The New York Times earlier this week.

China competes on price - and usually wins. America loses market share.

"We're finished," said our dinner companion last night. "We're fossils. We're yesterday's news. We're a nation of old people. The growth and innovation is taking place elsewhere - such as in China. You can feel the difference when you go there. New buildings. New roads. New cities. New shoppers. Here, everything is old. The buildings. The people. Everything.

"I tell my children to move to the Far East. We're history here."

This morning comes news that the Chinese have bought another auto company - Britain's van maker, LDV. And over on page 11 of The Wall Street Journal is a photo of the head of China's big bank, CCB. Asked about whether the bank was looking at acquisitions in the West, Mr. Guo Shuquing said he wasn't interested. Western banks are on a "downhill path," he said.

"Of course, there's something nice about living in a society which has peaked out," our friend continued. "You have all the grace and style of an advanced civilization without the annoying hustle and bustle. It's perfect for retired people...We live in a retirement society."

Bill Bonner
for The Daily Reckoning Australia

• Feds Have Economy on Life Support
• China’s Economy is Now Freer and More Competitive than the United States
• Have the Feds Given the Economy a Miracle Drug?
• If the Economy is Not Recovering It Isn’t Getting Enough Stimulus
• Rising in Defense of Goldman Sachs

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
• Banks or BHP?

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

• Normally Small Businesses Lead the Economy Out of Recession
• Meredith Whitney and the Buy Recommendation on Goldman Sachs
• Rising in Defense of Goldman Sachs
• Warren Buffett is Buying Four Percent of Goldman Sachs
• Is the Macquarie Model Dead?

If everyone's running up the street bashing windows, you'll experience pressure to join in. On the other hand, if, say, everyone is buying stocks because no one appears to be concerned that they are expensive, you'll experience subtle pressure to do the same.

In evolutionary terms, doing what other people are doing is generally a good strategy. It saves you the time and energy of thinking about the decision yourself. And you have to assume that they probably wouldn't be doing it if it didn't promote their survival in some way.

The shrinks call this phenomenon "pluralistic ignorance." We were reading about it last night over cocktails at Barney Allen's, right next door to our new head quarters in the heart of St. Kilda. It made a lot of sense, at least if you're trying to explain why so many people do so little when they have so much to lose.

Speaking of losing and just what's at stake as September begins, why don't we start with where the entire global recovery - and Australia's resilience - are supposed to reside: Chinese strength. The Shanghai Composite fells 6.7% overnight and is now down over 25% from its highs. Uh oh.

But it's not Chinese stocks that worry us. It's true there is probably a huge bubble slowly deflating in Chinese shares. Chinese banks lent nearly $1.1 trillion in the first half of this year and a lot of that found its way into the stock and real estate markets. But the bigger issue for Aussie investors is whether Chinese industrial stockpiling of raw materials is over.

If it is, then one of the big drivers of the resource rebound is in real trouble. You got a whiff of that overnight when October crude oil prices fell $2.78 per barrel back under $70. Investors are reconsidering the idea that China can lead a global demand recovery and justify the high p/e ratios reflected on major indexes.

For example, yesterday's Age reports that the Morgan Stanley Capital Insights (MSCI) index of Asia Pacific stocks, "are trading at a price-to-book valuation of 1.1 times, above the 30-year average of 0.7 times and around the same level at the peak of the last bull market." These stocks are priced for an export-boom to America.

But what if that doesn't happen? It's almost certain that it can't, given the retreating balance sheets of U.S. consumers. That leaves a Chinese growth model that's not focused on exports. That leaves China buying its own toasters, cars, ovens, toaster-ovens, clothes, capital goods, and textiles.

Does China have the capacity, along with India, to consume the world out of deflation? Hmm. What do you reckon? We reckon all this is setting up for a traditional September/October correction. And yesterday, there was more evidence to show why that might be.

The first and second quarters looked good for corporations because of massive cost cutting. This cost-cutting helped stocks beat "analyst's expectations." That created a bunch of manufactured enthusiasm about "green shoots." But you have to ask if the earnings outlook for firms really improved the first half? We'd argue that it didn't.

