Eric Roseman's Eruptions: Stocks, Global Markets and Commodities BLOG

Markets won't Bottom until Banks Stabilize

It should be obvious to most investors that until the financial sector stabilizes and starts to post a meaningful rally, stocks will not bottom and remain hostage to an ongoing bear market.

Already this month the banking sector has tanked more than 15% weighed down by another wave of losses in Q4 and yet fresh announcements of government bailouts, including a whopping $138 billion dollars for Bank of America.

As I stated a few days ago, the market will probably not bottom until we see a combination of bad assets removed from bank balance-sheets and a bottom in U.S. residential housing. These two important conditions are desperately required to finally end this crisis; other issues, including illiquid assets in other segments of credit, including revolving credit card and auto loans and now deteriorating commercial real estate loans will eventually be absorbed through additional write-downs or government handouts.

But establishing a separate entity to bundle toxic mortgage-backed securities and other illiquid credits must be done immediately.

Fed Chairman Bernanke proposed this solution a few days ago in a speech at the London School of Economics and even posited having the government buy bad assets directly from the banks. Either way, something has to be done to unclog bank lending and this solution is a step in the right direction.

Thus far, TARP or the Troubled Assets Relief Program ($350 billion already dispersed) has channeled funds directly to banks -- many of which don't even need the additional capital. Some banks regard TARP as a government "giveaway" that simply bolsters their capital ratios while doing nothing to unclog bank lending.

TARP cannot force banks to lend if they are reluctant to commit precious capital to risky borrowers in a deteriorating economy.

President-elect Obama, who takes control of the White House next week has secured the remaining $350 billion of TARP funds from Congress. Just exactly what he plans to do with this money is uncertain at this stage. Yet you've got to believe that government spending alone will not force banks to lend or consumers to borrow, especially amid an accelerated environment of falling asset prices and surging unemployment.

Deflation is now the buzzword. December CPI fell for the third straight month and was up just 0.10% over the last 12 months -- the lowest rate in more than 50 years. Deflation is a drag on the market, especially common stocks.

Buying equities remains largely too risky. My strategy is to focus on high-quality investment-grade bonds and some convertibles instead where income flows into your brokerage account. Income makes all the difference in a bear market. Many company dividends will be cut again in 2009 as profits crumble and CEOs opt to hoard cash and cut capital spending.

I doubt November 20 marked the low in this bear market. It's hard to believe that stocks have already discounted the worst in the earnings cycle with most consensus estimates pointing to a recovery the second half of this year. I think that's wishful thinking. If that's true then stocks have not seen their lows and should largely be avoided.

Have a good weekend. See you on Monday. 

 

    

Global Bear Market Grips EMU, Threatens Monetary Union

About 12 months ago at a Sovereign Society conference in St. Kitts, I asked the audience if they were bullish or bearish about the U.S. dollar's prospects. Not surprisingly, the majority of respondents were extremely negative on the dollar and wanted to increase their exposure to other currencies like the euro and gold.

That sentiment was also echoed at other seminars since 2002 as most investors don't trust the dollar's long-term prospects and naturally, I could not agree more. I think you have to have your head examined to be a long-term dollar bull.

It's incredibly alarming, frightening, how the United States has destroyed its balance-sheet over the last several years, including two military conflicts, a protracted credit crisis costing the country trillions and massive trade and budget deficits. Just staggering.

Back to the euro...

When the tide is overwhelmingly tilting to one side of a trade, you know the cliff isn't far. Sentiment was so excessively bearish on the dollar last winter that I warned against dumping the buck against the euro but recommended gold and the Japanese yen. I also plugged the Chinese yuan and Singapore dollar -- relatively flat over the same period.

Another dollar bull at the time was Jack Crooks, probably one of the best currency traders I know. He remains dollar bullish.

Well, twelve months later the euro has gone from darling to dog among currency investors and seems poised to unravel this year as the credit crisis comes home to roost in a big way as weaker EMU (European Monetary Union) members come undone.

