But then came the huge deleveraging of risk assets beginning in July of 2008. There's an old saying that when established currencies that are widely traded and very liquid, get grounded, the emerging market currencies (like the BRICs) get sent to the woodshed. And so, we had the BRIC currencies lose major ground to the dollar during this period of time.

However, in March of this year, the non-dollar currencies began to rebound versus the dollar once more. This rebound in the established currencies like, euro, francs, yen, and Aussie dollars, has led to an even stronger rebound in the emerging market currencies, including the BRICs.

So... I thought it best to take a step back, and look at the fundamentals of each of the BRIC countries, and see if the stage if set for yet another strong run on the dollar.

Before we start though, I wanted to tell you the two reasons I originally put these countries together to form EverBank's BRIC MarketSafe CD.

In the spring of 2009, China was making noise about the need for a new reserve currency to replace the dollar. The other BRIC nations joined in and at the next G-7 meeting, all four nations stood up and wanted to be counted as countries that want a new reserve currency, for they had see enough deficit spending in the US to convince them the dollar had no other avenue to follow but down.

The "markets" sort of shrugged off the BRIC nations call for a new reserve currency to replace the dollar. But I looked at it differently. I saw nations that had HUGE Treasure chests of dollar reserves, and nations that currently have a very large portion of the globe's population. I believed then as I do now, that these countries would need to be reckoned with, and eventually their cries for a new reserve currency to replace the dollar would be heard, loud and clear.

Since we announced the creation of the BRIC MarketSafe CD, where an owner of the CD receives the positive gains in the currencies over 3 years, but does not experience any currency risk, as the CD has 100% principal protection, the BRIC nations are receiving more notice!

At the last G-20 meeting, of which the BRIC nations are a part of, it was announced that the watchdog duties for the global economies were being taken over by G-20 (from G-8). And a week later, the G-7 Finance Ministers suggested that G-20 take over the currency watchdog duties!

Now G-20 has both global economies and currencies under their watch and care, and the BRIC nations are right there to offer their suggestions...

So... Now that we've gone through the background, let's take a look at the current fundamentals of these four nations, to see if the prospect of further potential currency appreciation is warranted.

First up... Brazil!

Brazil was the first Latin American country and first in the Americas to see its economy grind out of its recession. Brazilian GDP for 2009 overall will probably be just a nick over flat, while the forecasts for 2010 GDP show that economic growth will expand by 3.8%, as firmer domestic demand leads the economy.

For instance, Brazil's recent Industrial Production output grew 1.2% in August, which was the eighth consecutive month of growth.

Brazil currently enjoys a Trade Surplus of 1.5% of GDP, with forecasts for the Surplus to also grow to 3.1% of GDP by 2011.

Overall, Brazil's Current Account Balance is a narrowing 1.1% of GDP Deficit... as the economy gets back on track; the Current Account Deficit is expected to grow to 1.5% of GDP.

These are "manageable" deficit figures, and ones that would be welcomed in many countries of the world.

Inflation as always been a problem in Brazil, but assuming no economic shocks, and a strong currency (the real), it is expected that inflation could fall to 4.1% by year-end 2009, and remain stable throughout 2010- 2011.

Brazil is one of the world's largest democracies and emerging markets, which leads one to believe that their influence on the international stage will only continue to grow. Recently, China has moved past the US as Brazil's top trading partner. It is believed that Brazil and China will sign a currency swap agreement that would remove the dollar in trade settlements. I'll talk more about this in the "China segment".

The prospects for the real are good. However, one must always remember, that even with strong economic fundamentals, any mass sell off of risk assets, would be magnified for an emerging currency like the real.

Next, we have Russia...

When we announced the BRIC MarketSafe CD, I received a lot of responses to the announcement with wishes that we had not included Russia in the CD. Well, it wouldn't be a BRIC without Russia!

I told people that in essence, the only way I would buy Russian rubles is in a MarketSafe CD, and that the only way to look at Russia was as an "oil play"...

Who among us believes that oil prices will continue to remain in the $70 a barrel range?

OK... now that we've played that game... Let's get to the data!

Russia went against the flow in September, by cutting their base interest rate, when it was believed that a good number of countries around the world were preparing to begin rate hike cycles.

Russia's economy is still mired in a deep recession, as witnessed by the 10.5% fall in GDP from a year earlier, and industrial activity contracted by 12.6% in August!

Russia's economy had seen two consecutive months of growth before this step backwards in August, and thus the rate cut in September. There are only mixed signs that the recession in Russia has bottomed out. But that means the Russian ruble is much cheaper than a year ago, and will probably remain weak as long as 1. The price of oil remains in the $70 range, and 2. The Russian economy remains mired in a deep recession.

Growth for 2010 is forecast to be 3.5%, which would mean that Russia's recession will have ended late in 2009. An end of the recession and economic growth are very dependent on the persisting problems of the bad assets on the books of Russian Banks.

So... the rebound in the ruble may take some time to come to fruition. The good thing about that is that the ruble will remain cheap for new buyers.

Next... India...

India has maintained strong economic growth through the global financial meltdown, and will post a very impressive growth of 5.5% this year. This does represent a sharp deceleration from the 10% growth rates during the go-go years before the global financial meltdown. So, while 5.5% growth is lower than previous growth rates, it remains one of the best rates of economic growth in Asia!

Economic growth in India is forecast to grow 6.3% in 2010 as private consumption, investment and trade growth all show renewed strength.

Inflation in India, at present is not a problem coming in at 1.3% in 2009. However, as domestic growth takes hold, inflation is expected to rise to 5.1% in 2010.

The Indian Central Bank will continue to fight inflation, probably raising rates as we go along in 2010. The higher interest rates will go a long way toward additional currency strength.

India does not have a problematic current account deficit, like many emerging market countries. With rising exports at a 9.6% rate, the current account deficit will be the equivalent of 0.5% of GDP... Future growth in India will present itself as a problem as far as the Current Account Deficit is concerned. But it will remain manageable, and again, not the stuff that some countries experience.

The prospects for the rupee remain strong going forward.

And, last on the roster, but number one in the hearts of the fans....

China...

This is the proverbial 200 lb gorilla in the room! China has long been on my mind as the most undervalued currency on the planet, and as long as the Chinese government has their hands on the purse strings of the renminbi, it will remain that way.

However, there are signs that the Chinese government is looking to widen the use of the renminbi, which would eventually lead to more of a free float or at least a wider band of currency movement allowed.

The IMF recently wrote that the renminbi remains the most undervalued currency at probably a level of 40% undervalued versus the dollar. As long as the renminbi's daily movement is controlled so strictly by the Chinese government the renminbi will not be allowed to cut into that 40% figure by very much. However, with the signs of a wider use of the currency, it is thought that the renminbi could be allowed to float more in the future.

