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Mark's Market Blog

8-20-11: The world is running out of options.

By Mark Lawrence

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More market roller coaster runs this last week. It seems the markets are range bound for the moment between about S&P 1100 and 1200. Range bound markets never last; this one will break out soon enough, and to the downside would be the way to bet in my opinion. Recession continues to look more and more likely, and Europe has no good answers to their crisis.

S&P 500 March 1 2011 to August 19, 2011

I haven't talked about the middle east for a while because nothing has changed. Libya remains locked in a bloody civil war, but there are now signs that perhaps we're nearing an end. Syria is killing about 35 to 50 civilians per day. Bombs keep going off in Iraq, tensions remain high elsewhere. This is the new normal. My prediction: as food prices continue to rise, jobs for 3rd world 20-somethings continue to stagnate or disappear while the ranks of 20-somethings themselves grow, more and more of the world will fall into ungovernability. This is a problem that feeds upon itself: where will a collapsing government borrow money to buy food? Who will move a factory to an ungovernable region? Who will ship goods there, hoping the goods can be safely landed at a dock, transported to a market, and then sold in a currency that has global value?

Quaddafi may fall soon. If he does, Libyan oil production will ramp up quickly. Libyan oil is "light, sweet" and will have an immediate large impact on prices, which will drop quickly in the months after Quaddafi is exorcised.

A huge number of employers are still saying that they have problems hiring workers who are proficient in "Punctuality / reliability." In fact, this measure is one where things have actually gotten worse since the last time they did this survey in March 2007. Unemployment is over 9%, and yet punctuality is still a problem. Some argue that excessive unemployment benefits are removing many people's habit and desire to work.

Generally western economies have to grow at 2% or more, else they slip into recession. Germany's growth just dipped to 1.2%, indicating the strong possibility of recession. This is an expected development: when you're an export economy, and much of your customer base (southern Europe) is in recession, you have to expect it will hurt you too.

How's California doing? Our new budget is based on $4 billion extra money coming in, apparently from the tooth fairy. We're currently about two months into the new budget, and running $550 million below estimates on revenue. Why is the tea party willing to shut down government? Because we think government is like a teenage daughter out of control with a credit card. We're ok with the credit card being cut up, the cell phone getting shut off and the car being parked for a while. We think after the lesson is learned life will go on; no one actually dies of lack of text messaging.

How's Europe doing? They're arguing about Euro-bonds - a new type of bond that would be backed by all European government, not just Greece or Italy. For Germany, Euro-bonds are like cosigning a 2nd mortgage for your credit card addicted in-laws. They're talking rules, like in order to participate in Euro-bonds you have to meet certain standards of government accounting, transparency, deficits, and debt. Meanwhile, while the politicians are arguing, the European Central Bank has effectively invented them, using money from all of Europe to buy up bonds from the PIIGS and lower their rates. This is a bit like fighting with your spouse about getting a puppy while your 9 year old daughter has already brought one home and has it sleeping with her in her bed. Too late. In the short term, the ECB is winning their battle, Spanish and Italian bond rates are back down to a tolerable 5%. But the ECB has limited funds, they can't keep this up forever. This is a bit like saying your daughter has only $20 saved up from her allowance to buy dog food, so in a few weeks the puppy will starve and that will be the end of the problem. Bottom line: Europe continues to kick the can, but no one believes it anymore. The Euro experiment seems doomed, and the financial repercussions of that will be at least as bad as Bear Sterns - Lehman - AIG. In other words, the crash of 2008. At least. Spain and Italy are too big to fail, too big to bail out. Some think Europe can put off the crash for another two years. I question if they can make it six more months.

The ECB has now bought a bit over $2 trillion of European debt. It's estimated that their exposure to the PIIGS is about $450 billion. What if the PIIGS default? The ECB would need to be refunded, which money by charter comes from member central banks; they in return would likely need more money from their respective treasuries, which then implies either higher taxes or inflationary money printing. If the Euro breaks up, France and Germany could be looking at massive bailouts of their own banks due to PIIGS defaults, plus having to pay off their fair share of the ECB losses. If the Euro hangs together, France and Germany could be looking at an uncomfortable combination of inflation plus higher taxes plus recession. Europe is nearly out of options.

Bernanke announced that he will keep interest rates low through and past the next election cycle. To do this he's going to have to buy a lot of government bonds. This tends to increase inflation; to fight that he will have to raise the interest rate he pays banks on excess reserves - given the uncertainty in Europe, excess reserves sounds real good right now. However, excess reserves mean that banks can't loan, which drives us towards a recession. So Bernanke is keeping rates low to stave off a recession, but raising excess reserve interest rates which tends to move us towards recession. Really, Bernanke has almost no wiggle room left. If a republican gets elected President in 2012, expect a backlash. The Fed is not real popular with republicans.

US consumers continue to pay down debts. Consumer purchases are not what one might hope. Japan is 20 years into this same process; they have found clearly that when the government lowers stimulus to keep the deficit down, the economy and tax revenues drop even faster and they make no progress on their deficit. When they borrow money and spend to take up the slack from consumers, tax revenues rise and it costs them less than trying to lower their deficit. Japan is out of options. Europe and the US are close on the Japanese' heals.