For example, according to Goldman Sachs, 46% of Wall Street firms beat expectations by "a wide margin." But only 23% of firms actually reported better revenues than initially forecast. And for companies in the S&P 500, sales actually fell by 16% in the second quarter compared to the year before. And that was after a 14% year-over-year sales decline in the first quarter.

Now you can make more in earnings off declining sales. But we'd suggest that is not a very good sign of health. Companies achieved the higher earnings numbers through cost cutting and tentative restocking of inventories. You reduce your overheads and your cost of goods sold and fire people. That helps you beat "analyst's expectations." But it doesn't really mean your business is primed to throw off higher earnings and cash flows next year.

This may be why September sucks. As long as analysts are in collusion with reporting firms, you can fool investors for a quarter or two with cost cutting and some earnings engineering. But by the third quarter, the real state of the company is clear for anyone to see. All you have to do is look.

Amy Lubas from Ned Davis Research tells the Wall Street Journal that sorting through the market now is all about "differentiation." She says that, "In the initial stage of a recovery from a bear market, the stocks that have fallen the most tend to be the ones that rebound the strongest. After a bottom, the market shifts to more industry-specific and company-specific factors."

So if you're differentiating, what are you looking for? You're looking for the companies that have trimmed their operating overheads to become more efficient, that's for sure. But what you really want is a firm that increases its revenue growth without greatly increasing its capital spending (the secret of capital efficiency, as we have written about before).

There is good news and bad news for commodities here. The good news is that you can always find companies with ore bodies and assets that are exposed the higher prices that come with higher demand. The bad news is that you cannot generally assume demand for all commodities will rise, or that supply will stay constrained. You have to find out which commodities are correlated to the new kind of domestic-driven growth from the Chinese economy and which are not.

That's a full time job. It's what we're up to at Diggers and Drillers. And for now, the short answer is that we like LNG, lithium, rare earths, hot rocks, and precious metals. We do not, however, like commercial real estate one bit.

Dan Denning
for The Daily Reckoning Australia

• China Has Stopped Stockpiling Metals
• Bubbles… Busts… Bubbles… Busts…
• Chinese Economy Seems to be Growing
• Chinese Foreign Mining Acquisition Equal to All of 2007
• Buying and Holding a Bad Strategy if Bank Earnings Remain Unpredictable

By the way, what has happened to Stern Hu? He's disappeared from the front pages of Aussie papers. As far as we know, he's still being held in jail without charge. Do you reckon the writ of habeas corpus exists in the Chinese legal system?

Speaking of jails and steel, BHP says Chinese iron ore imports are recovering and spot iron ore prices are up 38% year-to-date because of the resurgence in Chinese demand. China's Ministry of Transport says iron ore imports to major Chinese ports were up 35% in July from a year earlier. That's a lot of steel.

But is it too much?

Is it possible China's steel industry - which is hovering up so much Aussie iron ore - has excess productive capacity? Would demand for iron ore be lower if the Chinese steel industry were more efficient? And what effect would that have on the Aussie ore industry?

We'll answer some of those questions in a moment. But first this from the 21st Century Business Herald, "Mr Xu Lejiang Baosteel chairman also confessed the existing of both structural and periodical overcapacity in China's steel sector. The former refers to the heavy polluting and energy-intensive capacity like construction steel, and must be weeded out. He said that while the latter points to those redundantly advanced capacities that cannot find sufficient demand like ship plate."

"China's steel output has taken up 48% of the world's total in the H1 of this year, further exacerbates the oversupply picture and hurts the healthy industrial development. And Mr Roland Verstappen vice president of ArcelorMittal also said steel overcapacity is quite clear in China and which will press down steel prices, sweep smaller mills out of the market and causes unemployment."

Full employment is a political objective in China, and probably dictates a fair bit of economic policy making. But if Roland Verstappen and Xu Lejiang are correct and China has too much steel capacity, we reckon it's something Aussie ore juniors (and their investors) should keep in mind. Of course for there to be a contraction in Chinese steel production, there'd have to be a policy shift...or the entire Chinese economy would have to contract/implode for a period after the popping of its own credit bubble.