What is this "wider use" I'm talking about? Well... you see, the renminbi is not a transactional currency, it is not liquid, and is traded on what's called a "non-deliverable forward". Which simply means it cannot be converted to physical form, or deliverable form.

It is my belief that China is taking baby steps to one day, have their currency take over the title of reserve currency of the world replacing the dollar. And to do this, the Chinese must begin to obtain a wider use of their currency.

They began this process by signing currency swap agreements with most of the Asian countries, and then moved on to Argentina. As I said earlier, it is believed that China will soon sign another of these currency swap agreements with Brazil.

The currency swap agreement between two countries eliminates the dollar from any transaction between the two countries, and only uses the currencies of the two respective countries. This is the "first step" toward gaining a wider use.

The "second step" came in September when China issued renminbi denominated bonds in Hong Kong. These were the first renminbi denominated bonds issued by China.

A wider use, in my mind, is equal to a stronger renminbi versus the dollar going forward.

Now for some data!

China's GDP is expected to grow 8% in 2009, and 8.6% in 2010. China's economic recovery this year has been fueled by government stimulus. But Hey! China has a treasure chest of reserves and surpluses... So, if any country was going to spend some money to boost their economy, China would be the one, for they have the money to do so!

And... with China being a Communist country, they were able to dictate where and to whom the money was being directed to, and how it was to be spent. This has gone a long way toward seeing the results of China's stimulus.

Inflation remains a problem in China, and the sooner the Chinese realize that a strong currency can go a long way toward fighting inflation, the better!

So... For now, the renminbi remains pegged to a basket of currencies, and controlled by the Chinese Government, through the Chinese central bank. However, there are signs that this arrangement for the currency is changing, and a wider use of the renminbi is the objective... If that's the case, then the prospects for a potentially stronger renminbi versus the dollar are very good.

And that's how I see the BRIC currencies/ countries...

Regards,

Chuck Butler
for The Daily Reckoning Australia

• BRIC – Brazil, Russia, India and China Suffer High Rates of Inflation
• The Greenback Dollar Decline
• Brazil is a Good Place to Become Rich
• US Dollar Declining as China’s Currency Rises
• Emerging Markets in the New World Disorder

One of the most interesting news items I've found was on the cover of The Financial Times, where I learned that a guy named Lahde "made tens of millions of dollars from betting against the financial and property sectors during [the] past two years", and he now wanted to thank "the low hanging fruit, i.e. idiots whose parents paid for prep school, Yale, and then the Harvard MBA" who made it all possible for him to find enough suckers.

He noted that "These people who were often truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government. All of this behavior supporting the aristocracy," he says, "only ended up making it easier for me to find people stupid enough to take the other side of my trades. God bless America."

This goes along with an article in the St. Petersburg Times about Tom James, chairman and chief executive of Raymond, James Financial, who had "some tough words for the wizards of Washington, DC who oversaw the $700-billion bailout package".

He reports, "The Brave And Wonderful Mogambo (BAWM) was right all along! Those government weenies are the biggest freaking morons you ever saw, and we as a country should be ashamed of ourselves for having elected such corrupt, half-witted, utter failures and congenital idiots!"

As you have probably guessed by now, he did not say those exact words, but he implied every syllable when he said, "Legislators were almost embarrassingly ignorant of how the financial system works", which I figure explains how they don't understand the linkage between their own Bad, Bad Performance (BBP) as legislators and the subsequent Bad, Bad Performance (BBP) of the economy, and he says that only 3 of 16 legislators that he talked to actually understood what was going on in the "credit crisis." Less than 20%! Hahaha! We're doomed!

Well, maybe these Congressional losers will understand the unfolding economic slowdown, as evidenced by the Baltic Dry Index, which is an index of the cost to transport stuff by cargo ship, and which has fallen precipitously, which seems very important to me, and to Junior Mogambo Ranger (JMR) Riccardo, too, who is also alarmed by this like - as I previously said - me.

It's actually beyond scary, in a terrifying kind of "ain't nobody buying nothing in a consumer economy" kind of way, which means that without the consumer buying stuff as his or her contribution to the famous statistic of "the consumer is 70% of the economy", we are, in case you ain't heard, freaking doomed!

Well, maybe not all buying is drying up, as silver market analyst, Ted Butler, reports that in the last 10 months, "some 150 million ounces of silver can easily be documented to have been bought by investors. Undocumented purchases would add tens of millions more ounces."

In fact, when you add it all up, "Investment demand for silver this year is running at a full 25% of world mine production and over 20% of total production (including recycling). This is a remarkable historical turnabout."

Thus, it is easy to see why Mr. Butler is "bullish beyond belief for silver", since this kind of demand means that "In silver, the documented 150 million ounces bought in the first ten months of this year is equal to 15% of all the silver bullion equivalent thought to exist!" Wow!

More than one-seventh of all the silver bullion "thought to exist" in the whole world was suddenly bought up in less than a year, and yet the price of silver has been pounded down to less than 10 bucks an ounce? No wonder I am so bullish on silver!

He also notes that the gold/silver ratio is at more than 80, which is "one of the biggest differences in history."

And not only that, but since there are 4 to 5 billion ounces of gold in the world versus only 1 billion ounces of silver, that means that "the total dollar value of all the gold in the world is worth 300 to 400 times more than all the silver in the world (80 times 4 or 5)".

Talk about undervalued! Hey! This investing stuff is easy! Whee!

Until next time,

The Mogambo Guru
for The Daily Reckoning Australia

• Silver and its Large Short Position
• Gold and Silver!
• Gold and Silver Demand Unprecedented
• Price of Silver Climbing to All Time High of US $1,012
• Silver Stats That Will Make You Salivate

What was America's Golden Age?

It is much too soon to write the history of America's decline and fall. Still, that doesn't stop us from guessing.

We would name the period between the fall of the Berlin Wall and the fall of Lehman Bros - a period of only 19 years - as the peak of US power and wealth. Of course, Americans were dreaming during those years. The dreams were the usual imperial sort - that the US Empire was such a benefit to the rest of the world that the foreigners would support it indefinitely. Rome didn't take any chances; it forced its conquered nations to render tribute...slaves...gold...and wheat. The American empire depended on trade...and the dollar. As long as the United States had a commercial advantage, the empire was profitable. But as the 20th century aged, so did the US economy. Its competitors - notably Germany and Japan - had a big advantage. They had been bombed out in the '40s. They could build anew. America's trade advantage slipped away...and then its trade balance went negative in the mid- '80s. It has been getting more negative almost every year.

The trade losses shrank after the fall of the House of Lehman. Americans cut back. But today we get news that the trade deficit has just grown more than in any month in the last 10 years. Have Americans suddenly become big spenders again? Probably not. But we'll have to wait for another explanation; we don't have one.

