Obama’s Yuan ‘Victory’ Spells The Dollar’s EndFinancial Intelligence Report August 2010 Stocks did not fare well in the second quarter of the year and have continued to decline slightly in the first few weeks of the third quarter. Since our last update, the S&P 500, a broad and representative index of the stock market, lost 1.76 percent on a total return basis, which includes dividends. Our model portfolio did a little better, declining by only 1.55 percent since our last review. For several months, we have been expecting to see an increased level of stock market volatility and we have not been disappointed. Volatility refers to the degree that prices move up and down. We’ve been told for years that stock prices go up 7 to 10 percent a year, on average. But prices don’t move straight up year after year, as buy-and-hold index investors have learned over the past decade. They also don’t move in a single direction for an entire year. Over the long term, Portfolio Review been quite profitable, as the Chinese stock market is down almost 30 percent from the peak. Brazil, by contrast, is perhaps the leading unleveraged economy, with total net debt running about a magnitude lower than the U.S. ratio of 375 percent of GDP. Perhaps not incidentally, Gluskin Sheff’s David Rosenberg recently wrote that “the bottom line is that all levels of society, and across most countries in the industrialized world, have far too much debt and far too much debt-servicing costs in relation to income.” Rosenberg continues: “The world is awash with $222.5 trillion of total liabilities across public and private sector claims, or the equivalent of 362 percent of global GDP. Extinguishing this debt will be deflationary even as central banks will be forced to print money as an antidote . . . We are really in the early stages of this de-leveraging cycle.” So world GDP is almost as highly leveraged as U.S. GDP. This is just another way of saying that the United States has led the world into a dead end where debt is concerned. Remember, debt is a commitment of future income to fund spending today. Considering that balance sheet and off-balance sheet liabilities exceed total world GDP by three and a half times over, we are well beyond the point where “deficits don’t matter.” It is almost inevitable that nations will maneuver to devalue their currencies competitively as part of a race to the bottom to ease the deflationary pain of de-leveraging. Obama’s strategists imagine the United States can “recover” with more of the same — more debt for a debt-saturated economy. In recent decades, the United States has exploited its position in issuing the world’s reserve currency to borrow vast amounts from poorer economies. By running huge trade deficits, the United States has supplied a surfeit of dollars to the surplus countries, which then recycled those dollars into U.S. Treasury obligations. With the U.S. private economy de-leveraging and credit contracting, almost the whole of the U.S. economic recovery is down to deficit spending. The advent of the Greek sovereign debt crisis has turned the attentions of the other OECD “advanced” economies away from stimulus toward mending balance sheets. From Germany, Spain, and the U.K. to Japan and Canada, the other G-8 governments are reining in deficits. With 40 percent of world GDP growth in countries with deficits of 10 percent of GDP or more, the potential for another down leg in the Great Contraction is too obvious to ignore. The reaction of currency markets to Obama’s “great victory” in persuading the Chinese to decouple the yuan from the dollar suggests that one of its primary effects will be to free other economies from buying dollars to hold down the value of their currencies. To the extent that this continues, it will reduce foreign purchases of U. S. Treasury debt, triggering a reversal of the carry trade, and leading on to much higher interest rates on U.S. government debt. In other words, the Obamanites have brought nearer the day of reckoning when the United States has no way to finance further profligacy other than by running the printing presses. Look out below. August 2010 Financial Intelligence Report Page 15 we’ve seen an average annual range of about 20 percent from the lowest to the highest price during the course of a year. This year, we seem to be experiencing an especially volatile stock market. Since the middle of April, stocks have fallen by at least 10 percent (a typical value for the total of one year’s returns) on three different occasions, with an average decline of 11 percent on each down move. The intervening recoveries have been weaker and weaker after each drop. The up moves have averaged only 9 percent, and each has ended at successively lower highs, a condition