But let us leave aside the bubble fall out in China for another day. Let's get back to Australia. BHP and Rio are larger suppliers to major steel makers. They'd be fine even if Chinese demand fell for a while. But the smaller ore outfits who have made supply deals with smaller mills...they might have a rougher time of it.

By the way, we don't have time to get into it in detail today, but yesterday we said to keep your eye out for tangible assets at good valuations. By that, we were referring to companies with net current assets at or in excess of their market capitalisation. It's more complicated than that. But we'll have to expand on it next week.

Some reader mail?

--Hi,

Peter H.

Good questions. Answers can be sent to dr@dailyreckoning.com.au

--Dear Dan,

Noah (Brisbane)

This morning it was the orange pill. And it was called Ibuprofen. The best way to deal with the garbage in the newspapers is not to read them. But the best defence against misinformation is your own education and knowledge. Keep building your ark.

--Dan,

Rose

The honourable men of Rome were more than vilified after they killed Julius Caeser. They were killed. More from Shakespeare next week!

Dan Denning
for The Daily Reckoning Australia

• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike
• Australian Iron Ore Shares on China’s Menu
• RBA Leaves Rates Unchanged, Rio Wraps Up Negotiations
• Red Bear Rising: Russia’s Resource Based Geopolitical Strategy
• The Iron Ore Pricing War Between China & Australia

"Chinese economy bounces back," says one headline in the International Herald Tribune.

"JPMorgan profit soars despite downturn," says another.

The average reader or TV viewer will go no further. "Ah," he says to himself, "good news; the worst is over. China is a green shoot as big as the Amazon. And JPMorgan is a leader in the financial sector. If the financial sector is doing well, the whole world economy must be doing well."

But here at The Daily Reckoning, we can't help ourselves. If we see a silver lining, we look for the cloud. We see garbage...we look for the rat... We begin with the JPMorgan profit announcement, because it is the most intriguing. Let us set the stage:

In the last half century, credit has expanded faster even than dress sizes. Naturally, this has made the business of hawking credit extremely profitable. Profits in the financial sector soared to 40% of the U.S. total. And every momma wanted her baby to grow up to be an investment banker.

But then, in 2007 & 2008, the bubble in the financial sector popped. Many banks and financial institutions went broke...or had to be bailed out by the government. Instead of being the world's highest-flying industry...finance became the scene of its biggest crash.

And now, from all we've been able to detect, a fundamental shift has occurred. People are no longer eager to go deeper and deeper into debt. Instead, they are eager to pay off debt...that is, to rid themselves of finance...and to get as far away from the financial sector as possible. Savings rates, for example, have gone from zero to 7% in just the last 12 months.

But in the midst of this remarkable and historic change, we get news that at least a couple of the biggest firms in the financial sector - JPMorgan and Goldman Sachs - are making billions in profits:

"Even as it weathers the worst economic downturn in decades, JPMorgan Chase said Thursday that it had made a $2.7 billion second-quarter profit as a result of stellar trading and investment banking results."

This was essentially the same story we got from Goldman. Neither bank made its money the old fashioned way -- by lending to worthy projects; they made their dough by "trading" and "investment banking." In other words, they made billions from speculation.

Anyone who takes this as evidence of a recovering economy should work for the government. Only a government economist or a mental defective (excuse us for being redundant) could believe that genuine prosperity can be built on a foundation of speculating by large financial institutions. You can see why by asking a simple question: whom were they trading against?

Speculating is a zero-sum game. No matter who wins, the economy is not a bit better off; it has not a centime more in resources. Goldman and JPMorgan report earning, together, more than $6 billion. Who was on the other side of that trade?

There is also something fishy about the whole thing. Trading is not only a zero-sum game, it's a game of chance. Traders lose money about as often as they make it. Of course, normally, the traders at the big banks have an advantage; they are not idiots. They make money by taking it away from the amateur traders, who are idiots. But what amateur traders put up $6 billion?

Our guess: the fix is in. They are taking advantage of the feds' stimulus programs...and trading against the biggest patsy in the world, the U.S. taxpayer. How? We'll find out how, later...