No account of America's glory years - roughly the period between the reign of George Bush I and that of his son, George Bush II - would be complete without mention of the events that happened on this day eight years ago. A small group of terrorists pulled off an amazing coup - bringing down two of America's iconic buildings, right in the heart of New York City...and on primetime TV! Historians might be tempted to use this event as a milestone, marking the end of the period of maximum happiness in the United States of America. We caution against it. It was only later that it became apparent that the US reaction to the terrorist incident was suicidal. The nation desperately needed to bring its ambitions back in line with its means. It needed to save and invest in new factories and new infrastructure. Instead, it wasted trillions fighting phantoms and nobodies. But as far as anyone knew, US influence, prestige and power remained near its zenith throughout the wars on terror and Iraq.

The fall of Lehman changed things. Then it was obvious that not only was America vulnerable, she was an enemy to herself. She had diddle- daddled during the glory years, dawdling with the lion cubs that would grow up and maul her. Now, in the period we are living through, she attempts to go back to sleep and rerun her balmy dreams. That is what "recovery" is all about - a return to the land of nod and nonsense...in which people think they can actually become wealthier by squandering money they don't have on things they don't need.

Fortunately, as near as we can tell, most private citizens are now awake. A report at the beginning of this week showed that they repaid debt at a rate four times faster than economists projected. Savings rates are rising. Spending is falling. People are doing what they should do - they're cutting back.

But the feds continue their efforts to sabotage the correction and destroy the empire. They have already blown-up the budget - with $9 trillion in deficits expected over the next 10 years. Now, they're working on the dollar.

Yesterday, the dollar fell to $1.45 per euro. Gold remained just below the $1,000 an ounce mark. And the Dow rose 80 points.

Stock market investors seem to be looking forward to another big bull market. But with the economy deteriorating, they are probably just dreaming, too. Median household income fell 3.6% over the last 12 months. Of course, that's just what you'd expect in a correction. But it's not what the feds were hoping for. So, they're pulling out all the stops to try to turn it around. Most important, they're pulling out the stop that keeps the dollar from rolling down the hill.

But the dollar will eventually come tumbling down...and those who are holding gold are going to be sitting pretty. Gold is, after all, the ultimate store of wealth.

The empire sinks into the mud. Yes, this is the downhill period...the slide into corruption...the period in which Juvenal complained that Romans were only interested in 'bread and circuses.'

When you are on the board of a decent corporation, for example, if you have a direct financial interest in a matter under consideration you're expected to 'declare an interest' and absent yourself from the vote. But in a mature democracy, the most self-interested citizens are those most likely to vote. Currently, about 20 million people work for government. About 45 million receive Social Security benefits. About 34 million depend on food stamps.

(People who count on the government to feed them, warned Jefferson, "will soon want bread." That doesn't seem to worry many people. But at least the state of Maryland has an Orwellian sense of humor about it. People who depend on government for food are given "Independence" cards.)

That's 99 million people who have a direct interest in expanding government outlays...with some overlap, of course. And it doesn't mean that every person receiving a Social Security check is going to back the feds. But it doesn't count all the millions more who get subsidies, bailouts, welfare payments (often masquerading as tax credits), government contracts, and so forth, either.

Well, how many people does it take to win a national election? Obama won with 63 million votes.

The dollar's weakness hasn't been missed by it biggest foreign holder - China.

Reported earlier this week in the Telegraph:

"'We hope there will be a change in monetary policy as soon as they have positive growth again,' said Cheng Siwei...talking about America.

"'If they keep printing money to buy bonds it will lead to inflation, and after a year or two the dollar will fall hard. Most of our foreign reserves are in US bonds and this is very difficult to change, so we will diversify incremental reserves into euros, yen, and other currencies,' he said.

"China's reserves are more than - $2 trillion, the world's largest.

"Mr. Siwei continued: 'Gold is definitely an alternative, but when we buy, the price goes up. We have to do it carefully so as not to stimulate the markets,' he added."

Then, two days ago, in came a report that China is going to issue bonds of its own - in yuan.

This news is a shot across the bow of America's imperial currency. It signals that China is moving into position to eventually challenge the greenback. Investors will have another alternative to the dollar...another bond issued by another government and backed by another economy...maybe one that is on the way up, rather than on the way down.

Meanwhile, Americans grow poorer. Bloomberg reports:

"'The decline in incomes we're seeing certainly has implications for consumer spending, particularly post-housing bubble when families can't tap into home equity through loans,' said Heather Boushey, a senior economist at the Center for American Progress, a research organization headed by John Podesta, a leader of the Obama administration transition team.

"The poverty rate is likely to keep rising through 2012, even after the recession ends, adding to pressure on the Obama administration to enact a second economic stimulus package, said Isabel Sawhill, a senior fellow at the Brookings Institution in Washington, a policy research group.

"'We will likely have not only a jobless recovery but also a poverty- ridden recovery,' Sawhill said. 'The stimulus money is going to go away long before the poverty rate peaks.'"

How can a consumer economy grow when its consumers are becoming poorer? We take up that question below...

Bill Bonner
for The Daily Reckoning Australia

• America’s Decline as a Great Empire
• Economy Has to Grow at 1% to Stay Even With Population Growth
• The Rise in the Dollar Doesn’t Have Everyone Convinced
• Difference Between the Dollar and the Yen
• A Recovery of Some Kind in Global Trade

The anniversary is the collapse of Lehman Brothers on September 15th 2008. It was like a financial "big bang," the end of one financial universe as we know it. But could there be more meteor strikes on the way for Planet Leveraged Earth? More on that issue below.

Slipping quietly under the radar in the build up to the Lehman anniversary is the fact that the All Ordinaries closed Friday at an 11-month high. Even a mediocre Friday session in New York will have to work to depress local shares. But it could happen.

In fact, our resident technical analyst and chartist Gabriel Andre told us last week that the S&P ASX 200 index had cleared (on the upside) the technically important 4,550 level. But he called this a "false breakout." The reason? None of his technical indicators have confirmed that there is any more momentum to the upside.

Of course, that doesn't mean the rally won't coast higher. We read from some analysts that there are still a lot of investors who are "underinvested" in stocks. But that hardly seems to be the problem at all. It's more like people are overinvested in an earnings growth story that's been fabricated from a mix of optimism and sleight of hand.

It will be a good test of Gabriel's new trading methodology. You may have seen last week that he's finally gone live with his "black box" method for finding trading patterns on ASX stocks. It's not a "black box" system, actually. Gabriel is simply testing the idea that you can capture price swings in blue chip prices using a combination of technical analysis and charting.

We will see if he's correct. It's an interesting proposition because it ignores things like the positive industrial output data from China that cheered Aussie investors last week. In fact, we reckon most technicians would be happy to chuck everything but a chart out the window when deciding to buy or sell. You don't eve n need a ticker symbol.