In 2005 the US started flying our stealth fighter, the F22. This plane can travel at over mach-1 without afterburners, is almost impossible to see on radar sets, can kill you from 30 miles out with missiles before you ever know it's in the air, and can dog fight with the best of them. Russia was planning to show their answer, the T-50 (picture at right), at the Moscow air show this last weekend. The prototype had to abort takeoff due to engine problems. While the T-50 looks sexy enough, the stealth, engines, and electronics are all at least a generation behind the F-22. We're spending billions of dollars to mass produce George Foreman so that he can match up against 110 pound Thai kick boxers. When the next war comes, and I'm getting more and more certain it will, we will rule the entire world's airspace in about two weeks. Then we'll just be left will the little problem of two billion angry people armed with AK-47s. That slogan, "One Texas Ranger, One Riot" is going to be severely tested as our perhaps 200,000 battle ready troupes will be matched up to 10,000 potential enemy combatants each. There comes a point where the enemy wins by smothering you in dead bodies.

Almost 20 years ago, I predicted that the first act of nuclear terrorism would happen shortly after 2000. We got our first major act of terrorism here in the US in 2001, but it was not nuclear. The basis for my prediction? 20 years ago you had to separate Uranium-235 from U-237 by converting it to a gas, uranium hexaflouride, then using a centrifuge to separate the isotopes based on their roughly 1% difference in mass. But at the time there was a promising new technology, laser-induced diffusion. You use a carefully tuned laser to selectively heat the U-235, increasing the efficiency of your filters by 100 times or more. GE has just applied for a federal license to build a laser diffusion factory that can product enough U-235 for 1,000 bombs per year. Iran has been experimenting with laser diffusion for over a decade. One can't help but think they will solve this problem too. Time to sell that vacation condo you own in Haifa or Tel Aviv. If you thought the assassination of Austrian Archduke Franz Ferdinand was a historically big deal, wait until Israel turns into the world's largest glass factory.

As population continues to increase, and more and more Asians enter the middle class and demand more and better food, prices continue to go up. Below is a chart of food prices in black, and with inflation subtracted in blue. Since the bulk of inflation in the world is a combination of food and oil, I think it's unrealistic to subtract out inflation. The food price trajectory is that in a year or two the riot-inducing prices of 2008 and the "Arab Spring" inducing prices of 2011 will be the new normal. You can perhaps compensate for market peaks or bubbles, you cannot compensate for normal. This will only place more pressure on 3rd world and emerging economies. As Lenin said, no government is ever more than three meals away from revolution.

Is racism dead? Depends on who you ask. While nearly eight in 10 whites say blacks have an equal chance in their community to get any kind of job for which they are qualified, six in 10 African Americans say job discrimination persists. Six in 10 blacks say the government should take a major role in trying to improve the social and economic position of blacks and other minority groups. Just one in five whites agree.

Laid-off workers and aging baby boomers are flooding Social Security's disability program with benefit claims, pushing the financially strapped system toward the brink of insolvency. Applications are up nearly 50 percent over a decade ago as people with disabilities lose their jobs and can't find new ones in an economy that has shed nearly 7 million jobs. The stampede for benefits is adding to a growing backlog of applicants - many wait two years or more before their cases are resolved - and worsening the financial problems of a program that's been running in the red for years. New congressional estimates say the trust fund that supports Social Security disability will run out of money by 2017, leaving the program unable to pay full benefits, unless Congress acts. About two decades later, Social Security's much larger retirement fund is projected to run dry as well. The trustees who oversee Social Security are urging Congress to shore up the disability system by reallocating money from the retirement program, just as lawmakers did in 1994. That would provide only short-term relief at the expense of weakening the retirement program. Claims for disability benefits typically increase in a bad economy because many disabled people get laid off and can't find a new job. This year, about 3.3 million people are expected to apply for federal disability benefits. That's 700,000 more than in 2008 and 1 million more than a decade ago.

In the 1930s, as market bubbles popped, banks went bankrupt, jobs disappeared, and unemployment skyrocketed and showed no signs of coming down, it's reported that businessmen went to FDR and said, "Please save capitalism, do whatever you have to and we'll support you." At the time the theories of Marx had significant popularity, that capital should be the property of society. Today it appears the only societies that flourish are those which practice some strange form of market-based communism, and capitalism is once again being questioned. After all, the deacons of capitalism, those on Wall Street, are mostly non-productive crooks. Determined that there would be no repeat of the Great Depression on his watch, Fed president Ben Bernanke has pulled out all the stops to stimulate our financial systems. There's general agreement now that he has no dry powder left, and still the economy has had no fundamental recovery. This condition is now world-wide: the more laissez-faire economies of the US, UK, Singapore are suffering, but so are the social-welfare states of Europe. Many 3rd world countries are falling into non-stop civil war, and that trend looks likely to only spread. Karl Marx was partly right in arguing that globalization, financial intermediation run amok, and redistribution of income and wealth from labor to capital could lead capitalism to self-destruct. His view that socialism would be better has proven wrong.

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