Credit spreads among weaker participants like Spain, Greece, Portugal and Italy have risen sharply over the last three months versus German bunds or bonds -- the anchor currency of EMU. The odds are growing that one or several EMU members will leave the euro-zone.

Yesterday, S&P downgraded Greece's sovereign debt rating, citing eroding competitiveness and a rising fiscal deficit. Spain is also about to be downgraded.

Over the last four months several euro-zone countries, including even Germany, have reduced or scrapped bond market auctions because of tepid demand. And I ask myself how on Earth is the United States going to con the rest of the world raising more than $3 trillion dollars of debt issuance in 2009 and 2010 to fund this never-ending bailout and massive fiscal spending bill? The Germans have a fraction of America's debt and have reduced or canceled auctions.

Yet the Europeans have some serious challenges ahead.

Rumors are circulating in Europe that Ireland is seeking economic aid from the International Monetary Fund (IMF) -- vehemently denied by the Irish government. It's hard to believe than an EMU member might need IMF assistance -- a first, should it occur since the creation of the European single currency in 1999.

This is not the first time Europe has experienced currency volatility. Back in September 1992, the euro's predecessor was the ECU or European Currency Unit. Though a synthetic unit prior to the euro's introduction in 1999, it served as a model for monetary union through the creation of ERM or the Exchange Rate Mechanism, which served as a guideline for those currencies in the grid. If countries were in accordance with spending guidelines then their underlying values would rise and if they exceeded budget limits then they would decline.

As economic recession took its toll in Europe, the British pound and the Italian lira bid adieu to the ERM and exited the exchange rate grid with humiliating devaluations in September 1992. Both the British and the Italians devalued their currencies about 20% and George Soros of the Quantum Fund earned almost $2 billion from shorting the pound ahead of its ERM exit. 

The euro will survive. It's already a hard currency widely in circulation and increasingly held at central banks worldwide largely at the expense of the dollar. Yet it seems highly possible that credit contagion will spell the end for weaker peripheral members which really had no business joining the euro-zone in the first place. It also bodes poorly for prospective currencies in the Balkans, Baltics and Central Europe where fiscal deficits are soaring.

In this environment I continue to view gold as the ultimate currency. All currencies have declined vis-a-vis gold since 2005 and I expect that trend to accelerate as currency chaos spreads to Europe.

Seeds for a Powerful Rally Lay in Money-market Fund Assets

Though I remain a bear in this economic cycle and don't see a bull market in the cards for a long time, the seeds for a tremendous liquidity-driven rally, if only for several months, lay in the cash-hoard accumulating in money-market funds.

In yesterday's column I pointed out that stocks will probably muster a formidable rally in at least one calendar year under the Obama Presidency, similar to what occurred under FDR starting in mid-1932. U.S. stocks, after crashing a cumulative 86% from October 1929 to June 1932, powered ahead with a 372% total return from June 1932 until 1937. 

The fuel to power any sustainable future rally will come from the mountains of cash parked in almost zero percent-earning money-market funds. 

For the first time since 1994, U.S.-based money-market fund assets exceed the total under management in stock funds. That statistic in its own right is a heavily contrarian signal, suggesting stocks are heavily oversold.

According to the Federal Reserve, data through November show total money-market fund assets at $3.7 trillion dollars compared to $3.6 trillion dollars invested in stock mutual funds; equity fund assets almost halved over the last 12 months from $6.9 trillion dollars in late 2007.

It's no surprise to learn that many hedge funds have been shorting money-management stocks since late 2008 as earnings compress amid a deluge of investor redemptions. Worse, the big fund complexes now have to contend with money-market funds yielding almost nothing as management fees exceed the effective yield paid by those funds. Not a pretty picture for fund company earnings.

