W.I.L. Finance Digest for Week of November 10, 2008

PLANETARY SECULAR DEFLATION: EXPLAINING GOLD TO GOLD BUGS AGAIN

Here is a/the bear case for gold. Globally we are at the effect of a secular deflation, the principal element of the case goes, and this is good for cash dollars and bad for just about every other asset (exceptions are those which are deflating even faster, like the Japanese yen). We have heard this side countless times to date in one form or another. This one adds a few new elements to the mix, and comes from a source with a rather unusual background (see article footnote).

The counter-case is that central banks are printing money hand over fist, etc., and this is bound to lead to massive inflation sooner rather than later. One maker of that case, which we carried a couple of weeks ago, claimed that the transition from deflation to inflation would be chaotic -- the reversal would be unpredicable and untradeable -- so you should own gold and ignore the pain if it falls a lot in the mean time.

To us the most compelling short-run evidence for the bear case is gold's price action. The article author, Al Martin, claims that the pros are all shorting rallies while the amateur public is buying dips. The action is consistent with that. Pros can be wrong and the public right, but that is not the way to play the odds.

The financial upheaval in global financial markets has led to a sharp increase in demand for physical bullion. As a consequence premiums on gold bullion and gold bullion coins have soared to levels never before seen, where indeed we find that one-ounce bullions coins are now trading as much as 14% above their bullion value, as people continue to chase them and mints worldwide are unable to keep up with demand. We do not advise paying this tremendous premium to own gold because the price is completely unwarranted. It should be remembered that the usual premium is 3%, but we are seeing enormous premiums simply because mints can not keep up with the demand for the physical gold coins. Demand for physical bullion/coins always increases during times when the markets are in a state of upheaval.

Why? Because there has been a pickup in demand for physical gold from the "unwashed," those who believe that gold will "shine" once again and those who believe that it will be $2000 per ounce tomorrow and those who believe the current economic turmoil will end with a round of hyperinflation. And they are wrong to believe that.

The economic calendar releases in recent weeks show a sharp deceleration in global economic growth. Indeed we saw last week through the U.S. Q3 GDP advance numbers that growth in the United States is now a red number, and it is expected to fall potentially 3-4% in Q4. We suspect that the entire planet will be in a negative growth mode by the end of this year.

The price action in gold is telling them that they are wrong. The planet is now entering into a global deflationary trend which will become more pronounced by the middle of 2009. Indeed the IMF is forecasting that global inflation will come in 2009 at a minus 2.7% number which is just another way of saying that we are at the onset of secular global deflation, wherein asset prices will continue to decline and the U.S. dollar will continue to rise in value. "Secular," in this case, means long term; "cyclical" means a trend that exists within a secular market.

You do not want to be paying a premium for a commodity whose price is falling and will continue to fall. There are many growing negatives that gold must contend with. In a deflationary trend you want to hold paper, not gold -- in this case "paper" meaning the U.S. dollar. The U.S. dollar has sharply outperformed gold this year in terms of an investment.

As the "deleveraging trade" continues on this planet, the dollar will continue to move higher and this "deleveraging trade" phenomenon will take years to complete. There are still far too may investment banks and hedge funds that have on their books a leverage of 30-1 or 40-1, or greater. The process of deleveraging assets has just begun ­ and we are not even halfway through it. This combined with the onset of what is going to be a very deep recession at a time when speculative bubbles in a variety of asset classes have just burst ensures that we will see falling prices and the rising value of the U.S. dollar.

The fear that grips the gold bugs and the gloom and doom crowd (that all the banks are going to shut down tomorrow) is just that. Indeed during the last several weeks we have actually come close to that on several occasions, but that does not mean gold would immediately be used in its capacity as the "currency of last resort." It does not. If banks are shut down, they are simply reopened the next day or a few days later. The Mad Max post-apocalyptic vision of the future simply is not going to happen. It is interesting to note that historically, in protracted periods of deflation, governments' ability to control economies and control nation states increases dramatically.

This is an economic phenomenon we are now entering as we are transitioning from an asset overhang into what will be a paper or dollar trade. Meanwhile the gold bulls conveniently overlook the negatives. As the global economies continue to deteriorate, there is increased selling of gold by all central banks, IMF, World Bank, etc. which have gold to sell.

Indeed we have seen a pickup in the selling of bullion from any institution that has gold to sell. The Washington II Accords, which had regulated the sale of gold for central banks and the IMF, have effectively collapsed under the pressure by global regulatory and lending institutions in order to raise money. There is a mad scramble to see who can sell more gold the quickest within the world of central banks and global financial institutions. Also the new mine supply of gold on the planet continues to increase. It takes gold bugs to shill the gold again.

It should be pointed out how long it takes for a planet to ramp up gold production -- from the time a piece is assayed to the time the first piece of gold comes out, including the time the mines and refineries and infrastructure is built, etc. is 7 to 10 years. That is true. But gold production has been ramping up n this planet since 2004. We are now seeing the effects of the over-production of gold.

Historically the price of gold has peaked 2-3 years before the supply of new mine gold peaks. In other words, as the price of gold peaks at any given time and continues to fall, one of the things that causes it to fall is increasing supply. We are seeing that phenomenon already. So that even in 2008 new mine supplies combined with bank and other institutional selling has brought 5500 metric tons of gold to market. That is a record amount of gold coming to market.

In the last analysis, this is what the gold bulls hate because statistics cut both ways: Only 16% of gold is used as a monetary metal the rest of it is used as a commercial and or industrial metal.

It should also be remembered that recessions are not friendly to industrial or commercial metal uses. We have seen that gold's other principal use which is jewelry has already begun to fall sharply. Gold's industrial usage, particularly in semiconductors, is also declining.

Gold's principal value is as a commercial metal, not a monetary metal. The gold bugs who incessantly promote gold are not economists. They have little understanding of Economics 101 and because most of them have a vested interest in peddling it somehow.

Gold will continue to under-perform as an asset class and will continue to fall in value. Now it is true what the shills say that gold has risen substantially in comparison to other currencies like the euro or the British Pound. The problem is that Americans are not buying and selling gold in euros or Pounds; they are doing it in dollars.

In dollar terms, it is likely that the price of gold will continue to fall because there is a host of negatives. For instance gold shills like to talk about the increase in demand, but you never hear gold shills talk about the increase in supply.

Gold is in a similar situation as it was in 1980, wherein you saw the price of gold peak in January 1980, but you did not see global production peak until 1983. This effectively cut the price of gold in half from 1980 to 1983. In intermediate terms, 6 months out I think you are looking at $600 gold.

Indeed many gold shills you may have seen on CNBC or Bloomberg will admit that there is a $200 premium in gold because of ETF gold funds -- which incidentally the unwashed have poured money into. More physical gold then comes to market through financial distress which further depresses the prices even more and will begin to take out that $200 premium.

As traders, we continue to short the December gold contract on rallies, as does about 80% of the trading community. The only people who are buying gold on dips versus shorting rallies are the one or two lot Joe Six Pack Unwashed. The professional side is on the short side of the gold market.

You must realize that the planet is entering a new era and it will be a period of protracted deflation and it is the only way that the planet can be held together economically and financially. In this era governmental power actually increases. This deflation is in a way being purposely brought on by governments, not in the sense of being in control during the collapse of speculative bubbles, but you will see governments fostering deflation more and more because it tends to increase governmental power at a time when governmental power needs to be increased in order to keep the planet together as the planets economies continue to unwind.

What is needed, as the unwinding continues, is for governments to stabilize the geo-political, economic and military situation of the planet or nation states will break up into little fiefdoms, which is what the gold bugs believe will happen. The reason why that is not going to happen is because we are entering a period of deflation, where the U.S. Dollar is going to be the king among paper currencies.

The U.S. dollar, during deflationary times, rises against an ounce of gold.

PETER SCHIFF HUGELY RIGHT, ENORMOUSLY WRONG AS HARD LANDING HITS CHINA

Schiff invested as if the U.S. would crash and that everything else would be fine. The decoupling theory never made much sense.

Peter Schiff has consistently made the case that the U.S. dollar and U.S. world financial hegemony as goners in the long run. See his book Crash-Proof: How to Profit From the Coming Economic Collapse for the full case. It is compelling. Too compelling perhaps? Once more, with feeling, everybody repeat after me: Just because something is inevitable does not mean that it is imminent.

Mike "Mish" Shedlock agrees with Schiff, with the little insert that between now and the dollar disappearing act there is this thing called a deflationary debt unwind. Thus, he says, Schiff is "Hugely Right, Enormously Wrong, at least over the intermediate timeframe." After the debt bubble unwinds, then and only then will inflation become the primary threat, Mish advises. It matches well with what is actually happening -- a major plus.

We will take a look at Schiff from two perspectives shortly. First let us note the massive influx of workers into Chinese cities is now in reverse as Chinese job losses prompt exodus.

Tens of thousands of migrant workers are leaving the southern Chinese city of Guangzhou after losing their jobs, railway officials say. The increase to 130,000 passengers leaving the city's main station daily is being blamed on the credit crunch.