market technicians call a downtrend. Volatility tends to instill fear in individual investors. Many surveys are finding an increase in bearish sentiment among all groups of investors. Even Federal Reserve Chairman Ben Bernanke is sounding less optimistic than he did a year ago, back when he was spotting the “green shoots” of economic recovery. In a recent statement, Bernanke said the U.S. economy faces an “unusually uncertain” future. His remarks also seemed to indicate that there is an unusual amount of uncertainty in the minds of the Fed policymakers as to how they can help the economy recover. He noted that the economy seems to be weakening but also said that the Fed had no immediate plans to do anything that could help. Stocks fell as Bernanke delivered his comments to Congress, likely because investors were unsure of what the Fed would do if the economy does weaken. Short-term interest rates are near zero; long-term rates are below 3 percent on the 10-year Treasury note. Cutting short-term rates to a level below zero is hardly a possibility at this time. The government has spent $3.7 trillion of borrowed money on bailouts with little sign of permanent improvements in the private sector job market. Analysts are rightfully questioning what tools the Fed has available if the economy does turn lower. Investors also face unusual uncertainties as Congress has delivered almost 5,000 pages of legislation to reform healthcare and the financial markets. Democratic leader and House Speaker Nancy Pelosi was correct in the healthcare debate when she said we would find out what was in the bill after they passed it. We now learn, for instance, that the healthcare bill will allow the government to track the sale of gold coins. To ensure that the IRS collects as much in taxes as possible, almost every financial transaction of more than $600 will now be reported to the government. This includes such trivial activities as selling unwanted gold jewelry to gold dealers. The IRS will expect this sale to be reported as income, and they will tax what they consider to be profit. The result is less money for consumers to spend and more money for government programs that have so far proven ineffective at getting the economy moving higher. This is only one example of how businesses now face more paperwork, more regulation, and more uncertainty. The impact on investor sentiment is noticeable. Bernanke’s public uncertainty is not the reassurance that investors were looking for. Now is definitely the time to maintain a defensive investment posture designed to preserve capital. Open Positions In uncertain times, stock market investors often turn to reliable companies that show steady profits and pay regular dividends. In the past month, cigarettes and chocolate were winners. Altria Group (MO) gained 9.40 percent. Nestlé (NSRGY.PK) added 6.97 percent. 12/1/03 6/1/04 12/1/04 6/1/05 12/1/05 6/1/06 12/1/06 6/1/07 12/1/07 6/1/08 12/1/08 6/1/09 12/1/09 6/1/10 Since Inception ($10,000 Hypothetical Investment) $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 12/03 6/04 12/04 6/05 12/05 6/06 12/06 6/07 12/07 6/08 12/08 6/09 12/09 6/10 FIR S&P 500 Page 16 Financial Intelligence Report August 2010 MO raised its earnings estimate for the rest of the year, noting that higher taxes have had little impact on demand as sales have reached a steady level. The company also will be refinancing its debt to lower the interest rate it pays. We may see this occur in some of the other large-cap companies we have in the portfolio. Lower interest rates can help boost earnings for companies considered stable enough to issue bonds. Nestlé is benefitting from the weakening dollar and the weakness of the euro. The Swiss franc is among the strongest currencies in the world, and Nestlé operates in Switzerland, reporting its earnings in francs. Indirectly, it’s a currency trade, but one with less risk since Nestlé is a very well-managed company with solid earnings. Closed Positions None. As always, ensure your stops are in place in order to protect capital in an increasingly nervous stock market. New Positions Inflation also shows up in the grocery store, and a couple of ETFs offer potential. iPath DJUBS Livestock TR Sub-Idx ETN (COW) invests in cattle and pork futures. These seemingly boring investments saw large gains in the 1970s. Live cattle soared nearly 1,000 percent. This is a thinly traded ETF, so use a limit order to enter. Dow iPath AIG Commodity Index (DJP) we have moved to “buy” from “hold.” August 2010 Portfolio Ticker Recommendation Date Entry Price Current Price Total Return Latest Recommendation PPH Pharmaceutical Holdrs 15-Sep-03 77.09 59.69 1.41% Hold PEY PowerShares High Yld. Dividend (ETF) 1-Aug-05 15.50 7.89 -34.79% Hold