Meanwhile, there is the news that China is back in business.

"Government spending pushes GDP growth to 7.9% for 2nd quarter," reports the IHT, "...fueled by a large economic stimulus package and aggressive bank lending...a surprisingly strong showing during the global economic downturn...

"...while most other major economies are contracting and suffering from the worst economic crisis in decades, China appears to have turned a corner...

"Growth in the second quarter was driven by strong auto and property sales, a rebound in manufacturing and huge infrastructure spending, which was propping up global commodity prices."

Further investigation reveals that bank lending and property speculation have gone wild. (More on this in today's essay, below...) And stocks in Shanghai are up 75% so far this year.

Now, let's try to get this straight. The world is in a slump. China sells stuff to the world. And yet, China is booming.

How could it be? Again, there's something fishy about it...as if the government were jiving the figures...as if the speculators had taken leave of their senses...and as if the whole thing were just the result of the same kind of misguided 'stimulus' that got us into trouble in the first place...

The Richebacher Letter's Rob Parenteau agrees that something isn't quite right. "Ask anyone who's done business there. Keeping a double set of books in China isn't just common, it's considered 'good strategy.' You've also got under-regulated Chinese banks hiding as much as $500 billion in bad debts - China's own version of 'subprime' loans to small businesses and Asian property speculators.

"On top of that, you've got a $40 billion tab left over from the Beijing Olympics... and a $140 billion tab for rebuilding Sichuan after their 2008 earthquake."

Boom...boom...ka-booooom!

Regards,

Bill Bonner
for The Daily Reckoning Australia

• Rising in Defense of Goldman Sachs
• Meredith Whitney and the Buy Recommendation on Goldman Sachs
• Is the Real Economy Growing, Expanding, and Making Money?
• Traders Sell Bank Stocks Due to Goldman Sachs Surprise
• Warren Buffett is Buying Four Percent of Goldman Sachs

Hold that thought. Her recommendation preceded Goldman's actual announcement on Tuesday that second quarter net earnings were up 65% to $3.44 billion. The company, like Wall Street's very own chosen-one-boy-wizard, has once again waved its magic wand and produced something remarkable. So let's remark on it...

The composition of its net revenues was a revelation. And as we reported in today's edition of Money Morning (where we are guest editing for Kris Sayce and also covering the Rio Tinto/China saga), Goldman's second quarter performance belongs to a bygone era of swashbuckling financial capitalism when interest rates were low and huge money flows made trading price movements in asset classes a full-time job.

Why do we say that? Goldman reported $13.76 billion in net revenues for the quarter. But 78% of those came from its "Trading and Principal Investments" group. That was a 93% improvement over the second quarter of 2008 and a 51% improvement over the first quarter of this year.

And yet again, the "black box" unit of "Fixed Income, Currencies, and Commodities" was the chief bread winner within the Trading group. It delivered $6.8 billion in net revenues, or 63% of the Trading group's revenues and 50% of total net revenues for the entire firm.

Investment banking-what Goldman used to do-actually experienced a 15% decline in year-over-year quarterly revenues. And the "Asset Management" business also saw a 28% decline in quarterly revenues compared to the same time last year.

We relay these things not to bury Goldman. Nor to praise it. But just to put it in perspective and ask whether the performance of this company-once you understand it from the inside out-is the sort of thing that should give you confidence about stocks now. Or, to the contrary, whether Goldman's performance is aberrant.

What did Meredith Whitney say about the matter? "Our more bullish outlook on Goldman Sachs shares," Whitney wrote, "is deeply rooted in our sustained bearish stance on the U.S. economy and the state of U.S. financials at large. Specifically, we expect a tsunami of debt issuance from federal/sovereign, state and local governments to fund woefully underfunded budget gaps."

"In addition, we expect corporate debt issuance to be at least 60% as strong as peak cycle levels, reflecting sizable debt maturity rolls. What's more, given fewer players in the market, not only is GS benefiting from market share gains on these products, but more widely in the derivatives products."