Guangzhou is one of China's largest manufacturing hubs, but many companies who export products have collapsed. Chinese officials are worried that a sudden increase in unemployment could lead to social unrest.

The most badly hit export companies are toy, shoe, and furniture manufacturers. There are already reports of demonstrations and social unrest in the provinces of Zhejiang and Guangdong.

... As the Chinese economy skids and jobs are lost, home prices collapse. USA Today picks up the story in Economy rocks China factories.

The speedy rise -- and speedier fall -- of River Dragon is a depressingly familiar story in China these days. Thousands of Chinese factories have shuttered in the past year, done in by:

• An export-killing global slowdown that began with the collapse of the U.S. housing market and the ensuing financial crisis.

• Rising materials costs that have squeezed profit margins.

• A deliberate Chinese government campaign to regulate sweatshop factories out of business.

The Chinese economy is absorbing another blow beyond crumbling exports: collapsing home prices. Nicholas Lardy, senior fellow at the Peterson Institute for International Economics in Washington, D.C., reckons a slowdown in construction could shave another 1 to 2 percentage points off China's economic growth.

"The property bubble is already starting to burst," says Yan Yu, a business management scholar at Peking University, researching the export center of Dongguan in southern Guangdong province. "House prices here in Dongguan have fallen by up to 50% this year," leaving many homeowners owing more on their mortgages than their homes are worth.

"People have worked all their lives and believed the hype and bought overvalued properties, then saw their savings vanish," says independent economist Andy Xie in Shanghai. "That carries more political risk" than rising joblessness.

The Wall Street Journal is reporting China Announces Major Stimulus Plan.

China announced a stimulus program that could exceed half a trillion dollars, its biggest move yet to rebuild rapidly weakening confidence and unleash domestic demand to counter the prospect of global economic recession.

The package of infrastructure investment and other stimulus measures is to be spread over the next two years and appears to include some measures that were already announced. Still, the huge scale of the planned response -- potentially 4 trillion yuan ($586 billion) -- underscores how rapidly the outlook for China's once-booming economy has worsened and how the country remains comparatively well-placed to deal with such a slowdown.

Other governments around the world are also considering fiscal stimulus plans to boost their economies, something the International Monetary Fund has encouraged. U.S. lawmakers, during their lame-duck session next week, are expected to consider a stimulus package focused on aid to local governments and extended unemployment benefits.

U.S. House Speaker Nancy Pelosi is pushing for a two-step plan with as much as $100 billion this month followed by a companion measure early next year that would include a tax cut. Outside economists are urging Democratic congressional leaders to move a much larger package -- as much as $300 billion, or 2% of U.S. economic output -- as the U.S. economy faces one of its worst recessions since the 1930s.

China's plan appears to be comparable in size. In a statement announcing the plan, China's State Council said it would deliver 120 billion yuan ($18 billion) of new spending in the last quarter of this year alone. The State Council -- effectively China's cabinet -- estimated that would drive an additional increase of 400 billion yuan in local and private-sector investment throughout the economy.

China's government is also making plans for new spending in areas such as low-cost housing, road and rail infrastructure, agricultural subsidies, health care and social welfare over the next two years.

...

In the video, Peter Schiff rants and raves about clueless economists and more spending and fiscal stimulus and states "We need that like a hole in the head". And on that point he is entirely correct.

I totally agree with Schiff. The cause of the economic crisis we are in now is a result of reckless spending and loose monetary policy. If reckless spending was the cause of this mess then reckless spending cannot be the cure. ...

After that initial opening, Schiff jumps off the deep end with a "print print print" rant about hyperinflation, a huge rant against Obama, talk of recovery in his funds, and finishing up with "There is no way the dollar can possibly survive what is coming."

The big thing Schiff missed this year was in his decoupling theories. Schiff invested as if the U.S. would crash and that everything else would be fine. The decoupling theory never made much sense. To believe in decoupling is to believe the tail wags the dog. And instead of saying how much his fund is up off the lows, he ought to disclose precisely how his anti-dollar fund plays are doing this year.

What happened was that although the U.S. stock market collapsed, China, India, Iceland, Japan, the UK, and numerous other places collapsed more. So when the dollar rallied on top of that, investments in those places got mercilessly hammered.

Even though the U.S. dollar index fell from 120 to 70, Schiff was still looking for a collapse of the dollar. It had already collapsed.

Schiff ignores ignoring monetary printing in China, huge bank bailouts in Europe, housing bubbles in Australia, Canada, Spain, and the UK, all bigger than in the U.S. The stock market bubbles outside the U.S. were even bigger than the stock market bubble here.

Furthermore, there has been more monetary printing in China this year than in the U.S. And as noted above China just announced the same reckless measures the U.S. did in trying to stimulate the economy. The UK and ECB are doing the same thing (bailing out banks), and the UK is arguably in much worse shape than the U.S. overall.

Finally, there were many signs the U.S. dollar were going to rally and those signs were pointed out in real time on this blog. ... For the record, I am now neutral on the U.S. dollar as the U.S. dollar index came close to hitting my target. ...

Deflationary pressures have never been greater in the U.S., UK, EU, Canada, Australia, and other countries. Collapsing debt bubbles, rising foreclosures, rising defaults, and rising unemployment are deflationary forces. And those forces are global, not just in the U.S.

Yes, the U.S. is going to print but so is everyone else. In isolation, what looks awful for the U.S., does not look so awful in relation to what every other country is doing.

This should be a good backdrop for gold and that is another point on which I agree with Schiff. Intermediate term, we could both be wrong.

And while there will be printing under Obama (by the Fed), at least that printing is likely to go for something. Money spent on infrastructure is far more dollar friendly than money used to blow up Iraq. There is also a chance that Democrats and Obama slash military spending, and if they do, it will be a dollar friendly thing.

I am not here to defend spending programs for the simply reason I do not agree with them. I happen to agree with Schiff. My disagreement is what the net result will be. Japan spent like mad and the Yen still rose. If the rest of the world spends like the U.S. does, it is certainly possible the dollar keeps rising as well. What is arguably more likely is that the dollar stabilizes within a broad range.

One thing that is for certain is that nearly everyone, especially Schiff, failed to see the deflation we are now in. And rest assured it is deflation that central bankers across the globe are fighting.

Schiff needs to get off his anti-Obama, anti-dollar mindset and take a look at the global economy and problems elsewhere, especially in China, the UK, and the Eurozone. That video proves he is not capable of doing so. It equally proves he does not fully understand the deflationary forces of Peak Credit and the global debt unwind that are happening. For a previous debate with Schiff please see Not Your Father's Deflation: Rebuttal and Peter Schiff Replies to Deflation Rebuttal.

Looking ahead, it is quite possible that if all pegs were removed and the Renmimbi allowed to freely float, that the Renmimbi, not the U.S. dollar would crash. Certainly the pound could crash (I think that is likely), and the EU might even break up.

The tremendous irony is that I happen to agree with much what he said in the video. I certainly am not bullish on U.S. equities, nor am I in favor of the programs that are likely to come out of Congress. However, when it comes to global conclusions and the U.S. dollar, I think it is a case of Hugely Right, Enormously Wrong, at least over the intermediate timeframe. After the debt bubble unwinds, then and only then will inflation become the primary threat.

DEBT TRAP DYNAMICS

Ballooning central bank holdings may stem financial system implosion, but this is a far cry from engendering a meaningful increase in either the market’s appetite for risk assets or the expansion of new system credit in the real economy.

How soon might we expect the financial system to return to some semblance of normality whereupon, e.g., certain abnormalities in the bond markets covered elsewhere on this page disappear? Using past recovery timetables as a yardstick is insufficient, as this crisis is clearly of a different character than other post-War experiences. Optimistically assuming that the massive intervention efforts by the central banks and national governments will effect a recovery, or accomplish anything other than possibly forestalling a complete implosion, are just so many ungrounded assumptions unless we have a reasonable theoretical framework that supports them.

Until positive credit growth can be reestablished we have deflation by definition. Doug Nolan notes that many of major credit growth drivers that were part and parcel to the credit bubble -- "Wall Street finance" in his parlance -- are now totally disgraced, and will not be providing any help there for a long time. They were creatures of the bubble, and they have died with the bubble. All that are left are the Fed, the federal government, the government-sponsored entities (Freddie, Fannie et al) and the banks. These credit-creation engines retain some capacity to stabilize things but, Noland notes, "All four must expand aggressively to bolster a highly maladjusted economic system, in the process sustaining confidence in the value of their liabilities. At some point, one would expect a crisis of confidence with respect to the quality of these credit instruments."

Those are our thoughts as well. As what point does the profligate expansion of balance sheets, bailouts, and guarantees cause the creditworthiness of the U.S. government and its agencies and instrumentalities to fall to the level of those they are purporting to save, and lose the effective free pass they have been granted thus far? This parallels the issue of when deflation will effectively give way to inflation -- the $64 question of the day, and for many days yet it seems.

