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Mark's Market Blog

9-24-11: Europe teeters on the edge

By Mark Lawrence

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Remember last week? Markets up five days in a row? Yah, that's all ancient history now, all those gains are gone and more. Markets dropped like a hot rock on news that Bernanke was learning a new dance, "the twist." I expect this drop to continue for several more days. This is another leg down, not the first, and most likely not the last. Serious questions remain about Greece, French and Italian banks, and the Euro. Very serious - I've noted in the past that default would likely lead to a run on the European banks. It appears that perhaps this has started. This is a good time to be in cash. Not money market funds, by the way: US money market funds hold a lot of European bonds and are not FDIC insured. I wasn't paying attention in 2008 to finance and economics, and I made some rather poor and expensive investment decisions based on my ignorance - GM would be my poster child for that. This time I'm not going to get caught out by these government scumbags like that.


S&P 500 March 14 2011 to September 16, 2011

As Europe teeters on the edge of collapse, signs of recession are starting to come out of China, and US unemployment hovers above 9%, how's the dollar doing? Great. It's up against nearly all world currencies. For all the heat and criticism we take, when the going gets tough, the tough go American. Only the Japanese Yen has held up. Time to start saving for that European vacation, next summer you might get it for 40 cents on the dollar.


A continuing resolution is required to keep the government running. This has turned into a showdown between house republicans and senate democrats, and obviously won't pass until the last minute, which will be midnight on September 30th. I must admit my sentiments on this are a bit aligned with the house - shutting down the government doesn't seem like much of a loss to me. As I've stated repeatedly, put me in charge and several departments, especially energy and education, get shut down asap. Fun fact: translate "Department of Homeland Security" into Russian. You get, colloquially, "Committee for State Security," better know by their very famous initials "KGB."

Gold, which has been looking quite frothy, is now dropping. A few months ago when the markets dropped, gold shot up as a safe haven. No more. Now the markets drop, gold drops with them. Many are calling the September 6 $1920 / ounce a high price for the next year, or possibly two. Gold ended this week around $1645, down 15% in two weeks. As money tightens and gets more dear world wide, people are becoming net sellers of metals. This effect is likely to accelerate, in my opinion. Notice that we're nearing a full-on European banking crisis, a time when Gold would be the "money of last resort," but gold prices dropped this week just like everything else. Gold is not money, it's a commodity subject to market forces just like any other metal, and by all appearances it has just formed the top of a bubble. If you own gold, be prepared to see it drop in value by another 10%, and very possibly by 50%. Have a look at the chart below, and ask yourself, "Does this look like the behavior of the One True Currency during a banking crisis?" Silver rose even further in its bubble and dropped even more Friday. I would not be surprised to see silver correct down to the $15 - $20 range, a third of its recent peak; gold could possibly correct to $800 or so, half of the recent peak. Time will tell.


Gold April 1 2011 to September 23, 2011


Silver April 1 2011 to September 23, 2011

Are we in a recession already? Is one coming? This is word play, unfortunately. A recession is defined as two quarters in a row of negative GDP growth. Negative growth is defined relative to inflation - if the inflation rate is 2.5% and GDP growth is 2%, then that's negative growth of .5%. Our government says there's no inflation in the US. All I can say is these guys shop at different stores than I do. As long as they're lying about inflation, they get a lie about recessions as a free bonus.

Bernanke says he wants interest rates on 10 year bonds to drop. It's been hovering around or just below 2% for a while now, begging the question, "drop to where?" To make this happen he announced the Fed will be selling $400 billion of short term notes and buying an equivalent value in 10 years bonds. This operation is called "the twist," named for the famous dance when this monetary game was first played during the Kennedy administration. Why are they doing it? Who will this help? Read the fine print in the announcement, actually they will be selling short term bonds and mortgage backed securities. Which mortgage backed securities they took as deposits from the big banks. This is not a stimulus program, it's another bank bailout. BofA, nearly bankrupt from bad loans, law suits and exposure to Europe, is going to get a get-out-of-jail card from the Fed that lets them exchange the junk bonds they already have on deposit with the Fed for treasury notes. I dunno about you, but BofA, Citi, JPMorgan and Goldman have never done nothin' for me. And Wells Fargo overcharged me for years until I smartened up and switched to small local banks. But now you and me and our children are going to bail out these over paid jerks yet again. Polite words fail me.