Whitney is bullish on Goldman because Goldman is good at trading its own book. But what's good for Goldman is probably not the same as what's good for everyone else. Real national wealth is not built on financial transactions. It's built on increases in productive that lead to rising wages and a growing capital stock. You might measure it on capital per worker. But however you measured it, it wouldn't have much to do with how good fixed income trading profits were.

By the way, did you see this the other day from the Financial Times: "Executives at Goldman Sachs sold almost $700m worth of stock following the collapse of Lehman Brothers last September, according to filings with the Securities and Exchange Commission." That sounds like a good trade.

One more note on the 4th branch of the American government. Bloomberg reports that Goldman may, "Lose its investment in a proprietary trading code and millions of dollars from increased competition if software allegedly stolen by a former employee gets into the wrong hands." Uh oh.

Last week in Manhattan, Assistant U.S. Attorney Joseph Facciponti revealed that ex-Goldman Sachs computer programmer Sergey Aleynikov has been charged with stealing Goldman's proprietary trading software. Aleynikov was arrested after he arrived at the airport in Newark, New Jersey.

The wrong hands?

Facciponti told the judge in the hearing that, "The bank has raised the possibility that there is a danger that somebody who knew how to use this program could use it to manipulate markets in unfair ways...The copy in Germany is still out there, and we at this time do not know who else has access to it."

Is there a fair (legal) way to manipulate the market? If the software can be used to manipulate the market...and Goldman knew how to use the software...has the prosecutor unintentionally revealed some of Goldman's magic secrets? Or is he suggesting that other traders using the software can beat Goldman at its own game now that they know what rules the bank uses? We'll let you decide...

Dan Denning
for The Daily Reckoning Australia

• Warren Buffett is Buying Four Percent of Goldman Sachs
• Rising in Defense of Goldman Sachs
• Citi Reports $4.69 Billion in Fixed Income Trading
• Traders Sell Bank Stocks Due to Goldman Sachs Surprise
• JPMorgan and Goldman Sachs Making Billions in Profits

Both the S&P 500 and the Dow Jones Industrials closed up about 2.5% overnight. Analysts upgraded estimates for Goldman's earnings. That sparked a buying frenzy in bank and financial stocks, which took markets higher. Presto, change-o, everything is bull again.

Or is it? We'd suggest that whatever Goldman did to goose earnings is probably not going to be possible for the rest of corporate America. However, that doesn't mean the pair trade doesn't have legs. In fact, have a look at the chart below and you might be convinced it's time to buy the S&P!

Click to enlarge

Thanks to massive stimulus from China beginning in November, there's been an explosion in consumer and business lending. That's translated, we'd suggest, into asset inflation. Exhibit "A" is the nearly 75% year-to-date climb in Shanghai's benchmark CSI 300 index. It has, as you can see, trounced the return in U.S. stocks.

Now there's more than one way to interpret this chart (this is what makes charts so intriguing but frustrating.) Is this the market's verdict on U.S. growth prospects and Obama's trillion dollar deficit plans? Is it vindication that China's stimulus has been a lot more successful and promoting real economic growth than the $787 billion pile of junk passed by the U.S. Congress?

Or how about a third theory? Is it evidence that China is in the accelerating phase of its own massive credit bubble? And could the collapse of this credit bubble lead to a Chinese Day of Reckoning?

If that's the case, then it would be time to sell commodities and buy Goldman, or at least time to sell commodities. A collapsing Chinese credit bubble would remove a lot of the demand and price support for Australian commodities (especially coking coal and iron ore). We covered the story while filling in for Kris Sayce at Money Morning today. You can read the whole story over www.moneymorning.com.au.

While we're on the subject of stimuli, a New York Times story from yesterday suggest that government capital injections and loan guarantees, along with new equity offerings, have allowed banks to evade the inevitable consequences of the popped credit bubble. But the evasion is like hiding under the bed from the bogeyman. He's still going to get you. Sucking your thumb and pretending otherwise won't help.

"The capital provided by the government through TARP, etc. has allowed the banks to continue holding deteriorated assets at values far in excess of their true market value," says Daniel Alpert of Westwood Capital in a note to clients, according to the Times. "It is unrealistic to believe that home or commercial real estate values are destined to recover any meaningful portion of bubble-era pricing."