You just need a chart and some tools to analyse it in order to find the trading opportunity (long or short). We'll keep you posted on how it goes. We reckon there are a lot more opportunities on the short side than the long side. But they are opportunities none the less.

"Some day this war is gonna end," said Lt. Kilgore on the beach in Apocalypse Now. He was almost wistful about it, in the same way you read a lot of investment professionals talk about the collapse of Lehman Brothers last year. They're discussing it as it if were ancient history.

Not Joseph Stiglitz. The economist told Bloomberg that, "In the U.S. and many other countries, the too-big-to-fail banks have become even bigger...The problems are worse than they were in 2007 before the crisis." That does not sound promising. It sounds ominous, especially for banks and other financial stocks.

There certainly were a lot of casualties that resulted from Lehman's loss. Here in Australia the roll call of fallen firms includes Allco, Centro, Tricom, and ABC Learning. Some were killed in battle. Others were wounded and taken from the field. But is the war really over?

The press coverage would suggest that the war on the financial crisis-fought with unwieldy weapons like interest rates and fiscal policy by besuited warriors like Ben Bernanke and Wayne Swann - is not over, but not critical any longer either. It's as if the Germans have been pushed back east across the Rhine. Berlin hasn't been taken. But the beaches have been stormed and the Hun beaten back.

Yet if you examine the lessons of Lehman, you wonder if we have really learned anything. The collapse in global trade and output was the worse since World War Two, following the fall of Lehman. You can see it in quite shocking fashion from the chart below, courtesy of High Frequency Economics. But what does the chart actually mean?

The chart shows the first real and large fall in global trade since the 1970s. But we think it also shows that global output and trade have grown with the globalisation of fiat money. The entire global economy expanded at a furious pace because of the amount of credit and leverage in the global system.

When you take away this leverage - a process that began like hitting the proverbial brick wall with the Lehman collapse - you find that a lot of economic activity disappears once credit vanishes. The huge slump in output persists. But what's crazy is that stock prices began to recover once the free fall in output seemed to end in March.

Stocks seem to be repricing a return to growth rates, pre credit crisis. But as we've argued here before, most of the first and second quarter earnings outperformance for publicly listed stocks was driven by cost cutting and inventory destocking, not any fundamental improvement in business conditions.

Another lesson from Lehman was that asset prices (across all asset classes) were much more heavily supported by leverage than anyone suspected. This was true for commercial and residential real estate. It was true for stocks. It was true for commodities. And it was true for bonds.

In fact, we'd argue that it's only government-backed leverage that is supporting the U.S. bond market. You could even argue the rally in stocks was made possible by Fed-created liquidity, which banks and brokerages took advantage of to engineer a massive stock market rally which is now ending.

It's a mistake to think that letting Lehman collapse was only a mistake because Lehman proved to be so interconnected to the rest of the financial system. It wasn't just that Lehman was one of a handful of firms "too big to fail." This is the most under-appreciated point about the last two years.

The most important lesson from Lehman's collapse is that when you combine massive leverage with securitisation and derivitisation, you get a financial world that is inherently less stable. Statistically speaking, it's far more prone to volatility and collapse. The interconnectivity of the global economy showed how quickly instability could be transmitted across borders.

If you're a student of networks, this may seem counter intuitive. You might think that increasing the number of nodes in a network decreases instability. The more nodes and interconnections there are, the easier you'd think it would be for problem nodes (Lehman) to be bypassed or isolated before they can destabilise the whole system.

Yet it seems like the more complex the global financial system has become, the less stable it has become. hy is that? Maybe it's because there are several important connections we're talking about. For example, the fact that information and prices are communicated swiftly around the globe does not make the world economy less stable.

It may make trading more volatile as people try to figure out what news really matters. But the interconnectivity of the world has just upped the pace of business. It's forced everyone to have faster OODA loops (observe, orient, decide, act). So if sheer connectivity isn't to blame for instability, what is?

One likely culprit is complexity. We simply don't know how things are inter-related in the global economy. And by "things" we mean cross ownership of assets and obligations. What's made the system so unstable is that the asset side of the global balance sheet has become opaque. It's become derivative. It's become relative.

In the meantime, the liability side of the balance sheet grew and grew, setting up an inevitable "complexity catastrophe," to use Eric Beinhocker's term. As far as we can see, the complexity catastrophe is still unfolding as the value of bank collateral continues to deteriorate. Government's are trying to arrest the rate of decline to prevent massive unemployment, and meeting with some success.

But one year after Lehman, we feel confident in saying that someday this war is gonna end. But it's not today. And it won't be today for quite some time.

Dan Denning
for The Daily Reckoning Australia

• Technical Analysts see the Market 80% Psychological and 20% Logical
• Lehman Brothers on the Verge of Liquidation
• Lehman Brothers (NYSE: LEH) Is Not Dead Yet
• Prices of Gold in the Top 10 World Currencies
• Financial World Has Every Reason to Encourage Government Stimulus

But first, we were poring over the reader e-mail last night. Many readers think we are being unfair, unconstructive, and un-brief in our critiques of Ben Bernanke, bankers, Kevin Rudd, and other economic know-nothing from across the political spectrum. So let us take a moment to be as clear as possible: policy makers and politicians are morons.

We're told Ben Bernanke is the right man to get us out of the trouble we're in. But isn't Ben Bernanke the man who got us into the trouble to begin with? Didn't he and Alan Greenspan lower interest rates so much they created a worldwide credit boom that is now deflating? Wasn't it their policies that enabled banks and Wall Street to securitise commercial and residential mortgages and send them far and wide into the balance sheets of the world as "assets"? And aren't those "assets" now falling in value, continuing to wipe out equity at the household and corporate level?

It is clear that politicians are still slovenly serving the interests of their corporate masters in the financial world. And it is clear that the financial world has every reason to encourage government stimulus, loan guarantees, and lower interest rates. This keeps the great leveraged credit machine of the Financial Economy motoring. And that machine keeps the financial industry in tall cotton.

Besides, the limits on executive compensation are window-dressing for public (voter) consumption. With bonuses limited by statute, we reckon more compensation for the financial industry will move back to stock option grants. That means for the financial industry to preserve its privileged status, stock prices have to move higher. And nothing enables that like credit. Borrow money and plough it back into stocks to line your pocket. Does that sound like something that may be happening?

Our point is that this whole interlude since the collapse of Lehman Brothers is an attempt to preserve the status quo ante. If the tools of monetary and fiscal policy (which are clumsy and theoretically flawed anyway) exist to make the financial and estate industry thrive, the real economy will continue to get screwed. We'd argue this recent recovery is nothing but an attempt to resuscitate the money-shuffling arrangement that was so profitable up until late 2007.