Another interesting snippet comes from Citigroup. The bank claims that retail money-market funds now account for more than 14% of the entire stock-market capitalization of the U.S. market -- far above the long-term average of 8%.

Like price-to-earnings ratios, book values or dividend yields, statistics like the above don't guarantee a major rally lies ahead for stocks. After all, since peaking in October 2007 U.S. and foreign stocks have mustered four false rallies with each short-term advance eventually breaking down to newer lows.

But the pool of money-market fund assets exceeding stock fund assets is nevertheless a powerful conduit for the bulls. If the market finally gets a major calalyst to sustain a longer term rally -- perhaps if the Fed starts buying back toxic assets directly from bank balance-sheets -- the market can skyrocket very quickly.
    

Market-Timing and the Mother of Market Bottoms

Does market-timing work? Better yet, does it matter if you’re a long-term investor dedicated to stocks or other asset classes? Don’t most investments appreciate over time?

The evidence suggests that knowing when to enter and exit a market can make all the difference in the long run.

Investment pros ranging from Warren Buffett (Berkshire Hathaway) to John Bogle (Vanguard Funds) chastise market-timing. Hedge funds, which charge high fees to time entry and exit points in global markets failed miserably in 2008 posting an average 18.3% loss, according to Hedge Fund Research. Worse, only several U.S. mutual funds actually earned a profit last year while the remaining 8,500 or so suffered 40%-plus losses. 

In 2008, the S&P 500 Index plunged 38.5% -- its worst year since 1931. The MSCI World Index, a composite of global mature market common stocks logged its worst year since its inception in 1969 – down 42%. Within the emerging markets universe, including New Frontier countries that include esoteric markets like Vietnam, Bahrain and Croatia, not a single bourse recorded a profit,  according to MSCI Barra.

Ten Years and Counting…

Investors can’t time the market consistently. And that applies to both individuals and professionals.

But does it really matter? The answer is a resounding “Yes!”

Investors who purchased the S&P 500 Index at the height of the last bull market in March 2000 are still licking their wounds almost ten years later.

A $10,000 investment in the S&P 500 Index in 2000 would be worth $7,000 through December 31, 2008. That’s a 30% decline and confirms America’s “Lost Decade” as it pertains to stock investing.

Despite the dollar’s big decline since 2002, which boosted the value of foreign shares when measured in dollars, the MSCI World Index turned an original $10,000 in 2000 into $8,007, a 20% loss. So much for passive long-term investing...

Timing a Depression Low

Yet the same investor who plunked $10,000 into the S&P 500 Index back in 1982 – the last secular bear market low – would have seen their original investment grow to more than $150,000 through December 2008. 

What’s even more amazing is how market-timing paid off in spades even during the Great Depression.

An investor with the dreadful foresight of investing $10,000 back in October 1929 in the Dow Jones Industrials Average (Dow) would have seen his investment crash to just $1,400 by June 1932 or a massive 86% wipe-out. Yet again, timing the market paid off brilliantly starting that same year when the U.S. market hit a low for the cycle.

From its bear market low of just 41.22 in June 1932, the Dow skyrocketed all the way to 194.40 by late 1936 – a whopping 372% return, excluding dividends.

By 1937, however, the Dow began to fall apart again and crashed 33% before finally bottoming in 1942.

Yet under FDR, the market seemed to gain traction by rallying a cumulative 121 points or  rising four consecutive years starting in 1933.

Once again, timing the market made a huge difference.

An investor who purchased the Dow in mid-1932 would still have earned a profit through 1942, the year the market finally bottomed.

But the poor unsuspecting investor who came aboard in September 1929 would have waited until 1955 to break-even. Waiting 26 years to recover your capital isn’t exactly the Field of Dreams; yet that’s exactly what might be in store for those investors who bought stocks at the height of the dot.com bubble in early 2000.

Bear Market Bottom still Lies Ahead

I’m not convinced the November 20 low was the ultimate bottom in this bear market. It might be another in a series of intermittent lows since stocks peaked in October 2007.