The economy lost 651,000 jobs in three months. Auto sales have collapsed, and retail sales have "fallen off a cliff." And there is at this point little indication that credit availability will normalize anytime soon for household, corporate or municipal borrowers. While the extraordinary efforts by the Fed and global central bankers have loosened the clogged-up inter-bank lending market, risk markets remain hopelessly paralyzed. The unfolding collapse of the leveraged speculating community continues to overhanging the marketplace. Securitization markets are still essentially closed for business.

We can continue to analyze developments in the context of two overarching themes: First, there is the implosion of contemporary "Wall Street finance." Second, the bursting of the credit bubble has initiated what will be an arduous and protracted economic adjustment. Each week provides additional confirmation of the interplay between the breakdown of Wall Street risk intermediation and the bursting of the U.S. bubble economy. This process has gained overwhelming momentum.

I know some analysts are anticipating an eventual return to "normalcy." The thought is that it is only a matter of time before "shock and awe" policymaking and trillions of newly created liquidity entice investors and speculators back into risk assets. This view is too optimistic, and history offers an especially poor guide in this respect. By and large, the unprecedented growth in Federal Reserve and global central bank balance sheets is (scarcely) accommodating de-leveraging. Between the hedge funds, global "proprietary trading" and other leveraged speculators, it is not unreasonable to contemplate an overhang of (prospective forced and deliberate sales) of upwards of $10 trillion.

It is popular to label Federal Reserve operations as a massive effort to "print money." Yet it is important to recognize that, at least to this point, the expansion of the Fed assets ("Fed Credit") is counterbalanced by the collapsing balance sheets of leveraged financial operators. The inflationary effects -- the increased purchasing power created by the expansion of credit -- occurred back when the original loan was made, securitized, and leveraged by, say, a hedge fund. Today's ballooning central bank holdings (and TARP spending) may very well stem financial system implosion. This is, however, a far cry from engendering a meaningful increase in either the market's appetite for risk assets or the expansion of new system credit in the real economy.

I do not want to imply that unprecedented monetary policy measures are not having an impact. Overnight lending rates (Libor) were quoted at 0.33% today, down from a spike to almost 7.00% in late September. And at 2.29%, 3-month Libor has dropped from early October's 4.82%. Other measures of systemic risk and liquidity premiums (including the 2- and 10-year dollar swap spreads) have dropped dramatically over the past month.

The problem is that the "unclogging" of inter-bank and "money" markets has had little effect on the pricing and availability of credit for the vast majority of borrowers operating throughout the real economy. After ending September at about 650, junk bond spreads have surged to 950 bps. Investment-grade bond spreads are also higher today than at the end of the third quarter. Benchmark mortgage-backed securities spreads have changed little, while Jumbo mortgage borrowing rates remain elevated. Risk premiums for municipal borrowings have been reduced only somewhat from extreme levels. Unsound borrowers everywhere have little hope of borrowing anywhere

There are complaints out of Washington that, despite oodles of bailout funding, the banks are refusing to lend. Well, total bank credit has expanded $575 billion over the past 10 weeks, or 32% annualized. Importantly, the asset-backed securities (ABS), collateralized debt obligation (CDO), and securitization markets generally remain closed for new business.

The heart of the matter is not so much that banks are refusing to extend credit but that the entire mechanism of Wall Street risk intermediation has collapsed. After ballooning into multi-trillion dollar avenues for credit expansion, intermediation through the ABS and CDO markets is basically over. The convertible bond market has also badly malfunctioned, along with the "private-label" MBS marketplace. Wall Street's "auction-rate securities" has ceased as a mechanism for credit expansion, along with myriad other avenues for securitization. And, importantly, derivatives markets, having evolved into an essential element of contemporary risk intermediation and credit expansion, have suffered a devastating crisis of confidence. Scores of leveraged strategies are no longer viable. Indeed, monetary processes essential for funding broad cross-sections of the economy have completely broken down.

Even if banks had a desire to make the same types of risky loans Wall Street financed throughout the boom (which they clearly do not), it is difficult to envisage how bank credit could today adequately compensate for the interrelated collapses in Wall Street risk intermediation and leveraged speculation. And unlike previous crises, no amount of rate cutting, liquidity injections, or policymaker jawboning will revive leveraged speculation. That historic bubble and mania has burst, and it is now only a matter of waiting to dissect the devastation wrought by the unfolding run on the industry. A typical Federal Reserve-induced return to risk-taking in the credit markets will be stymied for some time to come by an unrivaled inventory of debt instruments overhanging the markets.

How can the system can generate sufficient new credit to keep our asset markets and bubble economy from completely imploding?

The critical issue then becomes how the system can generate sufficient new credit to keep our asset markets and bubble economy from completely imploding. Well, we can assume at this point that the Fed will continue to accommodate de-leveraging through the ballooning of its balance sheet. At the same time, the federal government will soon be running trillion dollar annual deficits. GSE balance sheets will likely commence a period of aggressive expansion. And, importantly, the banking system will have no alternative than to expand rapidly. At this point, timid banks equate to a bubble economy spiraling into depression.

If the markets cooperate, perhaps over the coming months the now breakneck economic contraction will somewhat stabilize. I fear, however, that current dynamics are setting the stage for yet another stage of this vicious crisis. Some analysts believe -- and certainly it is the Fed's intention -- for ultra-low interest rates to assist in the recapitalization of the banking system. The early 1990's provides a nice example: Aggressive rate cuts and a steep yield curve provided a backdrop for troubled banks to quietly convalesce by raising cheap deposits and sitting on a safe portfolio of longer-term government debt securities. Why can't a similar operation bail the banks out of their current predicament?

One should note the stark contrasts between today's environment and that from the early nineties. First of all, 10-year government yields averaged about 7.8% in the three years 1990 through 1992. Bond markets back then were commencing a historic bull run and, strangely enough, the price of government debt ran higher in the face of huge deficits. There are reasons these days to fear an emergent bond bear.

Second, from the Fed's "Flow of Funds" report, we know that "Total Net Borrowing and Lending in Credit Markets" averaged $770 billion annually during the 1990-92 period. "Total Net Borrowing ..." last year approached a staggering $4.40 trillion. The important point is that today's bubble economy dynamics were not in play in the early ‘90s. Sustaining the system required a fraction of today's credit creation, thus there was little prevailing pressure on the banks back then to lend amid their "convalescing."

Indeed, banking system impairment and resulting Fed policymaking engendered the emergence of Wall Street finance in the early ‘90s -- from the Wall Street firms, the GSEs, securitizations, derivatives and leveraged speculation. All were more than happy to take up the slack in bank credit creation -- signficantly helping to reflate both the banking system and the overall economy in the process.

With the bursting of the bubble in Wall Street finance, the banking system will today have no alternative than to lend and expand credit aggressively. The banks provide the only hope for reflation, and there will be no room for ‘90s-style risk-free government carry trades. Instead, it will now be the banking system's role to take up enormous systemic credit slack and rapidly expand its portfolio of risk assets. Especially at this precarious stage of the credit cycle, the banking system's predicament ensures the ongoing need for hugely expensive government funded industry recapitalizations.

In today's interest rate and market environment, massive government deficits do not worry the bond market. I view the marketplace as quite complacent when it comes to the scope of unfolding Treasury and agency debt issuance. Actually, the Treasury, the GSEs and the banking system have in concert succumbed to Debt Trap Dynamics. With Wall Street risk intermediation now out of the equation, the system is down to four principal sources of "money" creation -- the Fed, Treasury, GSEs and the Banks. It is that old "inflate or die" dilemma that has already smothered Wall Street finance.

The good news is these sources of credit creation do today retain the capacity to somewhat stabilize financial and economic systems. The bad news is that going forward all four must expand aggressively -- in collaboration -- to forestall acute systemic crisis. All four must expand aggressively to bolster a highly maladjusted economic system, in the process sustaining confidence in the value of their liabilities. At some point, one would expect a crisis of confidence with respect to the quality of these credit instruments. And, you know, the way things have unfolded, Murphy's Law would only seem to dictate a destabilizing jump in market yields.

“BUYING USED FURNITURE AND SELLING ANTIQUES”

John Osterweis, portfolio manager, seeks value with a growth kicker.

John Osterweis is a classic stock picker, and his fund's charter grants him wide latitude around what he may buy. Among his fund's current holdings are a natural gas pipeline partnership units and a special-purpose acquisition company, or SPAC, which operates similarly to a blind trust.

Companies that truly grow their value, e.g., by increasing their normalized free cash flow level, are usually rewarded accordingly in their market valuations. Going forward we suspect that that may well be one of the few paths to stock market gains still open. Osterweis's strategy focuses on buying cheap stocks favored by value managers which also have the potential down the line to catch the eye of managers who favor growth and above average returns on capital. Sounds like a good match with the envisioned market environment.

Veteran money manager John Osterweis recently rode an Arabian horse in a grueling 6-hour-plus 50-mile endurance ride around Lake Sonoma in Northern California's wine country. The pair finished 12th among 92 entrants.

"I was sore for about a week after the event," confesses Osterweis, who at 65 is tall and trim. "But it's still fun to compete, and it was exhilarating."