At least some people agree. "A UN think tank on trade has warned that the current financial market rebound is not a 'real recovery' and that any world economic growth recorded in 2010 was unlikely to exceed 1.6 per cent," reports today's Australian.

"The depth of the recession has been so important that of course there will be a rebound ... but we still do not see that this is a real recovery," says Supachai Panitchpakdi, secretary-general of the United Nations Conference on Trade and Development (UNCTAD). "The actual increase in the commodities prices is mainly driven by appetite for more risk," he says. More on this in just a second.

UNCTAD's Chief economist Heiner Flassbeck, said, "the markets had been fuelled by financial speculation that in turn was driven by expectations of recovery. 'But anticipation of recovery is just a fiction, it is not there.'"The UNCTAD report also noted that, "Tumbling profits in the real economy, previous over-investment in real estate and rising unemployment will continue to constrain private consumption and investment for the foreseeable future."

Hmm. Maybe UNCTAD is reading the Daily Reckoning. But if not, for those who have eyes to see it, the truth is plainly in sight. You cannot correct the global imbalances of a leveraged boom with more leverage. But let's tackle on specific aspect of the report that suggests commodity prices may again be the subject of financial speculation. Is it true?

Frankly it's hard to say. We're more confident that profits in the real economy - once you take away the effect of credit and government money - are regressing to an historic mean. Some companies will make more. Some less. But the average will be lower.

However we did see one interesting chart yesterday from our trader Gabriel Andre. We were discussing with him whether the euphoria about Australia - the dollar, the stock market, real estate, and commodities - was suspiciously reminiscent of June 2007. You know, right before the ore hit the fan. Is all this feel-good news a sign of worry?

We decided to tackle the question with a picture. It's the chart you see below. The chart tracks the performance of Worley Parsons - a proxy for infrastructure and capital spending in the mining industry - versus the CRB commodity index. We are asking a question with this chart. The question is, does a peak in Worley's stock presage a downturn in the resource sector generally?

Click to enlarge

Gabriel writes that, "The level of $30 looks as a strong resistance for the stock. It's a previous low where it bounced back several times in 2007 and 2008. The recent action suggests the $30 may be a new high, finding resistance, especially because the correlation is obvious with the CRB and the CRB has already started correcting.

"If you pay attention to the details on the chart, it looks like the correlation is stronger on the downside. Worley can fall when the CRB rises. But when the CRB falls, Worley generally falls too. If you were asking me to turn this observation into a trading idea, it would be to short-sell WOR at the current levels with a stop-loss at $31. A correction towards $20 is possible.

Gabriel has been working on a system to trade these chart patterns in ASX 200 stocks for the last four months. Look for more information on that later this week. And in the meantime, keep in mind that if Worley is a proxy for the bull market in Aussie resource stocks, the charts are suggesting that all the positive momentum since March may be reaching its limit. When you check in the turn down on the CRB, you should be prepared for the possibility of a correction in commodity prices too.

If that happens, it would be perfectly consistent with the tenor of the news these days. As excited as we are ourselves about certain resource projects, the level of bullish consensus about commodity prices and corporate earnings is a warning sign. But - this is important - that doesn't mean you have to head for the hills.

As Gabriel's work is showing, you can use these kinds of signals to take profits before rallies expire. It can also save you from mis-timing your entry into a blue chip share. And ultimately, it should be able to help you identify the best time to get back into the share, after the inevitable correction has done its work.

We meant to write more about gold, sound money, and unsound economic thinking. But that will have to wait until tomorrow. Until then...

Dan Denning
for The Daily Reckoning Australia

• CRB Index Correction Likely to Go Further
• Worley Parsons (ASX: WOR) Announces Pilbara Solar Energy Project
• Note to Australia: Buy Resources, Not Banks
• Government Preparing Another Stimulus
• Recovery for the Real Estate Market

Now, to the markets. You may remember that yesterday we asked chartist Gabriel Andre to confirm or deny the claim by Chart Partners Group that the S&P ASX/200 could rise by another one percent-and then fall by 19%. It turns out Lord Swarm had published his own forecast yesterday in our sister letter, Money Morning.

"What is the target then for this current rally," he asked. " Well, as we anticipated a few months ago (see Money Morning dated May 14), it is likely that the next significant objective will be around 4,550 points. That is 300 points ahead, or 7% higher [than yesterday's open]. The Bollinger bands are widening, the volatility is up. The target could be reached soon.

"Two key points argue for an exhaust at this level of 4,550 points. First, the Relative Strength Index (RSI) clearly shows that the index is already overbought. You may know that a stock or index or any other asset can remain overbought (or oversold) for some time. However a high valued RSI usually means that the countdown has started for the trend in place. Here the RSI is valued at 74, above the overbought level of 70.

"Second, the level of 4,550 points corresponds to the 38.2% Fibonacci retracement ratio of the decline occurred between November 2007 (point A) and March 2009 (point D). It is likely to be a resistance area where investors and traders will take profits."

There you have it. Expect a rally to 4,550 then profit taking. You heard it here first. Or second, if you read Money Morning yesterday.

Sometimes technical analysis sounds like a foreign language. In many ways, it IS a foreign language. It makes the claim that the best way to understand and trade the market is to be fluent in the vocabulary of technical variables and chart patterns. It's a big claim.

Your editor does not pick up foreign languages easily. But just for grins, we asked Gabriel to try his technical speak on the CRB commodities index. It's been up, then way down, then back up. We wondered-all the fundamentals of supply, demand, growth, and recession aside - what the index looks like to trader with an eye for patterns and mind full of oscillators. We showed him the chart below, on to which he put the lines you now see.

Click to enlarge

His commentary was to the point: "23.6% Fibo (the very first retracement level) hit on last June 11 (point C), is likely to be the immediate target, around 265 points. A correction had followed then a rebound on a support level (green horizontal line) valid since last March. I expect the resistance at 265 points to trigger profit-taking. It should hold, as many commodities are a bit overbought on short-term basis."

Speaking of commodity prices, the RBA published its commodity price index yesterday. It was, in the spirit of the season, less bad than expected. The RBA said the index was flat in July after being down 3.8% in June. Coal and wheat were down, but beef, veal, and iron ore were up.

Like all other investable asset classes, commodities are trying to find a natural price floor. That floor would be based on the long-term demand in the real economy for tangible assets. And with commodities, you at least get predictable cycles where overcapacity in production leads to falling prices. Or, as we saw in 1999, years of underinvestment in productive capacity coincided with a surge in demand, creating a huge gap that led to spiking prices.

Now things are levelling off at a higher equilibrium. But what about other asset classes? Specifically, returning to the question we began today's letter with, can asset prices make new highs without new leverage in the system? And exactly who is willing to take on leverage now anyway?