Stocks might appear to be cheap against all valuation measures, including government bonds, inflation, T-bills and risk, including the VIX Index. But it’s hard to make a compelling case for equities when corporate earnings will remain hostage to a crash in domestic consumption, a freefall in residential housing and soaring unemployment. Valuations alone don’t terminate bear markets.

The Mother of Buying Opportunities

Sometime over the next 12-18 months the stock market will form “the” bottom. That event will mark the greatest entry point for stock investors in more than 27 years, possibly longer. And just like 1932 when the market hit its low point investors will sow the seeds for humungous long-term profits.

Timing the market does make a big difference. The historical evidence strongly suggests that knowing when to buy or sell stocks can either make or break the individual investor. History also tells us that stocks are likely to muster a massive calendar year rally or more under President-elect Obama, similarly to FDR starting in mid-1932.

 

 

    

TARP's Original Mandate Must be Executed

“This program is intended to fundamentally and comprehensively address the root cause of our financial system’s stresses by removing distressed assets from the financial system.”  Treasury Secretary, Hank Paulson, October 2008

Back in October 2008, at the height of the global crash, Treasury boss Hank Paulson provided hope that the United States would finally tackle the clogged mortgage-backed securities crisis affecting global capital markets. Investors demanded the creation of an entity to place bad assets under one roof. But Treasury has since made a U-turn, changing its original plans. 

Mortgage securitization is largely responsible for this crisis. Since 2001 Wall Street spearheaded a bull market in residential lending through the creation of mortgage-backed securities. Indeed, Wall Street -- and not traditional banking, was indirectly responsible for more than 70% of all real estate loan origination.   Under TARP’s (Troubled Asset Relief Program) original mandate, the Treasury would apportion a sizable share of the original $700 billion dollars of tax-payer funds to place busted mortgage-backed assets into a separate entity, similar to the 1989-90 Resolution Trust Corporation (RTC) vehicle created to bundle bad loans. The RTC worked to help U.S. banks and Savings & Loans to finally separate bad loans and clear the way for economic recovery following the last real estate bear market.

But since October, Paulson has backtracked. Instead of dealing with the crux of the current credit crisis affecting counter-party trust and bank balance-sheet transparency, of the lack thereof, Paulson decided instead to disperse TARP funds directly to banks; now most banks that have tapped into TARP won’t lend capital to a credit-starved economy and in some cases, has resulted in widespread hoarding whereby financial institutions are using TARP money to boost their balance-sheets’ capital ratios. That’s not what the original plan sought to achieve.

Toxic assets include bonds backed by mortgages, including complex mortgage-backed securities, auction-rate securities backed by student loans and potentially a blizzard of other securities tied to commercial mortgages, credit card loans and auto loans. The size of these bad loans continues to grow, compounded by rising defaults made worse by an economy that is rapidly contracting since September.

Meredith Whitney, who ranks as the most accurate bank analyst predicting this credit-inflicted deluge since 2007 predicts banks will be required to fork over even more capital as loan-losses continue to rise. This will only delay any recovery in battered bank balance sheets since the initial TARP objective has been changed.

Until the United Statesfinally creates an entity to bundle toxic and mostly illiquid assets, the credit crisis will continue. Thus far, Treasury has simply handed out tens of billions of dollars directly to banks whom remain reluctant to lend as the economy heads deeper into the financial abyss.

To be sure, several segments of credit have markedly improved since late November, including the TED Spread, LIBOR, investment-grade corporate bond spreads and even a series of new corporate investment-grade and junk debt issuance since December. But the bad assets still plaguing the U.S. and European financial systems has not been addressed.

Bad assets must be segregated, identified and isolated from the financial system in order to improve institutional counter-party confidence and transparency. The credit crisis remains alive until this primary objective is tackled, if at all, by the next Treasury Secretary.