PFE Pfizer 1-Aug-05 26.64 14.50 -31.92% Hold R DY Dr. Reddy’s Laboratories (ADR) 15-May-06 33.55 29.4 -11.74% Buy BDX Becton, Dickinson and Co. 15-Feb-07 77.46 66.92 -8.93% Hold GSK GlaxoSmithKline (ADR) 15-Mar-07 54.72 36.36 -23.21% Hold NVS Novartis AG (ADR) 15-Jun-07 55.96 48.55 -3.19% Hold DBU WisdomTree International Utilities Fund 15-Oct-07 33.38 18.42 -37.07% Buy BRK.B Berkshire Hathaway 12-Oct-08 52.40 76.63 46.24% Hold MO Altria Group 19-Dec-08 15.28 21.41 56.73% Buy KMB Kimberly-Clark 19-Dec-08 51.11 62.36 28.84% Hold JNJ Johnson & Johnson 12-Jan-09 58.34 57.12 1.96% Buy SNY Sanofi-Aventis 12-Jan-09 31.5 29.75 -5.56% Hold GLD* SPDR Gold Shares 2-Feb-09 92.63 115.85 25.07% Buy GDX Market Vectors Gold Miners (ETF) 27-Feb-09 33.36 48.18 44.42% Buy DJP Dow iPath AIG Commodity Index Tot. Ret. 26-May-09 36.23 38.41 6.02% Buy NSRGY.PK Nestle 30-Jun-09 37.95 50.35 32.67% Buy GLD SPDR Gold Shares 1-Oct-09 97.89 115.85 18.35% Buy TBT U ltraShort 20+ Year Treasury ProShares 28-Jan-10 47.92 34.88 -27.21% Buy PFIUX Pimco Unconstrained Bond Fund 28-Jan-10 10.91 11.12 1.92% Buy FPNIX FPA New Income Fund 28-Jan-10 10.98 10.99 0.09% Buy BMO Bank of Montreal 20-May-10 55.56 57.46 3.42% Buy as of close July 21 *maintain GLD at 10 percent of total portfolio value August 2010 Financial Intelligence Report Page 17 Financial Briefs Global Banks Face $5 Trillion Credit Squeeze Banks across the globe had to raise trillions of dollars in capital as a result of the financial crisis, and now the bill for that borrowing is coming due. It’s not a pretty picture. Worldwide, banks must repay or roll over $5 trillion of debt to bondholders and other creditors through 2012, according to the Bank for International Settlements. “There is a cliff we are racing toward — it’s huge,” Richard Barwell, an economist at Royal Bank of Scotland, told The New York Times. “No one seems to be talking about it that much. (But) it’s of first-order importance for lending and output.” Of the $5 trillion total, European banks owe $2.6 trillion, and U.S. banks, $1.3 trillion. The situation is more serious in Europe, not only because of the larger number but also because the sovereign debt crisis is hitting Europe harder than the United States. Banks that need to roll over their loans and bonds will be competing with their own governments, which also have huge borrowing needs. That could cause a widespread credit crunch, making it even more difficult for consumers and businesses to borrow. European banks may face an added burden, as the recent stress tests could force them to raise still more capital. “If it turns out that a bank, under certain assumptions, has too little capital, then it has to get more capital or reduce its balance sheet,” German Finance Minister Wolfgang Schaeuble told Deutschlandradio. Asia’s Dr. Gloom: China’s Stocks Will Crash Soon Economist Jim Walker was dubbed Asia’s “Dr. Gloom” in 1996, and his views about China continue to fit that bill. Chinese fiscal and monetary stimuluses have given life to many corporations that are in trouble below the surface, says Walker, whose one-man firm Asianomics is based in Hong Kong. “There are an awful lot of companies that don’t make any money in China, and they need to go,” he told Forbes Asia. Major manufacturing cities are suffering labor shortages, thanks to the real estate bubble that has drawn away workers and will ultimately burst, says Walker, who was formerly chief economist at Crédit Lyonnais Securities Asia. He’s skeptical that China is accurately reporting economic figures, such as its GDP growth, which totaled 11.9 percent in the first quarter. China’s huge current account surplus, currency manipulation, accommodative monetary policy and soaring inflation will lead to big trouble, Walker maintains. He expects Chinese stocks to crash as soon as 2011. “The people who think China is the answer to the world’s problems are the ones who in 2005 said the U.S. housing boom could continue forever,” Walker said. Many other experts share his bearish views about China. The problems already are boiling over, says Harvard economist Ken Rogoff. “You’re starting to see that collapse in property and it’s going to hit the banking system,” he told Bloomberg. “At the speed (the economy) is growing, it’s going to have bumps.” Tax Expert: Wealthy Still Have Chance to Avoid Year-End Tax Hike For months, conventional wisdom has been that wealthy taxpayers will face an increase in the top rate next year to 39.6 percent from the current 35 percent. However, that rise is no longer a certainty. President Barack Obama and congressional Democrats want to maintain Bush-era tax cuts for families earning less than $250,000 a year and boost taxes for those who make more. Meanwhile, Republicans want