The portfolio chief, who has been a money manager for more than a quarter-century, runs the $300 million Osterweis Fund (ticker: OSTFX), which focuses on out-of-favor stocks. Osterweis, a former marathon runner, also is a principal of Osterweis Capital Management, which he founded in 1983 after years of working as a sell-side analyst. The San Francisco firm oversees roughly $4 billion in assets for institutions and wealthy individuals. The money is spread across separate accounts and equity, fixed-income, balanced and hedge funds.

Osterweis and his team of five veteran stockpickers seek companies with free cash flow, plus dividends and stock buybacks. He uses a go-anywhere approach that cuts across stocks of all sizes. The fund usually has 35 to 40 holdings, and its annual investment-turnover rate is around 50%.

Says Osterweis: "We try to identify companies that would certainly be only regarded as value, but where there is some catalyst that will enable the company to transform into a growth company. It is a bit like buying used furniture and selling antiques."

In good and tough market climes, Osterweis's strategy has served the fund well. Even though it lost more than 15% in the 12 months through September 30, that was still better than about 2/3 of its mid-cap-blend peers and market proxies like the Standard & Poor's 500 index, which was down 22%. And over three, five and 10 years, the fund generated gains of 0.66%, 8.15% and 11.77%, versus 0.22,%, 5.16% and 3.06% for the S&P. Since its inception on October 1, 1993, the fund has returned 11.57%, compared with the 8.39% generated by the benchmark average.

The big margin versus the S&P over 10 years (8.71% annually) compared with 5 years (a good but relatively smaller 2.99%) undoubtedly reflects the huge outperformance of value stocks during 2000-2003 as compared to growth stocks. Value managers severely lagged during the late stages of the 1990s tech/internet stock mania, but more than made up for it after the mania fever broke with a vengeance. The fund's top 10 holdings, which comprise 34% of the fund's portfolio, may be found here.

Russel Kinnel, mutual-fund research director for Chicago-based fund tracker Morningstar, calls the Osterweis Fund "a hidden gem...with a great track record that still has a small enough asset base to provide years of growth potential." Morningstar gives the fund five stars, its highest ranking.

A good example of the kind of stock that Osterweis favors is Crown Holdings (CCK) [formerly Crown Cork & Seal], his fund's fourth-largest holding. He bought shares of the beverage-can maker in 2004, when they were under $9 and the company was struggling with a huge potential asbestos liability and rising commodity costs. The stock is now around 20.

What Osterweis and his team detected was a leading company in a consolidating industry that was headed toward stronger pricing power. "We saw that the industry had really evolved into an oligopoly, where the can producers were beginning to regain pricing power," he says. "While it was not a rapid-growth business, Crown's market share and pricing power were improving, and its asbestos liability was diminishing. We saw the company evolving into a growth stock."

It proved to be a savvy pick. He says that Crown, which has a market value of $3.2 billion, remains attractive today, with annual revenue and free-cash-flow growth of 5% and 25%, respectively. Osterweis cites consensus estimates that Crown will earn $1.67 a share in 2008 and roughly $1.93 in 2009.

Another buy was spirits producer and marketer Diageo (DEO), whose brands include Guinness, Smirnoff, Johnnie Walker and Captain Morgan. He added Diageo to his portfolio in October 2003, when it was changing hands at under 40 a share. It now is in the low 60s.

"When we bought it, people regarded it as a hodge-podge of businesses with relatively poor management and no growth," Osterweis says. "What attracted us was that new management came in and essentially streamlined the company. They focused harder on the liquor and beer segments, dumped Burger King, and started buying back the stock pretty aggressively. It was subsequently cleaned up, polished and transformed into a terrific company with a global focus."

He considers the stock, which is trading at about 15 times fiscal 2008 earnings and 13 times next year's predicted net, attractive.

Osterweis's fondness for growth sometimes leads him toward investments that are far from plain vanilla. This year, he put more than 3% of the fund's assets into Trian Acquisition (TUX), a special-purpose acquisition company, or SPAC, similar to a blind trust, managed by billionaire investor Nelson Peltz and money manager Peter May.

Peltz and May have a history on Wall Street. See this early 2007 article from Fortune, "The Reinvention of Nelson Peltz."

SPACs are set up simply to acquire companies, public or private, and they charge investment fees that can be hefty. But Osterweis saw Trian as an "exciting opportunity" and a smart defensive play. It probably will buy a company in the food or packaging business. If a deal is done, unit holders like Osterweis will receive a stake in the new company. If no transaction materializes, they get their money back, with interest. "It is like cash that could turn into an equity stake in a company run by superb investor-managers like Peltz and May," he says.

The Osterweis Fund's flexible charter allows investment in such entities. "We wrote our prospectus with the broadest mandate possible," says the portfolio manager. "It is more honest and less inhibiting."

This past July, Osterweis bought shares of Lab Corp of America (LH) because of its "attractive valuation and unrecognized growth potential." The company, which runs diagnostic and testing labs around the country, recently was trading at 13.5 times its expected 2008 earnings of $4.59 a share and 12.2 times 2009's estimated $5.10. Revenue is growing at 5%-plus annually. "We expect consistent growth even in a weak economy," Osterweis says.

Another company that he expects to fare well, irrespective of the economy, is HealthSouth (HLS), which runs in-patient rehabilitation hospitals. "Even in a down economy, people are going to continue to get strokes and break their hips and need hospital rehab," Osterweis says. The stock, which is currently trading around 12, has slid by about 40% since October 1, in the market's general downturn. In the money manager's opinion, it has become attractively valued against its peers.

The company is expected to generate adjusted free cash flow of about $1 a share this year and $1.30 next year. "And we think earnings and free cash flow will grow pretty steadily over the next few years," Osterweis says. He thinks HealthSouth could double or triple in the next 12 to 18 months.

The Osterweis Fund's 2nd-biggest holding is Websense (WBSN), which has generated a cumulative return of 30%-plus since it entered the portfolio in June 2004. The company develops and sells software that helps companies keep their Internet connections secure. Websense, which is launching several new products in 2009, is expected to make $1.36 a share this year, versus 90 cents in 2007, and its net is likely to hit $1.55 next year. The stock is at around 20.

In energy, Osterweis holds pipeline partnership Magellan Midstream Holdings (MGG), whose distribution growth of 8% to 10% annually should drive 20%-plus profit growth. Osterweis sees Magellan earning $1.40 a share this year, versus 98 cents last year.

He also likes natural-gas producer Questar (STR), which he considers undervalued relative to its expected annual average revenue and earnings growth of 15% and 20%, through 2012. Per-share profits should hit $3.70 a share this year, versus $2.86 in 2007. And demand for the clean-burning fuel is likely to keep rising.

When he is not at work, Osterweis frequently can be found palling around with his equine friends -- mostly Arabians -- on his small ranch about an hour's drive north of his San Francisco office. "Riding is great," he says. "It helps me maintain my perspective in volatile markets." These days, that is especially important.

THE GREAT BOND MARKET CRASH OF 2009

There are a number of reasons why Treasury bond yields and the yield curve in general are likely to rise sharply in 2009.

Martin Hutchinson is not buying, from what we can tell, the idea that we are in a real deflation. He predicts that the massive issuance of debt by the federal government and the emergence of higher inflation will at long last cause Treasury yields to rise from their current low levels. If the rise in the yield curve is a percentage point or more the loss in market value of government debt holdings will be huge, making the losses to date in subprime mortgage credits and even the stock market seem small by comparison. The "safe haven" of government debt will be revealed to be other than that.

Investors have spent the last few weeks bemoaning the devastation to their portfolios caused by the stock market downturn, which if it does not produce recovery by year-end will have made 2008 the worst stock market year since 1937. Their misery would be compounded if they knew that next year, while it may avoid more than moderate stock market mayhem, is likely to produce the worst bond market carnage in U.S. history.

By bond market carnage I am not referring to carnage in the market for securitized subprime mortgages, defaulted credit card receivables, Russian subordinated debt and Venezuelan trade paper. That has by and large already happened, although only a portion of the losses in those markets have already been admitted to -- no more than $600 billion of the eventual total of perhaps $2.5 to $3 trillion in losses.

The rest of the market is taking Blackstone's Steven Schwarzman's approach of demanding that "market to market" accounting rules be reversed immediately. Tough, guys, you were happy enough to have the spurious mark-ups from "mark to market" in good years, which enabled you to pay yourselves fat bonuses without actually having earned anything. It is only fair that the inflated prices at which your portfolios were valued at the top of the bubble should be marked down to reflect the new and unpleasant reality.

Next time, perhaps we can stick to the old rule that assets do not get marked up in value until they are sold, but that clear impairment in value results in a markdown. It will mean fewer bonuses for Wall Street traders, but never mind, they would only have to pay them all away in taxes -- making Wall Streeters pay more tax was the principal "change" President-elect Obama and his supporters have been calling for. British experience in 1973-75, long before "mark to market" had been thought of was that eventually all excesses in financial institutions' balance sheets must be paid for, and that once recession hits it is quite possible to go bankrupt while presenting a balance sheet of unspotted solidity to the unsuspecting public.