Sovereign Wealth Funds Shun Global Investing amid Crisis

Only 12 months ago pundits claimed most emerging markets would be immune from the credit crisis engulfing the United States and Europe. They were dead wrong.

The emerging markets have plunged more than 65% from their all-time highs while rich oil producing nations, including the Gulf States, have crashed.

On Thursday, the region’s first default occurred as Global Investment House, a top Kuwaiti investment bank, defaulted on most of its $3 billion dollar debt obligation.  >This follows the Kuwaiti government’s rescue of Gulf Bank, the country’s fourth largest bank in November after suffering massive losses tied to bad trades.

Since peaking last July, commodities prices have collapsed. Oil, the largest constituent of the four commodity indexes I track (CRB, GSCI, Rogers and AIG-Dow Jones), has tanked more than 70% since hitting an all-time high of $147 a barrel.

Provided oil prices remained strong, the Gulf States were largely immune from the gathering credit storm as oil revenues went through the roof, expanding trade surpluses and boosting the power of the region’s SWFs or Sovereign Wealth Funds. That picture is now dampened by rapidly compressing asset values throughout the region, including the real estate boom in Dubai.

Over the last four months a host of major financing projects in the region, mainly in Dubai, have literally evaporated along with collapsing oil prices. Trade surpluses have started to shrink and foreign investors are hitting the brakes on local development projects and heading home. It’s not a pretty picture.

Sovereign Wealth Funds have also been bashed over the last 12 months with billions in paper losses.

SWFs in the Gulf States rank among the largest foreign investors in U.S. and European financial services companies since the onset of the credit crisis in August 2007.

At first, bulging oil surpluses were viewed as a White Knight by troubled Western banks; now with oil prices tanking, the region’s SWFs have stopped shopping overseas and have started to repatriate capital as liquidity grows scarce at home. It’s the same story in Asia where SWFs have halted international investments as domestic capital markets swoon.

Nobody is immune from the greatest credit squeeze since the 1930s. Not Russia, not the Gulf States, not China and certainly not India.

I suspect that hostile or non-Western friendly oil producing nations will begin to warm up to U.S. foreign policy if oil prices remain at these low levels. Venezuela, Bolivia and Russia come to mind as those nations that until recently have embraced a tough tone, calling the shots on local drilling projects and tossing out the Americans and Europeans following government nationalization of energy infrastructure.  

Have a good weekend. See you on Monday. 

When Diversification Eludes the Investor

Many hard-working professionals in the investment business are now being unfairly scrutinized by investors in the wake of the world’s greatest heist last month. 

Over the last several months numerous well-heeled investment advisors have either committed suicide or have been arrested.

Since December alone, three prominent advisors have committed suicide, including Germany’s billionaire investor, Adolf Merckle, who lunged ahead of an oncoming train on Tuesday after his empire crumbled in the wake of bad bets in the market in 2008. Merckle was a respectable businessman and in no way a fraudster.   

A secular bear market such as this one has the power to unleash all the filth from the financial system, including the biggest investment scam of all-time – Bernie Madoff’s massive $50 billion dollar lie. Yet the others who claimed their lives recently were not part of any scam.

Instead, they were victims of bad investment decisions that caused massive losses to their investors, including one of Bernie Madoff’s investors who killed himself just before Christmas in New York City after learning that his $1.5 billion dollar company had evaporated under Madoff.

Over the last 12 months over $30 trillion dollars’ worth of assets have been wiped-out by the bear market. The deflation now underway has been formidable, destroying financial empires, investors’ dreams and causing all sorts of economic hardship. Though we don’t like to compare this bear market to the Dirty Thirties there’s no doubt that this is the Grand Daddy of bear markets with virtually all asset classes devastated since late 2007.  

Unfortunately, the Bernie Madoff scandal has turned many investors away from entrusting their assets to legitimate and hardworking investment advisors, including hedge funds, mutual funds and financial planners. Suddenly, investors need to know if they’re advisor is “real” and if their assets are truly safe in an environment of growing distrust.