This means all the new equity raised by banks after the stress-tests has merely papered over capital adequacy and solvency issues for now. The banks have simply refused to revalue loans on their books and continue to carry them at unrealistically high valuations. If they sold them, they'd got a lot less for them, forcing them to raise more capital (or wiping out their capital and revealing them to be insolvent). Yet many banks are under the absurd illusion that if they hold certain assets to maturity, they won't suffer any losses.

This is the same as saying million of Americans are going to make their mortgage payments as they lose their jobs and find themselves underwater and unable to refinance. The default and foreclosure data coming out of the U.S. housing market suggest the banks are kidding themselves, or misleading shareholders, or both!

It's the sort of calculated mis-truth that can cause a short-term crisis to last years and years. The correction is postponed through phoney accounting. It leads to a Ushinwareta Junene, or a lost decade, as the Japanese say. We prefer the Zombie metaphor-an economy full of living dead loans that threaten to infect the real live survivors.

In a ten (or even 17 year period like that) you get low growth, high unemployment, and stock market benchmarks that do not keep up with inflation. Stocks as an asset class perform poorly. Bonds, on the other hand, might go through rallies and corrections and be more tradeable (or rally on deflation concerns, as Marc Faber pointed out late last week).

But whatever happens in ten years from now, it's pretty clear that the "doing something is better than doing nothing" mantra of Keynesian intervention is a big fat deficit-adding failure. Unemployment is rising. The economy is not fundamentally better off. And bank balance sheets retain a whiff of unreality. More spending cannot be the answer when too much credit was the problem.

-Phillip J. Anderson is one of our panellists at the upcoming "Australia in the Red" summit in Melbourne on Friday, July 21st at the State Library of Victoria. In his book "The Secret Life of Real Estate," he explains a 17-year cycle in property prices related to land values.

Fortunately for Aussies, the cycle heads mostly up. Not so fortunately, there are periods in the cycle where it corrects and falls in real terms. If you buy near the top and prior to a four-year period of decline, it can be bad for your financial plans.

We're not sure why, but this idea that cycles run in 17 or 18 year periods keeps cropping up. Last week on CNBC, Art Cashin made exactly the same point. He pointed out that from 1966 to 1982, the Dow Jones traded in a range.

If you began investing in 1966, you didn't make much money for the better part of two decades. On the other hand, the 1982 to 2000 cycle witnessed one of the greatest bull markets of all time in stocks. Get your timing right and get in the right asset class and cycles do your work for you. Or so it would seem.

Our sense is that right you have a lot of competing cycles. You have a historic low in interest rates across the globe. That led to a period when the cost of capital was incredibly cheap. This kick started an industrialised production boom in the developing world which has a momentum of its own. But is it sustainable?

You also have demographic and psychological and simple life cycles. As affluent Western investors get older, they seek to cash in on accumulated gains and enter into a golden retirement. Where will the money to move markets higher come from? An increase in mandatory superannuation contributions?

We'll leave you today with a nearly incomprehensible chart that shows an even more intriguing longer-term cycle. The char appears to show that global energy production per capita has peaked and is headed for permanent decline...in other words...industrial civilisation has a lifespan of around 100 years...and we have reached that life span.

That would seem like bad news. Of course, perhaps post industrial civilisation will be a more pleasant place, albeit with fewer calories and no climate control. In all seriousness, though, if there is any truth to the idea that energy production per capita has peaked, it means China has picked a very bad time to have an energy-intensive industrial revolution. And to the extent Australia is now dependent on China for its prosperity, well the consequences are self-evident.

If the Credit Depression coincides with the Energy Depression, then you'd want to consider a very different financial survival strategy. More on that tomorrow.

Dan Denning
for The Daily Reckoning Australia

• Traders Sell Bank Stocks Due to Goldman Sachs Surprise
• Business Cycle Theory Explained by Joseph Schumpeter
• Meredith Whitney and the Buy Recommendation on Goldman Sachs
• The ASX Bubble, Fueled by China
• JPMorgan and Goldman Sachs Making Billions in Profits