This is the question that we think the markets are working through right now. You get the sense that people feel better about the economy. And they feel like the worse of the financial crisis is over. At the very least, investors feel that systemic risk-the chance of a total meltdown-has been averted. There are still risks, but perhaps not as grave as the risks faced once Lehman Brothers collapsed in September of last year.

One reason investors feel better is that governments have now stepped in and made clear they won't let any systemically important firms collapse. That's been a messy process. But it seems to have reassured people that the worst case scenario is impossible.

We're not so sure. If anyone has learned anything in the last two years, it's that the improbable is still possible. It only has to happen once, and it only has to happen to you for an event to derail a lifetime of planning. We reckon investors will bear the lessons of the last two years in mind as they approach markets today.

But it sure doesn't look like that's happening now, does it? So what, really, is happening? We reckon one explanation is that the financial system has simply doubled down on itself. Banks and institutions have partly shored up their balance sheets by selling new shares or, increasingly in Australia, bonds. They've taken the rest and made financial bets which generated paper profits and the false dawn of an earnings recovery, which has been priced into stocks.

You wonder though, how much of the liquidity made possible by central bank policies and government fiscal stimulus has simply found its way right back into speculating on higher asset prices. Is this a recovery in asset prices that simply duplicates the speculative excesses of the credit bubble peak last year? Hmmn.

If the entire financial world-institutions and retail investors alike - reverts back to the bubble era thinking, then you can almost guarantee further losses. This is the debt-deflation scenario. But it's a scenario where the losses are taking grudgingly, drip by drip, in the face of furious attempts to releverage the system.

We were going to say that recommitting to the bubble could guarantee a retesting of the 2003 lows on stock markets. But this time, it may be a bit different. Because the monetary authorities will not allow a large firm (or sovereign state?) to fail-and because people believe there are no firms whose failure is big enough to take down the system-you'll get a very different kind of crisis in phase two.

The credit bubble cannot be reflated. But the rate at which asset markets grind lower (in real terms) can be drawn out if there are no catalysts to cause a panic and if liquidity efforts by central banks remain in place. For example, we reckon that Aussie banks and fund are carrying hundreds of billions of dollars in unlisted assets on the balance sheet that are probably worth a lot less. But those assets don't have to be re-valued continuously (marked to market). We reckon there are serious problems with those assets.

For one, there is the composition of them. Are they infrastructure funds? Listed property trusts? Commercial real estate loans? And then, don't forget, there are the listed assets, which also include commercial and residential property.

Our main point is that asset values are probably much lower than investors would like to admit. But because of changes to accounting rules, no one has to realise any losses on these assets which would require more capital or, in some cases, force a firm into solvency once the value of the asset was written down.

So the zombie assets slumber on the corporate balance sheets in the hopes that everything recovers, the bubble is reflated, or excess bank reserves make their way into the economy to inflate asset prices (although in real terms, investors will lose ground).

In any event, you can be sure the "authorities" would like you to believe that a gradual reflation of housing and stock prices means there is nothing to fear any longer. But they may be underestimating one major change in investor psychology over the last two years: fear.

It is all well and good for the financial industry to turn Fed credit into asset price speculation. But at the household level, how are investors going to behave? We reckon most investors who expect to retire in the next ten years cannot afford to have another year like last year. The entire investor class that has seen stock and house prices rise for most of their adult life is counting on those assets to live off of in retirement.

Now they have a choice: stay in the game to make back some of what you lost and benefit from government reflation policies. Or cash out, hope you have enough to get by with, and adjust your expectations for a less lavish retirement than you had hoped for.

No one likes downsizing his expectations, of course. But as was discussed last Friday at our Debt Summit, attitudes towards wealth and debt may also move in cycles. Those cycles are informed by the unique experience of each generation. If you've experienced nothing but prosperity and rising stock and house prices, you're happy to take on debt and you tend to discount risk.

But one good wealth-destroying recession is the kind of thing to temper both your expectations and your attitudes toward risk. We would not be surprised at all to see investors begin with holding liquidity from the stock and property markets. They are eighteen months closer to needing that money than they were when the crisis began. We suspect this will modify some behaviour.

Maybe it's not all that complicated. We'll see. But it could be that a permanent feature of this recession-and of globalisation for that matter-is lower real wages and income for Western workers. For Western workers to become retirees, then asset prices will have to bridge the income gap. However, as Glenn Stevens himself admitted a few weeks ago, the credit bubble created an exaggerated expectation about the rate of return you can expect from stocks and houses.

We reckon those investors who are first to realise this new reality of expectations will profit best. That is, they will modify their asset allocation plans accordingly. They won't liquidate entirely. But they will probably (and prudently) risk much less of their capital, while putting the rest to work buying tangible assets at a good valuation. More on this subject tomorrow!

Dan Denning
for The Daily Reckoning Australia

• CRB Index Correction Likely to Go Further
• S&P/ASX 200 Clears Resistance Line
• U.S. Fed Leaves Rates Unchanged, Morons
• Have the Chinese Stopped Industrial Stockpiling of Raw Materials?
• Aussie Banks Addicted to Foreign Borrowing

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

Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman and Morgan Stanley.

The immense scale of the carnage has been impressive so far, but what is more astonishing is the mind-numbing intervention by the U.S. establishment. Over the past month alone, thanks to the bail-out of Fannie Mae and Freddie Mac, the US has more than doubled its national debt. Moreover, the 'Troubled Assets Relief Program' (TARP) would have further increased America's debt to U.S.$11.3 trillion. And as if this level of indebtedness was not enough, Mr. Paulson has also agreed to insure money-market funds.

Let there be no mistake; the U.S. has now transformed itself into a great socialist society by using taxpayers' money to buy-out private companies. In my view, this ridiculous measure is a slap in the face of capitalism and will further promote reckless and dubious practices. Essentially, by bailing out the behemoths (Fannie Mae, Freddie Mac and AIG) and allowing the smaller fish (Lehman Brothers) to fail, the U.S. establishment is sending out the following message:
"If you want government protection, please become too big to fail. If your demise threatens our entire financial system, we will help you. Otherwise, we will let you fail."

There can be no doubt that this policy of 'selective socialism' is totally insane for several reasons. First and foremost, who has given these officials the power to decide which company is worth saving and which one is insignificant enough to fail? Next, what kind of message are they giving to the remaining banks - please merge quickly and grow in size or else you will be allowed to fail? Furthermore, America already has a horrendous debt problem (debt to GDP ratio in excess of 400%) so who has given the U.S. Treasury the authority to take on more debt? Finally, who is going to pay for these trillions of dollars of bailouts?