The $2.5-3 trillion loss from value impairment of junk debt is however less than the value impairment that can be expected in the next year from the decrease in value of Treasury bonds and other prime quality debt. This prime debt has been used as a "safe haven" by investors for the last 20 years, and it is nothing of the kind.

Currently the 10-year Treasury bond yields a pathetic 3.78%, well towards the low end of its long-term historic range and well below the U.S. inflation rate of about 5%. Including the housing finance agencies Fannie Mae and Freddie Mac debt of about $5 trillion (which is now explicitly government guaranteed) and the $4.3 trillion held in the social security trust fund, there is about $15.6 trillion of U.S. federal debt, a total that increased by over $1 trillion in the year to September 2008 and is increasing even more rapidly currently. Add about $9 trillion of home mortgage debt and $6 trillion of high quality corporate debt (and ignoring debt of financial institutions, which can be expected to be largely matched against other debts) and you have a total outstanding amount of $30 trillion of debt subject to interest rate risk, excluding the junk and near-junk that is currently in the process of defaulting.

There are a number of reasons why Treasury bond yields and the yield curve in general are likely to rise sharply in 2009:

• Borrowing requirements. Treasury borrowed over $1 trillion in the year to September 2008. It is expected to borrow close to $2 trillion in the year to September 2009. That is 13% of U.S. GDP. Not all of this is deficit; about $500 billion is refinancing and another $500 billion is for bailout schemes, some of which the U.S. taxpayer may eventually see back. Still, in terms of GDP that is far more debt than the U.S. capital market has ever been asked to absorb, other than during World War II. At some point, "crowding out" must occur. We certainly cannot assume that Asian central banks will want to take the entire load, at interest rates less than zero in real terms.

• Inflation. The Fed appears to believe that the current recession will bail the United States out of its inflation problem. The example is given of Japan in the late 1990s, after which the Fed explains that they will avoid the mistakes of the Bank of Japan, thus preventing damaging deflation. Actually that seems to be wrong on two counts. The main mistake in 1990s Japan was not monetary but fiscal. Government spending was allowed to expand inexorably, producing ever larger and larger deficits. That mistake appears to be only too likely to be repeated here. The difference is that the U.S. currently has a 1% Federal Funds rate and 5% inflation, the approximate opposite of Japan in the early years of its slump. With M2 money supply (the one the Fed will divulge) up at an annual rate of 18.3% since the beginning of September it seems likely that inflation will accelerate -- as it did in the recessions of 1973-74 and 1979-80.

• Rising real rates of return. The yields on Treasury Inflation Protected Securities have already risen from just over 1% to nearly 3% since the beginning of 2008. Given the excess of bonds coming to the market, it makes sense that real yields should rise. That in itself suggests that conventional Treasury bonds are hopelessly overvalued -- with the 10-year TIPS yielding 2.82% and the 10 year Treasury 3.78%, the implied rate of U.S. inflation over the decade to 2018 is 0.96% per annum, for a total rise in prices by 2018 of less than 10%. If you think that is likely, I can get you a deal on Brooklyn Bridge!

Thus Treasury bond and other prime bond yields can be expected to rise sharply in 2009. This will cause losses to their holders. To the extent that such holders are foreign central banks, the U.S. probably does not need to worry. Foreign central banks have been gentlemanly holders of U.S. debt through periods such as 2002-08 when the dollar has depreciated. A rise in interest rates simply gives them another way of making a loss. Personally if I were the Chairman of the People's Bank of China and Treasuries had lost me the kind of money they have in the last five years I would probably declare war on the U.S., but fortunately central bankers are a phlegmatic and tolerant lot!

However domestic holders are a more serious problem. To the extent that pension funds have losses on their holdings of bonds, they will need to raise contributions. To the extent that insurance companies have such losses they will need to raise premiums. Some entities will be hedged, but by doing so they will have simply transferred the interest rate risk to somebody else; by definition of derivatives the total outstanding derivatives position must be zero, however large the individual positions taken.

Assuming the $30 trillion state, mortgage and private corporate debt outstanding has an average duration of 5 years, a fairly conservative assumption, and neither the shape of the yield curve nor the premiums payable for risk alter significantly by the end of 2009, a 1% rise to 4.74% in Treasury bond rates by December 2009 would cause a total loss to investors in the $30 trillion of Federal, agency, mortgage and prime corporate debt of 3.9% of the debt's principal amount, or $1.17 trillion. Not as bad as the credit losses.

However once rates start rising, they are likely to rise much more than 1%. To cause a loss of $3 trillion, the same as the estimated credit losses, 10 year Treasury bond yields would have to rise to 6.43% ... hardly an excessive assumption. 10-year Treasuries yielded 6.44% on average during 1996, at the beginning of the Fed's money bubble, in which year inflation was 3.4%.

More extreme moves are certainly possible. In 1990, 10-year Treasuries yielded an average of 8.55%, while inflation in that year was 6.3%. A rise in the yield curve to an 8.55% 10-year Treasury yield would cost investors $5.06 trillion, almost double the credit losses from subprime and its brethren. Should we revert fully to the days when Paul Volcker was Fed Chairman and get the 13.92% 10-year Treasury yield of 1981, a year in which inflation was 8.9%, the cost to investors from the interest rate rise alone (we can assume a few additional bankruptcies, I think) would by $9.33 trillion, about 2/3 of the current value of common stocks outstanding and more than three times expected credit losses.

One can debate the probability of the various outcomes above. Inflation is already around 5% and is unlikely to drop much, so the 1996 estimate for the peak 10-year Treasury yield would seem low. On the other hand, while inflation could well reach 8.9%, it seems unlikely that we will need to push Treasury yields quite up to 1981's Volckerian levels, at least not within the next year. So the 1990 estimate is perhaps the best, involving a loss to investors of around $5 trillion or a little over. Such a loss will produce fewer calls for bailouts than the $3 trillion credit losses, but just as much economic damage, albeit much of it unnoticed by the general public.

And it is still ahead of us!

Investment-Grade Corporates Bonds May Offer Stock-Beating Returns

The stock market is priced for a recession, but the bond market is priced for a depression.

We, like most investors we regularly communicate with, are equity-oriented. Bonds are a related but different game, and most of the time a less interesting one in our view and by the dictates of our temperament. There is also bonds’ “guaranteed certificates of confiscation” reputation that we have a hard time shaking out of our brains, even if it is no longer strictly valid.

However, we cannot ignore reports we keep hearing from credit analysts and bond fund managers that some extraordinary investment opportunities are showing up in the non-government bonds market during this credit crunch.

Stocks averaged an 18% or so annual average total return during the 1982-2000 bull market. (Most market participants earned far lower returns due to their inability to sit still -- a separate story.) That was an anomaly and people should lower their sights going forward. In the old days achieving a consistent 12% return via stock picking was justifiably thought to be outstanding. Today single-A and triple-B corporate bonds are yielding 10% to 12%. That definitely gets our attention.

As does this: At bear market bottoms, stock earnings yields -- the inverse of the P/E multiple -- are often greater than low-end investment grade corporate bonds. Look at this table:

At major market bottoms 1932 and 1974 the S&P 500 earnings was notably greater than Baa corporate bond yields. At the 1982 major cyclical stock bear market low, which was accompanied by bond yields still close to their all-time highs of late 1981, the S&P earnings yield was slighly lower than those of corporates. Today, based on a conservative estimate of earnings, stock yields have a little ways to go to catch Baa bonds. Of course much depends on just how "conservative" today's earnings estimates turn out to be in light of the upcoming year's results.

Note that whatever pundits may be claiming, and whatever the individual values that are surfacing, the overall market is not that cheap today, absolutely speaking, compared with previous major market bottoms. Given their senior claim on company earnings, bonds offer more downside protection than stocks while offering a pure yield-based return that is entirely acceptable. Worth considering.

The stock market is priced for a recession, but the bond market is priced for a depression. So says Rob Arnott, the brainiac who heads Research Affiliates, an institutional advisory.

That is not hyperbole. Corporate bonds rated Baa or BBB, the low end of investment grade by Moody's and Standard & Poor's designations, offer the biggest yield premium since the early 1930s, notes RBC Capital Markets.

That is a problem for pulling the economy out of the credit crisis, but an opportunity for investors. Indeed, investment-grade corporates with near-record premiums arguably offer better return potential than common stocks, especially relative to their risks. "I have not seen this many markets offering double-digit opportunities since 1989-90 or ever so briefly in 2002," says Arnott.

Part of it reflects the sheer weight of numbers. Corporates rated Baa yield about 550 basis points (5.5 percentage points) more than comparable Treasuries, nearly half again the spread in the 2002 post-WorldCom-Enron debacle and twice the average of post-war recessions.

You have to go back to the early 1930s, when Baa corporates yielded 700 basis points over Treasuries, to find a comparable situation. And notwithstanding all the hyperventilation in the media that this is worst financial crisis since the Great Depression, there has never been such a full-court response to the threat of debt deflation -- the $700 billion TARP, the bailout of Fannie Mae and Freddie Mac, the likelihood of trillion-dollar deficits and a doubling in the Federal Reserve's balance sheet in just over two months.