S&P, those charming folks who helped bring you the Great Recession and recently downgraded US debt, have just downgraded Italy's debt. French banks are losing stock value at a frightening rate. Also Moody’s downgraded Bank of America, Wells Fargo and Citigroup, citing that the US government will be less likely to bail out the bank going forward. Even a stopped clock is right twice a day. . . Moody's dropped their ratings on Greek banks to junk, and S&P has also downgraded Italian banks. Europe is getting no love at all.

The Hourglass effect: as the middle class gets squeezed, the money is to be made selling cheap stuff to the lower classes, and top end goods to the upper classes. For example, for the first time in about 40 years, sales of Tide laundry detergent are dropping. Want to make money? Sell cheap imports at the dollar store, or high end stuff at Saks and Tiffany's. If your business plan is to sell pretty good stuff at reasonable prices to people making $60,000 to $120,000 per year, well, good luck with that.

Poor Microsoft, Google, Apple. . . they've built up huge war chests of cash; $40 billion, $35 billion, and $100 billion respectively. They would like to do something with this cash, like declare a dividend or something. But the cash is held in off-shore subsidiaries to avoid US taxes. If they repatriate the money, they pay. I got news for them: taxes will most likely be going up, not down. They would be smart to pay now. By the way, on current trends sometime in the next week or three Apple will be not only the most valuable company in the world, but it will be worth more than Microsoft and Google combined. You can't make money manufacturing cars or clothes, but if you starve yourself and get into movies, if you can throw a football, if you drop out of Harvard and make a popular web site, if you make iPods and iPads and iThingies, then you make serious money. It's true what the Russians said: there are certain excesses in capitalism.

The new Fortune 400 is out. Bill Gates remains the world's richest human with $59 billion - enough to buy ten McDonald's double cheeseburgers for everyone alive. The cutoff this year is $1.5 billion, a mere billion no longer makes the cut. 70% of the people on the list made their money, only 30% inherited it. Altogether the Forbes 400 got 12% richer over the past year, with Mark Zuckerberg leading gainers at $11 billion. At the same American poverty surged to new levels. As they say, the rich are getting richer and the poor are getting poorer.

Sunday Boeing delivered the first 787 Dreamliner to Nippon Airlines, three years late. This plane was supposed to put a knife in the heart of Airbus; unfortunately it's proven to be a very sharp double edged knife and a lot of the blood flowing around is Boeing's. Boeing has a history of taking bold risks, betting the company and growing. Boeing bet on several new technologies all at once: carbon fiber construction, shopping out major parts to international partners, new engines and flight control systems. As the plane hasn't been in service yet we still don't know about the durability of the Boeing carbon fiber or the resilience of the new avionics. The international partner thing bit them rather severely on the butt, a lot f the initial work had to be scrapped and re- sourced back into the US. This time they nearly lost the company, and frankly with money tightening up all over the world, their bet is not over yet. Boeing all by themselves is about 5% of total US exports, if Boeing goes down we will all feel it. In Boeing's defense, if this works they are now a couple steps ahead of Airbus in design and manufacturing technology, and they should be able to leverage this advantage into significant market gains over the coming decade. The 787 sells for about $200 million, so it will be awhile before I order mine. Perhaps, like John Travolta and his famous personal 707, I'll wait for the used market to develop. You all know what they say about airplane values dropping the instant you fly them off the lot.

House sales continue to deteriorate, in spite of record-low mortgage rates. Of course, as banks are mostly not lending, those interest rates aren't real. Sales of foreclosed houses and short sales are more and more to cash buyers. Older people are starting to buy condos for cash as rental investments, as they can't make any money on deposits or bonds.