to preserve reductions for all income brackets. The wrangling in Congress may lead to a one-year extension of the cuts for everyone, says Roberton Williams, a senior fellow at the Tax Policy Page 18 Financial Intelligence Report August 2010 Center. “The simplest solution this year would be to say, ‘We have a struggling economy. We don’t want to raise taxes at all,’” he told Bloomberg. “It’s a compromise that would get things past the end of this year.” If Congress does nothing, all tax brackets revert next year to the rates before the 2001 and 2003 reductions. But incumbents will likely face angry constituents in November elections if taxes go up. So legislators have strong incentive to do something soon. That means Democrats might be willing to give in to Republican demands for a year. Still, most experts say taxes will ultimately rise. “You can’t solve the deficit problem with spending cuts alone,” Clint Stretch, the legislative affairs director at Deloitte & Touche, told Barron’s. “It’s inevitable that we’re going to have to raise taxes.” Former Federal Reserve Chairman Alan Greenspan, whose backing of George W. Bush’s 2001 tax cuts helped persuade Congress to pass them, said lawmakers should allow the reductions to expire at the end of this year. “They should follow the law and let them lapse,” Greenspan recently told Bloomberg Television, citing a need for the tax revenue to reduce the federal budget deficit. Faber: Fed to ‘Print Money Like Crazy’ by October Gloom, Boom and Doom publisher Marc Faber says the Fed will begin “massive” quantitative easing by October. “The economy is not robust,” Faber told Bloomberg. “We have mixed signals, but in general, the economy is still weak.” And despite the euro’s recovery to $1.30, Faber also says he thinks Europe is stuck in a sideways economy for years, as austerity cuts and bailouts weigh on growth. “I am not a great believer in this austerity that they are proclaiming,” Faber said in an interview. “I think the fiscal deficit will actually stay very high or even increase,” he said. “And I think that if they decrease the fiscal deficit then it will be offset by very expansionary monetary policy, in other words monetization, so the whole burden to support the economy will fall on monetary policies. Then they’ll print money like crazy,” he said. “Under a fiat monetary system you can print endless quantities of money and so stocks may adjust in real terms but not necessarily in nominal terms to the extent that the super bears are predicting.” The global economy is headed toward a sharp slowdown this year as the effects of these measures wane, adds New York University economist Nouriel Roubini. “Private sector de-leveraging has barely begun,” Roubini writes in an online column. “Moreover, there is now massive re-leveraging of the public sector in advanced economies, with huge budget deficits and public-debt accumulation driven by automatic stabilizers, countercyclical Keynesian fiscal stimulus, and the immense costs of socializing the financial system’s losses.” Cramer: Forget Double-Dip Recession, Firms Are Strong If academic economists listened to individual companies, instead of focusing on Washington or blaming the banks for everything that’s gone wrong, they wouldn’t be predicting a double-dip recession, says The Street’s Jim Cramer. What would change if they did that? According to Cramer, academics would realize that, for the first time in a long time, the fundamentals of individual companies now matter more. “I’m going with the companies,” Cramer says. Even though emerging-market economies may be providing the engine for this recovery train while the United States is the caboose, “we’re moving again, and that’s what counts,” Cramer notes. “Growth is pretty much in all regions, driven very strongly by increased global activities,” says the Mad Money host. “The companies are telling us the truth.” MarketWatch reports that Moody’s has joined those who think Canada’s economic recovery is ongoing, even if the U.S. falls back into recession. Jimmy Jean, an economist at Moodys.com, says Canada’s economic recovery is safe, even if the U.S. suffers a double-dip recession. “It is often thought that when the U.S. sneezes, Canada catches a cold,” Jean wrote in a report. “But with the shift toward a service-oriented economy over the last three decades, Canada has grown more immune to U.S. woes.” August 2010 Financial Intelligence Report Page 19 Hugh Hendry: Euro, China Heading for a Fall Outspoken contrarian British hedge fund manager Hugh Hendry thinks the euro is finished and China is headed for a fall. He also wishes President Barack Obama was over with as well. “If there was a way to short Obama, I would,” Hendry told The New York Times. Hendry runs