Whether this is the road to enlightenment or perdition is a question I will leave to others. It is what it is. All of Washington's horses and all of its persons are arrayed to prevent the 1930s from happening again, for better or worse. This suggests that corporate bonds should not be priced as if it were.

Part of the problem is that prices are being depressed by sellers in an illiquid market. The last quote on $100,000 bonds will determine the value of a $1 billion issue, depressing the remaining $999.9 million.

That has produced much pain for corporate-bond investors, such as Dan Fuss, the market veteran who heads the Loomis Sayles Bond Fund (ticker: LSBRX) and also is its biggest shareholder. So he has been hit by the 25.9% year-to-date negative return, according to Morningstar.

The Loomis Sayles Bond Fund yields 9.78% on a portfolio that is primarily invested in what Fuss deems the sweet spot of the market -- single-A and triple-B corporates yielding 10% to 12%. About a quarter of fund is in junk bonds, where he is picking up yields upwards of 18%.

More importantly, Fuss says, these yields are on deeply discounted bonds. So, buyers of these bonds, which are selling for 60 or 70 cents on the dollar, will participate in their eventual recovery, earning capital gains along with hefty current yields.

"I prefer discount bonds to admittedly cheap equities," especially as corporations delever and rebuild balance sheets, he continues. The best use of corporate cash now may be to buy back bonds at discounts, effectively discharging debt for pennies on the dollar, Fuss says. It is a reversal of the past quarter-century, during which companies took on debt to do leveraged buyouts or repurchase stock.

That is happening, but because of the nature of the corporate market, it is a poker game with companies not wanting to tip their hand. That would immediately boost the prices of the bonds they want to buy on the cheap.

Meanwhile, the stock market has not fully priced in the likely decline in earnings ahead, according to Michael T. Darda, chief economist of MKM Partners in Greenwich, Connecticut. At major market lows, stocks' earnings yield (the inverse of the price-earnings ratio) exceeded or almost equaled that of Baa corporate bonds.

Even based on conservatively estimated 2009 earnings on the S&P 500 of $68.50 -- about a quarter less the Wall Street consensus -- the S&P trades at a P/E of 12.4. That is an 8.06% earnings yield, 86% of the 9.39% Baa corporate yield.

In 1982, the S&P bottomed at a 6.6 P/E, a 15% earnings yield, close to the 16.3% on Baa corporates. In 1974, the 7.9 P/E resulted in a 12.7% earnings yield, well over the 10.5% Baa yield. In 1932, the 5.6 P/E equated to 17.9% earnings yield, more than half again the 11% Baa yield.

Fuss also opines that investors increasingly will be starved for yield, which will force them out of Treasuries and into riskier but vastly more remunerative corporates.

Interest rates are likely to continue to fall, with the futures market pricing in another half-point cut in the fed-funds target, from 1% currently, after last week's seemingly endless parade of horrible economic numbers. The yield on the benchmark 10-year Treasury note dropped 18 basis points, to 3.78%, but the market was under pressure late in the week amid worries about the federal government's record borrowing needs.

Seeking Converts

John Calamos has been trading convertible bonds for four decades. He says he has never seen them so cheap.

Convertible bonds are a specialty niche of the investment world that we have generally had a hard time wrapping our arms around. Most of our recollections are of owning bonds of companies we were not particularly interested in on the basis that the yields were decent while the embedded warrant was undervalued in theory. Or something like that. But some who have devoted a lot of effort to the specialty have done quite well, such as John Calamos. And Calamos claims converts as a group are cheaper than he has ever seen.

Indeed, as elsewhere in the credit markets (see article immediately above), the dislocations from the credit bubble collapse have caused some what can only be deemed irrational anamolies. For instance, when a company's convertible bonds yield more than its straight debt, the only explanation that makes sense is that the market expects the company to go bankrupt, in which case the option to convert will not be worth anything and the straight debt's senior status in the credit cue will be valuable. But then the two bonds issues' yields should be junk-like, not investment grade-like; yet it is the later which prevails. Ergo, the market's pricing does not make sense. The anamoly may reasonably be projected to disappear when order returns to markets ... whenever that may be.

Reflecting the chaotic path which led to the current state of affairs in the converts market, convertible bonds in aggregate have fallen almost as far -- by one measure -- as the S&P 500 itself. Things are not supposed to work that way. As a company's stock falls, the value of the option to convert a convertible bond issue into the stock of course also falls. But then the yield and superior creditworthiness of the convert issue are supposed to kick in and cause it to decline less than the stock. This is not some head-in-the-clouds theory that markets are always efficient and liquid, a la the credit derivatives market until recently and portfolio insurance strategies ca. 1987. This is in fact how markets have worked in practice. Until now. Extraordinary times.

John Calamos launched his career and built the foundation of a $1.7 billion fortune trading convertible securities. Now 68, and with 38 years in the business, he says converts have never been such a deal.

"This is the most undervalued I have ever seen the market," he says. "It's unbelievable."

Convertibles are bonds or preferred shares that entitle owners to convert them into common shares if they feel so inclined. Most converts are issued by small or midsize firms seeking to borrow at low interest rates. If the issuer's stock does well the bond will be converted, diluting common shareholders. But that is not too harsh a penalty for success, figures the issuer, which in the meantime enjoys a coupon a few points below what might have been paid on straight debt.

And if the issuer gets into trouble? In bankruptcy, convertible bondholders get paid back after straight bondholders but before equity investors. The fixed interest payment gives the convertible a minimum value, even if the common share price sinks after the convert is issued.

The bear market, which has killed both stocks and junk bonds, has, not surprisingly, been unkind to converts. The Lehman Aggregate U.S. Index, which tracks straight investment-grade debt, has a total return since January of 0.1%. The Merrill Lynch convertible securities index is down 37% -- nearly as bad as the S&P 500's 38% fall (including dividends).

Calamos sees converts as innocent victims of a liquidity squeeze. Until recently convertible bond arbitrage was a big hedge fund play. Funds would go long converts and short the underlying stock, pocketing the bond yields while staying neutral in the equity. The trade became so popular that it accounted for 80% to 85% of the $315 billion in convertible securities trading volume in June, before the market crashed.

In September, however, the arbs got slammed when skittish bankers called in loans, forcing many to bail out. The selling reached a crescendo when hedge fund investors ramped up redemptions and Lehman Brothers flooded the market with its holdings to raise cash. Then the Securities & Exchange Commission temporarily banned short-selling of financial stocks in September, putting hundreds of convert plays off-limits to the arbs.

Calamos himself got caught in the crossfire. His Calamos Convertible Fund, 74% in convertible bonds and 7% in convertible preferred shares, is down 31% so far this year. Calamos Asset Management's (NASDAQ: CLMS) own stock has lost 72% of its value.

The son of a Greek immigrant, and a pilot on observation planes in the Vietnam War, Calamos became a stockbroker fresh out of the service in 1970. With a bear market and inflation raging, he began putting clients into converts to earn income during the hard times and position them to profit from a rebound.

At night he earned an M.B.A at the Illinois Institute of Technology. In 1977 he set up his firm to focus on converts. The Black-Scholes options pricing model was new, and Calamos (like his rivals) used it to value the conversion option. Operating out of the suburban Chicago town of Naperville, near where he grew up, Calamos remains one of the largest convert managers, with $33 billion under management.

His model tells him today that converts are on average trading 8% below fair value. And that fair value assumes stocks are worth only what they are trading at today, not the much higher prices they were trading at a year ago.

Convertible bond market routs are often followed by strong recoveries. In 1990 Merrill Lynch's convertible securities index fell 7%, before returning an average of 24% annually over the next three years. In 1994 the index fell 6%, then averaged a 20% annual rise over the next three years.

Given the recent selling frenzy and drop in equity values, many converts are way out of the money and trading as if they were straight bonds -- trading, that is, on the strength of their coupons and redemption values. That means you get the embedded stock option -- a long-shot bet that the common will do well -- for next to nothing.

Drugmaker Amgen (AMGN) has straight bonds, rated A+ by Standard & Poor's, maturing in 2014 and trading at 88 cents on the face-value dollar to yield 7.2% to maturity. Amgen converts maturing in 2011 are trading at 84 cents for a yield to maturity of 7.8%. With the latter you get a warrant on Amgen's stock at $80. True, with three years to run and Amgen common at $50, that option is not worth a lot. But the option is surely not worth a negative sum. The convert is callable (at 100), but that option on the part of the issuer reduces its value by only a smidgen.

Straight bonds from oil and gas rig maker Transocean (RIG), rated BBB+ by S&P, are selling for 93 cents. They carry a coupon of 5.25% and a yield to maturity in 2013 of 7.1%. A Transocean convertible bond that matures in December 2037, also rated BBB+, is trading at 81 cents. Transocean's stock would have to more than double to make a conversion profitable. But even if it does not, the convert probably will not disappoint long term. Because a put feature enables investors to sell it back at par in 2010, its yield to put is 12%.

Unless you are a real gambler, or plan to buy several converts, the best bet is a low-cost convertible bond fund (see table at end of article). Vanguard's convert fund charges 0.8% a year and is down 33% in 2008. Calamos has reopened his Convertible Fund. It charges a front-end 4.75% load and expenses of 1.1% a year.