Although these bailouts may offer short-term respite, I am of the opinion that the recent antics of the U.S. establishment will make matters much worse over the mid- to long-term. History has shown time and time again that no nation has ever printed its way to prosperity. In fact, all the of the nations that have resorted to money-printing in the past, ultimately saw a total economic collapse. Furthermore, the middle-class and the impoverished people in those countries got totally wiped out due to runaway inflation. And apart from a handful of rich people who were able to ride the inflationary wave, everyone else suffered a great deal. I wish I could come up with more cheerful news, but I am afraid the same economic outcome is likely in the United States. If the clowns in Washington continue with their senseless inflation agenda by adding more monetary fuel to an already raging fire, I suspect we will see a massive deterioration in the American way of life.

Now, I am aware that the majority of commentators and pundits are applauding the recent bailouts. According to these folks, the bailouts were necessary to prevent an outright collapse of the financial system and the government intervention also helped to restore calm in the financial markets.

For sure, the recent nationalization of assets may have helped the markets in the near-term, however I fail to see how it can be good for the global economy over the long-term. Remember, it was the same reckless money-printing in the aftermath of the NASDAQ bust which caused this massive financial crisis, and now the U.S. establishment is throwing more money into the system! In the short-term, this injection of liquidity may act like a shot of heroin for the desperate drug addict, but in the longer-term, this dosage of monetary poison will end up killing this terminally-ill patient. After all, how can these bailouts be good when they will further destroy the purchasing power of the U.S. dollar? How can these measures be hailed by the investment community when they will cause food and energy prices to skyrocket in the years ahead? How can more monetary inflation be good if it punishes savers at the expense of debtors?
Make no mistake, this reckless monetary inflation will eventually cause the U.S. dollar to become worthless and America may have no option but to issue a new dollar bill (Figure 1). And if other nations also embark on this inflationary road to nowhere, we will see a terrible hyper-inflationary depression with currencies plummeting against tangible assets.

Figure 1: US Treasury's new dollar bill?

Courtesy: Hank & Ben's Money Printing Corporation

Despite the horrendous economic environment we find ourselves in, it is fascinating to observe the sheer denial amongst the investment community. Most fund managers, economists and analysts still want the public to believe that the United States is not in a recession and that its housing situation is about to improve! Nothing could be further from the truth. How can the United States not be in a recession when entire industries have been wiped out? Next time, when somebody tells you that the U.S. economy is stronger than you might think, please ask them which industry or group of industries are growing? As far as I am aware, investment banks, automobiles, homebuilders, consumer discretionary and mortgage related businesses are all facing a severe slump. Yet, Mr. Bush and his comrades have no problem in citing the strength of the American economy.

In summary, I maintain my view that the current crisis is far from over and I suggest that you stay well clear of the financial sector. Although, the financial companies may seem cheap due to the recent declines, I can assure you that they could get a whole lot cheaper. The truth is that nobody knows what is on and off the balance sheets of these institutions and at the very best, we may see a lengthy period of consolidation before we get a sustainable recovery in financial stocks.

As far as the broad market is concerned, I suspect the stock market is extremely oversold at the current levels and we may get a technical rally over the coming weeks. Unfortunately, our fundamentally superior resources stocks got sold off in the recent stock-market rout and this may be the best opportunity you will ever get to buy solid, viable companies at such fire-sale prices. So, if you have not done so already, I suggest that you invest your capital in energy, food and metals as these assets are likely to move higher when the newly created 'money' seeps through the system.

Regards,

Puru Saxena

For The Daily Reckoning Australia

• Central Banks are Free to Create as Much Inflation as They Want
• Bunch of Turkeys
• Inflation is Our Future
• The FDIC Is in Trouble
• America’s Debt Woes

The government wants people to understand their money is safe in the banks. That's why that last bit is in there. It's designed to keep foreign holders of Aussie dollars from engaging in a run on the dollar and bringing their money home, wherever home might be (Japan, for example).

The Australian dollar is up in early trading. But its huge slide in just a few months is remarkable. It's good for exporters (especially farmers). Aussie agricultural goods now become relatively cheaper on foreign markets. It's not as good for consumers, who could see higher prices on imports (and there are a lot of imports in the consumer goods sector of the economy).

The big question, of course, is how shares will react to the weekend's events? So far so good. They're up 6% in early trading.

Polling the crowd this weekend and the Melbourne Investment Expo, we got the impression that there was a bit of capitulation on Friday. Investors who could not afford to lose anymore capital may have exited the market during the big 8.3% slide. Fear gave way to abject terror.

There may also be another reason-aside from the panic in the banking market-for Friday's frenzied selling. When Lehman Brothers was allowed to fail, it defaulted on some US$130 billion in senior debt. Against that debt, hedge funds and other Wall Street investment banks had sold some US$400 billion in credit default insurance.

Remember, anyone can sell credit default swap (CDS) insurance. It's a little like writing options. You collect the premium and hope you never have to pay out on the policy. So firms like Goldman Sachs (NYSE: GS), JP Morgan Chase (NYSE: JPM), and Morgan Stanley (NYSE: MS) sold huge amounts of credit insurance against default in Lehman bonds.

One theory making the rounds last week was that those investment banks and hedge funds were selling assets and hoarding cash in preparation for judgement day on how much of that insurance they would actually have pay out. An auction was held last week to determine the value of the outstanding Lehman CDS.

Based on the results of the auction, it looks like anyone who sold default insurance on Lehman bonds will have to pay out around 90.25 cents on the dollar to the holders of the CDS. Obviously, that could be a huge number, based on the gross value of the CDS outstanding ($360 billion). But if the banks and hedge funds have already hedged against their risk in writing these credit default swaps, it won't be any big deal.

If, on the other hand, you were a hedge fund selling CDS on Lehman's debt without making any provision that you'd actually have to pay up, well you, my friend, are in a sorry state. And you were probably selling assets like cheap underwear to raise cash last week. What does any of this have to do with the Aussie share market?

Blue chip Aussie mining shares like BHP Billiton (ASX: BHP) and Rio Tinto (ASX: RIO) and OZ Minerals Limited (ASX: OZL) have been the darlings of hedge funds wanting to own commodity stocks. The Aussie dollar has also been a popular commodity currency and yield play. If hedge funds and investment banks were liquidating commodity positions to raise cash for the Lehman CDS auction, it would most likely hammer Australian stocks.

That's one reason Aussie stocks fell much harder on Friday than stocks on Wall Street. Australia has a high percentage of stocks that were attractive to leveraged speculators when commodity prices were high. Now, those assets have seen a large amount of selling. With the Lehman CDS auction behind us, will the selling end?

We'll see. Beyond Lehman, there are the larger issues in the global financial system. On that score, politicians in Europe raced against the opening of global markets this morning. They announced a package of reforms that would: guarantee interbank lending, guarantee debt issued by banks until 2009, give government's permission to buy preferred shares in banks, make provisions to directly recapitalise any banks that were deemed "systemically critical."