the successful hedge fund firm Eclectica Asset Management, an old-school macroeconomic fund company. Eclectica’s flagship fund, the Eclectica Fund, is up about 13 percent this year, besting by far the average 1.3 percent loss among similar funds, the Times reported. Like Jim Chanos, his fellow hedge fund manager stateside, Hendry believes China’s days of heady growth are about to end in crisis. He compares the country to Starbucks: good at growing quickly, not so good at creating wealth. “The idea is that things would happen today that are commonly thought of as impossible, most notably a significant reversal of China,” he says. During a recent trip to China, Hendry filmed himself in front of empty office buildings and giant new bridges in the middle of nowhere, both of which he says signify a credit bubble poised to burst. Hendry is devising ways to bet on a spectacular deterioration of China’s economy, the Times reported. He declined to divulge any details. China should boost interest rates or allow its currency to strengthen to help curb inflation pressures, the Asian Development Bank said. China, like most Asian countries, boosted government spending and slashed lending rates last year to help spur economic growth amid a global recession. The region’s policymakers now are mulling how much to ease stimulus spending and raise rates to keep their economies from overheating. Meanwhile, others also see the euro headed for a fall. Royal Bank of Scotland Group said the euro’s gains are close to petering out amid fragile market confidence. “Confidence will take a hit if European economic growth begins to fade,” Greg Gibbs, a currency strategist in Sydney, wrote in a report. “It is hard to see confidence in European debt markets improving further from here. Perhaps the stress tests will deliver one more spurt of confidence. But it is close to a peak and so is the euro.” Meanwhile, Obama is getting rave reviews in the District of Columbia and Hawaii, but he’s not playing as well in Wyoming, Utah, Idaho, and West Virginia, according to newly released national poll numbers. A recent Gallup survey indicates that, during the first half of 2010, 85 percent of residents in the District of Columbia approved of the job Obama was doing as president, with 68 percent of Hawaiians giving him a thumbs up. Democrats overwhelmingly dominate in Washington, D.C., and they also greatly outnumber Republicans in Hawaii, the state where Obama spent much of his childhood and teenage years. Survey: Wary Americans Paying Down Debt, Not Saving Americans are paying down debt more than they are saving, a recent American Express Spending & Saving Tracker survey shows Seventy-five percent of the 2,004 adults surveyed reported that their debt has not increased during the past six months, MarketWatch reports. The survey sample included the general U.S. population, plus the affluent and young professionals. Fifty-two percent of affluents, 46 percent of young professionals, and 38 percent of all others said their debt has actually decreased. However, consumers’ stated savings goal for the year appears to have decreased by $2,000 since January, when they said they would try to save an average of $14,000. To date, consumers report having saved 25 percent of their savings goal during the first six months of the year. “Consumers are taking a measured approach to their finances — loosening their purse strings for meaningful experiences such as dining out and traveling with friends and family, while keeping their eye on their financial goals for the year,” said Pamela Codispoti, American Express senior vice president and general manager for consumer card products. However, even though consumers appear focused on getting out of debt, those surveyed also expressed positive long and short-term spending intentions. Sixty-four percent said they expect to spend as much or more during the next six months compared to the past six months. According to economists at Morgan Stanley, the gain in U.S. imports in May points to a pickup in Page 20 Financial Intelligence Report August 2010 Financial Intelligence Report offers these informative reports on a variety of topics. They can be mailed to you for a charge of only $15 per report (a $49 value). For details, contact customer service at 800-485-4350. Financial Intelligence Report (#81) is a publication of Newsmax Media, Inc., and Newsmax.com. It is published monthly for $99 per year and is offered online and in print through Newsmax.com and Moneynews.com. Our editorial offices are located at 560 Village Boulevard, Ste. 120, West Palm Beach, Florida 33409. For permission, contact the publisher at P.O. Box 20989, West Palm Beach, Florida 33416. 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