Industrial Bond Yields Strongly Support Deflation Thesis

Mike Shedlock provides convincing evidence that, contra Martin Hutchinson above, deflation is the dominant force right now. Treasuries and AAA rated corporate bonds have done well. Lower rated bonds not so well. Stocks we all know about. This is consistent with rising default risk, which is what one should expect during a deflation and not expect during disinflation (falling but positive inflation) or accelerating inflation.

Sherlock Holmes informed us that when you have eliminated the impossible, whatever is left must be the solution. What is left is deflation.

As one might expect in a credit crunch, default risk is rising. One measure of that risk is corporate bond yields. Let us take a look and see how various grades of bonds are performing.

Charts of the Bloomberg AAA Rated Industrial 10-Year Bond Index, the Bloomberg A Rated Industrial 10-Year Bond Index, the Bloomberg BBB Rated Industrial 10-Year Bond Index, and the Bloomberg B Rated Industrial 10-Year Bond Index are shown.

As you can see, only AAA rated bonds are performing well. This is strong evidence that we are not in a period of "disinflation" as some claim. In a disinflationary environment, one would expect risk premiums to drop, not rise. Action here is consistent with rising default risk, which is what one should expect in deflation.

Those harping about prices of consumer goods, food, services, etc., are missing the boat about what deflation is and what one should expect in deflation. Trillions of dollars of debt are being wiped off the books via bankruptcies and foreclosures while inflationistas worry about the price of eggs going up by 35 cents. It is truly mindless.

The above chart sent by my friend "BC" is quite telling. It shows risk premiums of Baa rated bonds over 3-Month T-Bill rates going all the way back to 1934. This spread is at an all time high. Otherwise, the highest points on the chart are during the Great Depression and the stagflation period in the '70s and '80s.

So which one is it, Stagflation or Deflation? This is where it pays to evaluate more than one indicator at a time. To resolve the question, one needs to look at other factors such as the treasury yield itself.

The idea of stagflation is simply not consistent with falling treasury yields, especially 30 year bond yields near 4%. Disinflation is consistent with falling treasury yields as is deflation. However, as noted above, rising corporate bond yields are not consistent disinflation. And finally, inflation is not consistent with collapsing 30 year bond yields.

One cannot cherry pick data, one needs to look at all of it and see where the preponderance of the evidence is. In addition to the above charts one must also consider collapsing commodity prices and a collapsing stock market, both of which are consistent with deflation. Periods of disinflation are where the equity markets make the greatest gains.

Inquiring minds should also consider Parents Pull Kids From Day Care (And Other Deflationary Topics) for a look at base money supply and how that supports the deflation thesis.

Thus the data are crystal clear. We are not in a period of inflation, we are not in a period of stagflation, we are not in a period of disinflation.

If you exclude all the options proven to be impossible, the remaining option no matter how unlikely it may seem at first glance, must be the correct answer. That answer is deflation. We are in it, and have been for some time.

“RESCUE” IS NOW OUT OF CONTROL

The bailout process has become too dispiriting – if not to say too horrifying – to watch.

Rick Ackerman finds finds he has to avert his eyes from the out-of-control bailout process. The actions themselves make no sense, and "Paulson, Bernanke and Friends" have no clue. We heard Nancy Pelosi defending the bailout proposal for the auto-makers on the radio last week ... or was it the week before? We had to avert our ears.

At the rate Goldman Sachs shares have been falling lately, they could reach our $29 "hula target" by Thanksgiving. Barely a week ago, we predicted a plunge to $29 when GS was trading above $90; yesterday (November 12) the stock hit $64. At the time, we vowed that if the forecast did not pan out, we would don a grass skirt and dance the hula in Times Square in the middle of Feburary. So far, and unfortunately for Goldman's shareholders and partners, we have not had much cause for worry.

The $29 projection was purely technical, based on Hidden Pivot analysis. But you do not have to be a chartist (chart here) to see that Goldman's survival issues will only grow more challenging. If you merely ponder what the firm was doing to make profits by the tankerful a year ago, you would have to wonder how they will make their money now; for the firm was operating at the very center of a smoke-and-mirrors business that no longer exists. We do not doubt Goldman can survive and make a profit. However, in the deleveraged financial environment that now exists, and which will probably continue to exist for at least a generation, we would be surprised if they can make even 1% of what they made in their halycon days as a global wheeler-dealer.

Meanwhile, there can be little doubt that Paulson's latest ditherings contributed to the whack that financial stocks took yesterday. We should come right out and say it, since the mainstream media probably will not: Paulson, Bernanke and Friends have lost control. Yes, they have. As much should have been obvious to anyone tuned to Paulson's speech yesterday. Turns out he is no longer keen on buying up bad mortgages; instead, he now wants to pump credit money into the consumer economy. Just what we need: more consumption with more borrowed dollars. And this time with no housing as collateral. What a complete idiot! Can anyone in America -- other than homebuilders and Kudlow, perhaps -- be fooled into thinking that cajoling consumers into taking on more debt is somehow the answer to our problems?

And how about the banks' new go-easy policy on mortgage deliquents? That is about as effective a way as you could devise to bring the housing disaster to a quick and catastrophic end, since it gives the waning majority who are current on their mortgages an incentive to skip a payment or two in order to qualify for whatever aid might be coming down the pike. We will not even get into the tragicomic drama occurring on the legislative side, as Pelosi et al duel with a lame-duck President over "saving" the automakers. Would $100 billion more in loans produce, even in 10 years, Chevys and Fords that the whole world would want to buy? Maybe. But we surely would not bet on it, especially since the competition will not exactly be standing still.

The bailout process has become too dispiriting -- if not to say too horrifying -- to watch. The thing has gone out of control, and everyone knows it.

FEED THE WORLD – AND BOOST RETURNS

Donald Coxe is convinced that we are in the midst of the greatest commodities bull market of all time. His hunger: food.

We have not previously had the privilege of encountering the work of Donald Coxe, and it sounds like that is our loss. Coxe has apparently helped his mostly institutional followers "anticipate some of the biggest shifts in markets, be they in stocks or commodities." His major calls and points in this interview with Barron’s:

• Investing in developing markets works as a concept only when the overall population and middle class are growing, and there is a high savings rate.
• This is not a time to be in a hurry to commit large amounts of money to the equity market. Stocks are cheap, but can get much cheaper. However ...
• Certain stock groups tied to increased consumption of food -- fertilizer, seed, and farm equipment stocks -- are trading at 1974 bottom-like multiples while tying into Coxe's favorite investment theme.
• He also likes energy, gold, and base metals.
• Watch the TED spread (T-bill vs. Eurodollar yields) closely. That is a reliable indicator of system stress.

On Coxe's bullishness on gold stocks, contra Al Martin above: "A period of massive reflation always leads to a good move in gold."

Once a week, loads of institutional investors drop whatever they are doing to tune in to Donald Coxe's strategy conference calls. Small wonder. With a keen sense of history and wry sense of humor, Coxe has helped his followers anticipate some of the biggest shifts in markets, be they in stocks or commodities. As global portfolio strategist for BMO Financial Group, a Toronto-based bank that is among Canada's largest, he now sees real hope for two sectors that have been taking poundings: banks and commodities. Though he launched the Coxe Commodity Strategy Fund this past summer, right before commodities took a nose dive, Coxe remains convinced that we are in the midst of the greatest commodities bull market of all time. For his reasons, please read on.

Barron’s: What is your take on the monetary scene?

Coxe: The Fed has doubled the debt on its balance sheet in five weeks. We do not know how long they are going to be carrying out these policies, which would send Milton Friedman spinning in his tomb. On the other hand, they had to do it. I challenged groups this week, saying, if I had said to you a year ago things will be so bad that the Fed will double its balance sheet in five weeks, would any of you have ever invited me back to speak to you? And, of course, the reaction was the same: Clearly you are stark raving mad.

Are the economic prospects any better in Europe?

The Europeans had thought it was an American problem, but European banks have lent a vast percentage of their capital to these Slavic countries, with even worse demography than Europe. Emerging markets are such a powerful asset class because each generation is bigger than the next, and there is an increasing middle class and a high savings rate. That is the stuff of real economic power, and a terrific investment concept. By contrast, in the OECD countries, each generation is just 60% of the predecessor generation, there is no growing middle class and there is a zero savings rate. The formula across the OECD is for sluggish growth at best.

How should investors approach today's stock market?

If you are not deeply in the equity market, this is not a time to be committing large amounts of money. Stocks are cheap but they can get cheaper; we know that. We got back to the Dow having a multiple of 5.9 in December of 1974, which was the foundation of Warren Buffett's wealth because he started buying at that level. The Dow is not anywhere near 5.9 [its multiple last week was 11], but some of my favorite stocks are trading at lower P/Es than that. I can tell you they are the fertilizer, oil and agricultural companies.

Buffett was already wealthy by December 1974, and he started buying much earlier than the bottom. Whatever.

Tell us some more about those industries.