Greece continues to make austerity promises in return for cash. Their latest promises:

  1. Pensions of more than $1,650 a month will be cut by 20%.
  2. Payments to state workers who retired before age 55 will be reduced.
  3. 30,000 civil servants will go into "labor reserve" -- that means their pay will be reduced by 40% and they have 12 months to find a new job.
This might be an advance look like how US states deal with their upcoming budget crises, starting perhaps in about six to eight more years.

Suppose the Euro breaks up. Anytime there's a huge financial dislocation, someone wins and someone loses. Who would the winners and losers be? Much of Germany's federal debt is owed to other countries, denominated in Euros. After a breakup, the Deutsche mark would rise strongly and much of this debt would evaporate. The Bundestag is going to love that. On the other hand, Germany makes their money exporting, substantially to Europe, and when prices across Europe of Mercedes, VWs, and Braun and Krups appliances double overnight, German industry is going to take a big hit. In Club Med, prices will rise through the roof, but the prospect of selling locally manufactured goods into those prices should jump-start local industry, leading to job creation and eventually exports. Um, if there's a world left to export to. . .

We're nearing a full-on run on the European banks, including the French banks - perhaps one could even say being led by the French banks. French banks hold a lot of debt from the PIIGS, and the French government looks to be in no position to bail them out. French bank stocks are dropping at a breath-taking rate; by some estimates their capital is so low that they're already bankrupt. In the US when we had this problem three years ago, Bernanke, Paulson and Geithner printed up a couple trillion dollars to keep the banks alive. You can argue if that was appropriate; however the important point here is that France no longer uses the Franc, they cannot print money. The Euro can only be printed by the European Central Bank, and they're not really allowed to do this without the approval of the 17 member governments. I can't get four teenage boys to agree on a pizza, try to imagine getting 17 governments to agree on throwing money at someone else's banks. It's very unclear that if a run on the banks starts, that Europe has a body with the authority or means to do something. I believe we're all going to find out about this, in detail, soon. Meanwhile, in typical Bernanke fashion, our Fed is loaning dollars to European banks at record rates.


Dollar Loans from the US Federal Reserve to Foreign Banks

Desperate negotiations are ongoing between Sarkozy and Merkel to build a bailout fund with enough credibility to save the Euro. US treasury secretary Geithner, the man who loves all bankers, said at the IMF / World Bank meeting in Poland, "The threat of cascading default, bank runs and catastrophic risk must be taken off the table. Decisions as to how to conclusively address the region's problems cannot wait until the crisis gets even more severe." The current plan is to allow the European Financial Stability Fund to buy bonds from distressed members, thus keeps the money flowing to troubled countries like Italy and Spain that are "too big to fail." If those bonds go bad, the European Central Bank would pay the first 20% of the losses. Thus it is hoped that the EFSF would operate on a five to one leverage ratio - putting up $200 billion would give it $1 trillion in effective assets. Isn't that quaint? Leverage got us into this mess, and we're going to use leverage to get ourselves out. This plan is probably against the terms of the Maastrict treaty, and passing the plan in the Bundestag would likely cause Merkel her job. And there's still the Pizza effect - you have 17 governments and they all need to agree. Our government did something like this three years ago, but they did it in the midst of panic and misunderstanding, and they did it behind closed doors. Today the European voters are clearly against such things, and the doors must open when the 17 governments all vote. Most people think a Euro breakup would be disastrous and the probability is under 20%. I'm with that first part, the disaster part. I'm not with the second part, I don't see a path for the Euro to continue. I don't see the northern nations agreeing to share economic power with the southern nations. I do expect that something will be done, the can will be kicked yet again, and stock market investors will drink the kool-aid will glee. Bond investors will not, they will use such a facility to dump suspect bonds on the EFSF and get themselves away from trouble spots. Interest rates will improve for a time while this is happening, then get worse again later when the kool-aid EFSF money runs out. But this is what politicians do with difficult problems: kick them out to after the next election and hope for a miracle.