While the Euro nations try to unfreeze the banking sector by effectively guaranteeing all lending, regulators in the U.S. and the U.K. are taking similar steps. The British government will take controlling stakes in the Royal Bank of Scotland and HBOS Plc. The Brits have also decided to inject about A$125 billion in capital directly into the banking system.

We covered the big-picture implications of this policy response in yesterday's special Sunday edition of the Daily Reckoning. If you missed it, you can find it here (Australian Resource Shares, What's Next). But it's not hard to see what's going: government guarantees to all bank lending, and direct, unsecured government lending to anyone who asks for it.

Will putting more money (credit) into the hands of those who created the problem in the first place actually help? Probably not. As Jim Rogers told CNBC, it's setting the stage for an 'Inflationary Holocaust.' It's hard to believe at first that the current deflation in financial assets will give way to astonishing inflation. But that's just what we expect to happen.

Specifically, governments will boost lending to the private sector via central banks. You can also expect direct stimulus for households via rebate packages and tax breaks. In the long-run, big government spending programs on public works, infrastructure, and energy are a certain political winner.

And where will the money come from? Good question. It will be printed or borrowed into existence. Money supply will rise. And with the banking sector effectively nationalised, private investors will look for a real hedge against the inflation being unleashed.

We would take a strong look at over-sold Aussie oil stocks right now. Not only are they over-sold from a technical perspective, but the oil price has nearly halved from its highs earlier in the year. You may not get a better chance to buy them at this price.

Of course, if the market gets any worse than it got last week, it will no longer be the worst financial crisis since the Depression. It will be the worst financial crisis of modern times, full stop. If that is the case, it marks the end of one era and the beginning of another.

In the meantime, however, you could do worse than build a "Robinson Crusoe" portfolio. That is, when his ship ran aground and all his colleagues were lost at sea, Crusoe spent three days salvaging anything from his ship that would be of use in living on his deserted island. His misfortune was severe. But he had enough sense to realise the ship contained items that would be essential for his survival after the shock of his shipwreck.

The stock market offers you a similar opportunity, once the selling abates. You will get an excellent chance to buy Australia's best shares at very low prices.

Dan Denning
The Daily Reckoning Australia

• The Asian Banks Have Finally Been Heard From
• Short Selling Ban May Kick Off Market Liquidation
• $4.1 Billion in Investor Funds Have Been Frozen Overnight
• Big Australian Resource Stocks Up 24% in 2008
• Government Sponsored Enterprise Debt and Australian Banks, a Ticking Time Bomb?

Meanwhile, Alan Carpenter's Labor government in Western Australia has been kicked to the curb. The Kingmaker Nationals party threw its weight behind Liberal Colin Barnett. Carpenter must feel like John Howard. One day, you're riding a resource boom. The next, you're fired!

The big question for investors is whether the change in government will kick off a boom on uranium production and exploration. We reckon it will, if the government can stick. We provide the table below from ABARE to give you an idea of which uranium projects in all of Australia are the closest to production.

By the way, if you think Colin Barnett's plan to build a canal from the Kimberley to Perth to solve WA's water problems is hallucinatory rather than visionary, you should check out China's $69 billion South-to-North water project.

Nearly two thirds of China's GDP is generated in the North. But there's not enough water to keep industrial activity humming, much less for growing things or keeping people hydrated. Fresh water may someday be more important a liquid than crude oil. Canada, incidentlly, has the world's largest fresh-water reserves. They don't call it the Frozen North for nothing.

By the time you read this, Lehman Brother's may have already been dismembered and sold into various parts and pieces. Merrill Lynch may have merged with Bank of America. What a spectacle.

There stands Henry Paulson like a paper wall. It appears that the best efforts of the U.S. Treasury Secretary to jawbone a deal to save Lehman brothers have failed. "Unable to find a savior," reports the New York Times, "the troubled investment bank Lehman Brothers appeared headed toward liquidation on Sunday, in what would be one of the biggest failures in Wall Street history."

Since the credit crisis broke in July of 2007 with the collapse of two Bear Stearns hedge funds, the markets have sent any investor who cares to listen a clear signal: it's a bear market in credit. The bad debts accumulated in the credit boom must be liquidated before the financial markets can recover.

But, to paraphrase a ten year old on a road trip, "are we there yet?" How many pundits are going to call the bottom with a Lehman liquidation? A lot, we'd guess. But they'll be early. There are still two big remaining bastions of funny money from the credit bubble. Three, actually.

One is in the Alt-A mortgage market. Bloomberg reports this weekend that Alt-A mortgages originated in 2006 an 2007 are already showing markedly higher delinquency rates than even submprime loans of the same vintage. Yet the Alt-A buyers were supposed to be lower credit risks (How this was established is a mystery, since many Alt-A loans were made without any documentation of the buyer's income, or, without right exaggeration in said incomes.)

Now, of course, the whammy has tripled. Home prices are falling. Payments on option ARM loans are increasing (as the interest is added to the principal, meaning the new loan value is anywhere from 110% to 120% of the original value). And that exaggerated income? It remains what it always was, a fiction.

So there are US$1 trillion in Alt-A loans on the books of companies like Wachovia (NYSE:WB), Washington Mutual, (NYSE:WM) Fannie Mae, and Freddie Mac. The best case scenario is that the market has already priced in this second wave of housing destruction. After all, both Wachovia and WaMu are down massively (WM down 92% in the last year and WB down 70%). We know what happened to the GSEs.

But after the sea of bad debts from collateralised mortgages is drained, there is a whole ocean of other debt-related assets just over the horizon. Securitised credit card receivables and auto loans come to mind. Then there is the massive credit default swap market. And of course, the huge bubble in Treasury bonds.

Here's a prediction: the liquidation of Lehman and merger of Merrill may very well produce a further rally in the U.S. dollar and a gold price under $700. And then gold will have bottomed. Investors will gradually realise that U.S. bonds are the last great refuge of the credit fraudsters.

What then? Bonds sell off and resource equities and precious metals begin to rally from their current battered state. That's what happens next. C'mon people! It's basic Austrian economics! Or, as Roger Garrison of Auburn University puts it, "The misallocation of resources during the period of artificially cheap credit has the feel of genuine growth, but the good feelings are followed by bad ones."

"The commitment of too many resources to projects that will yield output only in the remote future has as its counterpart an undue scarcity of resources for producing output in the near and intermediate future. With the passage of time, the misallocation becomes apparent, after which follows a period of liquidation and reallocation—in a word: a recession."

What a contrast. A recession in the paper economy of America looks like a dead certainty. This fact has pushed all stock prices down to near bear-market lows and made resource shares very cheap. Yet these shares retain the ability to grow earnings on the back of strong trends in the real economy of the developing world. What's not to like about that?

Dan Denning
for The Daily Reckoning Australia

• Lehman Brothers (NYSE: LEH) Is Not Dead Yet
• Uranium: A Carbon-friendly Substitute for Coal
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