The core investment concept of our time is that we are living through the greatest simultaneous effervescence of personal economic liberty in history. When people go from abject poverty to dwellings with indoor plumbing, electricity, basic appliances and access to motorized transportation, they have more economic liberty than 99% of humanity enjoys and we are adding 50 to 150 million people a year to that list. The gigantic investment returns are all going to be tied to companies that meet real human needs and do it better than other companies. What a great time to be an investor, because it is not just about the dwellings and the transportation, it is about the high-protein diet. When I came back from a trip two years ago, I said the biggest commodity story is going to be food, bigger than the other ones. It is high-protein food. The way to play that is through the fertilizer stocks, the genetically modified seed stocks and the farm-equipment stocks. [Coxe would not recommend specific companies, citing his firm's compliance restrictions.]

What are the big trends in food consumption?

If you look at areas under cultivation, wheat has only gone up in hectares a little bit in a decade. Rice is flat in a decade. Meanwhile, our need for protein has gone up dramatically because people are consuming more beef and pork. But more important than oil in this decade is milk. In rural India, the kids are getting animal protein and they are going to be physically stronger than their parents. Their brains are going to be better.

But there is still a serious global food shortage.

Until four months ago, when you Googled "global ‘blank‘r crisis" it was the global food crisis. The global food crisis was our big theme. The global financial crisis has pushed the food crisis off the front page at a time when people are actually getting together to say, "How do we deal with this problem?" We have an enormous challenge, but we also have the technology to increase farm productivity. Investors who invest in this are going to make a lot of money, and they do not have to apologize to anybody for doing it. If it had not been for [the development of genetically modified crops], corn would have gone to $10 a bushel [instead of a recent high of $7.50] and we would have had another 100 million people starving. This is a great investment theme.

Which commodity groups do you like best?

Agriculture is first. We will need more fertilizer. There are only three farm-equipment companies of any size in the world. Terms of entry are difficult. You have to have dealerships. CNH Global [CNH] is one of the top three companies in the world in the field. It is a subsidiary of Fiat and its stock has collapsed, but earnings have not collapsed. In May it sold for $45 a share. It is $17 now. The next group has to be gold stocks. A period of massive reflation always leads to a good move in gold.

Next?

The third group is energy. Despite Obama's plan to spend $150 billion on alternative energy, each year we still lose 4.5 million barrels of oil a day that we have to replace. Oil is trading now at $61 a barrel, but oil for delivery in 2015 is trading at over $90 a barrel. Those with reserves in politically secure areas of the world will do well. Venezuela could solve a large part of the world's energy needs, but not under the current management.

How about base metals?

Those stocks are selling for pennies on the dollar. Take BHP Billiton [BHP]. It was $95 in May, it recently fell to $30, but it is back up to nearly $40. This is an unrivaled set of assets, a great balance sheet, top-notch management and no scandals.

Is copper worth a look?

Copper is now at $1.80 per pound, where it was in 2005. But as soon as the economy recovers, copper always doubles in price. It is levered to growth in China and India. They have an increasing percentage of well-off people who use energy and metals, and each generation is bigger than the last. Since 1995, China has had a plan to create 200 cities of more than one million people. The investment strategy should be tied to areas of the world that are growing the fastest in the next five years.

As for stocks in general, when will we know that they are ready to rebound?

In every bear market since 1972, when the banks went through a period of at least six weeks where they outperformed the S&P, it was over. But we cannot use the rule this time because of the TED spread, which has a 100% forecasting record in all bear markets.

You have our attention.

The TED spread is the spread between the front-month T-bill contract and the front-month Eurodollar contract, because the Eurodollar contract is uninsured deposits in banks around the world in dollars. Therefore it is the measure of risk in the system. It reached a high of 500 after Lehman Brothers collapsed. The highest reading we have ever had up until then was 415 when Continental Illinois bank went bust in 1984 and got saved in order to save the system. The only reason they knew they had to save it was because of the spike in the TED spread. I know that from having interviewed the people involved. I used it to predict the crash in 1987. Then there was a long period where my knowledge of the TED spread was useless.

What does TED tell us now?

The spread has fallen to a little under 200 because of the various bank-rescue programs, and it could easily get to 140-145, which signal that banks are in a position to start lending again.

Does that favor any particular sector?

As they put this money into the banking system, then the oddity is that when the bear market ends, the bank stocks will be among the leaders in the rally that will come. This is based also on the principle of redemption and religion, which holds that when you have redeemed your sin you can come into heaven. When the bankers have stopped sinning and have gone through enough penance, then ...

How do we know this will happen?

The TED spread certifies for bankers collectively they are entitled to go to heaven because it indicates they have gotten their balance sheets in order and the system is working again and money is flowing more freely.

Which banks are you buying?

We like those that show that they actually had a pretty good risk culture beforehand, but a couple of mistakes were made. The system is shot through with corrupt practices.

Thank you, Don.

This little interchange at the end is rather cryptic and leaves us a bit mystified as to how the TED spread indicator is currently overriding the banks outperforming the S&P for 6 weeks indicator. But we get that the TED spread is something to be monitored closely. It has indeed been a long time since that indicator was front and center.

A RECIPE FOR THE NEXT GREAT DEPRESSION

The original New Deal unequivocally made the Great Depression much worse, and much longer-lasting, than it would otherwise have been. Washington seems determined to repeat the experience.

Thomas DiLorenzo shows how all the words in deeds coming out of Washington appear to be pursuing invariably the same object, evincing a design to create another 1930s-style economic disaster. With no revolutionaries to throw off such misguided policies, we had best be prepared for exactly such a recurrence.

Along with the ascendancy of the Democratic Party to control of the executive and legislative branches of government has come the repetition of the tired, old mantra of an alleged need for a "new New Deal." God help us. The original New Deal unequivocally made the Great Depression much worse, and much longer-lasting, than it would otherwise have been.

One of the most readable expositions of why the New Deal was an economic debacle is Jim Powell's book, FDR's Folly. It summarizes more than a half century of economic research on the actual effects of the New Deal and presents the results in a very readable, conversational style that is suitable to a general reading audience. And every bit of it is being studiously ignored by the powers that be in Washington. After his voluminous survey of the ill effects of New Deal interventionism Powell concludes with "lessons for today." Every one of these lessons is not only being ignored by Washington policymakers, but the policy proposals coming out of Washington are ominously structured to do exactly the opposite of what Powell suggests.

Lesson Number One is that "the basic problem with central banks is that like socialist economic planners, they can never have more than a fraction of the vast knowledge needed to make a society work, knowledge that is dispersed in the minds of millions of people. In addition, when central bankers make mistakes -- as they inevitably will, since they are human beings -- these mistakes harm not just the economy in a city or a region but the entire country. The Fed's response to the current economic crisis, which it created by creating the housing bubble, has been to declare more and more central planning powers for itself."

Lesson Number Two is that "deposit insurance must be priced to reflect the risks of the banks that buy it. Having the federal government provide deposit insurance inevitably introduced political pressures to offer deposit insurance at the same price for all banks, which meant subsidized banks engaged in risky practices and contributed to the instability of the banking system." The federal government recently expanded the coverage of federal deposit insurance, thereby guaranteeing more excessively risky lending in the future.

Lesson Number Three is, "Especially because taxes are the biggest burden millions of people face today, it is crucial to cut taxes. Tax cuts mean expanding economic liberty ..." President-elect Obama is promising punitive taxes on the most productive people in America -- higher income families and investors and savers, combined with government handouts that he mislabels as "tax cuts" for people who do not even pay income taxes.

Lesson Number Four is "efforts to ‘soak the rich’ will backfire, because the investments of the rich are needed to create jobs." If Obama's campaign and, indeed, his entire political career, has been about anything it has been about soaking the rich and "redistributing" income and wealth through the tax system.

Lesson Number Five is "public works and other ‘jobs’ programs must be avoided because they increase the cost and burden of government, making it more difficult for the private sector to function." All of Washington is foaming at the mouth over the prospect of more pork-barrel spending, laughingly labeled "stimulus package."

Lesson Number Six is that "especially during a recession or depression, the government must not enact laws preventing prices from adjusting to circumstances. Prices are vital signals that help people decide what to produce and consume." The government has been doing exactly the opposite. Stopping prices from adjusting to realistic levels is the whole intent of the Fed's policies as well as the Wall Street Plutocrat Bailout Bill.

Lesson Number Seven is that "government must not enact laws preventing wages from adjusting to circumstances. ... Labor union monopolies have been major obstacles to adjusting wages." One of the first orders of business for the Obama administration will be to strengthen labor union monopolies by passing a law that prohibits secret ballot voting in union certification elections.

Lesson Number Eight is, "only if investors feel private property is secure will they be willing to make long-term financial commitments needed to spur recovery and boost employment." The government has been busy charging businesses that have simply gone bankrupt with crimes, promising more of the same, placing price controls on executive pay, increasing the taxation of investment with higher capital gains taxes, and generally demonizing the entire American capitalist system as a means of shifting the blame for the economic crisis that its own stupid policies have created.

In other words, everything going on in Washington today is a recipe for another Great Depression.

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