I have warned a couple times recently that the world banks could lock up and your Visa and ATM card could prove useless for a period. For a couple weeks now what few European customers I have left have had problems paying me with Visa, as apparently my clearing bank will not accept a promise to pay from several European banks. I'm supposed to be exporting, but the banks won't let me. You should have a stash of $20 bills available for extreme banking emergencies. I admit freely that it's unlikely you'll need it, but 1) if you need it nothing else will do, and 2) if I'm wrong, in a few months you bring the money back to the bank, and you've lost about $2.37 in interest. This is very cheap insurance that means in a full-on world wide banking crisis your family will still get to eat.

A few weeks ago BofA stock started dropping. When a major stock breaks below $5, the rules of many mutual funds forbid them to buy or own it, so if predatory traders can get the stock to $4.99 the bottom will fall out and they can make huge money on the breakup. BfA stock went from $50 before the 2008 crash to $6.30 a month ago. At that point Warren Buffet stepped in and bought a huge block of stock - $5 billion worth - in a sweetheart deal, and loudly proclaimed the basic soundness of BofA. The stock promptly shot up to $8.50. How's that working out? BofA stock today is $6.11 and dropping. It seems to me we're perhaps just a few weeks away from Too Big To Fail, Part II: The Tea Party Strikes Back.

Protectionism is in the air. It's widely believed that trade protectionism made the Great Recession longer and deeper. I dunno, I'm not an economic historian. However, the US has been running a trade deficit for 20 years now, shipping treasury notes and jobs out and shipping cars, electronics, clothes, and toys in. China is consistently accused by most of the western nations of manipulating their currency, subsidizing industries, and destroying the environment, all violations of world trade agreements. Whatever the truth was 80 years ago, in my opinion China is not being a good neighbor or trade partner, and a bit of protectionism would be fine with me.

In China real estate developers are not getting paid. By some estimates real estate development is 60% f China's economy. Imports of metals used in construction, like copper, are dropping. Money is getting very tight, and everything do to with the construction industry is looking very shaky. Black market money (loan sharks) are now a primary source of funding for developers. The end is near. Soon, sometime in the next year or two, the world's most populated country is going to have a "come to Jesus" moment. Some are holding out hope that China will save the world; I question whether they can save themselves. In 1987 when everyone else was saying "Time to learn Japanese, soon the Japanese will own everything and your boss will be Japanese," I said "History will record that 1987 is the peak of the Japanese economic empire. I called that one perfectly. I'm now calling that 2011 is the peak of the Chinese economic empire, at least for the next several years. Japan had really horrible demographics, lots of old people. Chinese demographics are bad but not Japan bad, so they might recover again after four to six years. But the next few years are going to be very rough for Chinese people and for anyone who's invested in China.

Because China's tobacco industry is state run, it is nearly impossible to control. Tobacco generates 6.7% of the government's revenue, and tobacco companies donate to a number of charities including funding for 42 school libraries in Xinjiang and 40 in Tibet. Here in the US we go see the Redskins play in "FedEx Field." In China pre-teens attend schools like the Sichuan Tobacco Hope Elementary School where the sign over the entrance doors says, "Talent comes from hard work -- Tobacco helps you become talented." A survey of 13 to 15 year old boys by Peking University revealed that most of them had their first cigarette at age 10. This is no surprise when there are regularly vendors outside school gates, ready to sell toys and cigarettes. Tobacco advertisements are banned on Chinese TV, radio, and newspapers, but for $30,000 you can sponsor a school. The Ministry of Education wants to see more proof that these tobacco company sponsorships cause harm before they will take action. I guess when you've got over a billion people a bit of lung cancer is a good thing: people die young, fast, and cheap.

Sales of hybrid cars are dropping fast. No surprise there: hybrid SUVs and big luxury cars carry a price premium of $10,000 and get you essentially no increase in gas mileage, and the Honda Civic and Accord hybrids were both technology and sales flops. The word "hybrid" was used to sell a lot of expensive, useless junk.

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