The majority of investment advisors are credible, hardworking individuals and don’t deserve the fallout now underway as a result of the Madoff scam. These professionals have spent their lives working hard to build client relationships and trust; now some investors are turning away because of the widespread fear ingested by massive capital losses and the massive Madoff Ponzi scheme.

A good financial advisor is more than someone you can turn to for professional asset management and consulting; he or she is also a friend, someone you can trust to discuss your financial planning goals and, in many cases, becomes a part of the family. Numerous advisors have successfully served their clients for generations and will continue to do so in the future despite all the nervousness and hype surrounding Madoff.

As a rule, my advice is to never entrust all of your assets to one advisor. It doesn’t matter how great the performance, endearing trust or the long-term relationship fostered. I’ve always told my prospective clients that they should never give me all of their money to manage because they should diversify their risk, asset allocation and manager skills. It’s a rare admission in this business to turn away money but it’s the right thing to do.

Regrettably, many Madoff investors lost their entire fortunes because of greed and poor financial planning. They forgot or dismissed the number one rule in investment management: diversification of assets, including diversification of financial advisors.

There’s certainly no guarantee in this business. Yet the best defense remains diversifying your nest egg across several advisors or money managers to protect yourself from capital losses. Also, make sure you truly understand the investment objective of that product before you commit capital to a mutual fund, hedge fund or any other investment vehicle. Read the prospectus, ask questions and, if necessary, make inquiries about referrals and never let one advisor manage all of your money.  

Healing starts with Credit, not Equities in 2009

In December investment grade corporate debt soared over 15% as credit spreads plummeted following a crash in September and October.

If you’re debating an investment in high quality bonds then it’s not too late. The Dow Jones Corporate Bond Index yields 7.04% or 460 basis points or 4.6% more than benchmark ten-year Treasury bonds. Twelve months ago that spread was barely 2%, or 200 basis points. Treasury bonds are expensive while corporate debt is cheap.

When comparing the relative risk-reward scenario of stocks versus bonds, I think high quality debt is the optimal asset allocation choice. Any healing in the markets will start with credit, not common stocks.

Stocks will not lead a recovery in 2009. Though a bear market rally remains highly probable – stocks are up 22% since the November 20 low – risk remains high despite a 40% plunge last year. That’s because corporate earnings have fallen off a cliff since the fourth quarter and consensus estimates for the first half still appear too bullish.

 

Even in a best case scenario for stocks, volatility will remain prevalent and that means a box of Rolaids for most investors. Why take a chance on stocks this year amid the great economic “unknown” when you can tap into 7%-plus yields on corporate debt with the scope for big capital gains if bond prices rise? The tradeoff makes sense.  

Even the largest financial services companies or banks are now backstopped by the federal government. Spreads on these bonds are even wider than non-financial corporate debt and have the implicit guarantee of Uncle Sam since October. For example, Bank of America’s January 2011 notes provide an effective yield of 6.03% or 514 basis points more than Treasury bonds.    

High-yield bonds, or junk bonds, got smashed to pieces in 2008 suffering their worst year on record – down 25%. Junk debt now yields 13.8%, according to the Merrill Lynch High Yield 100 Index. But as the corporate default rate climbs sharply from 3% now to 10% or more this year it’s hard to imagine junk bonds can muster a significant rally. Historically, junk bonds don’t appreciate when the default rate is climbing.     

The stock market can continue to rally this year, similar to 1932 when it more than doubled in a short period of time following an 86% crash from 1929 to March 1932. Yet even after doubling in 1932 from March to late June the Dow finished the year down 15%. Talk about a wild market!

It makes more sense to me as an investor to buy high quality corporate bonds in 2009. You get paid nicely to wait for a recovery in bond prices while stocks remain hostage to great economic uncertainty and more, including regulatory changes, rising unemployment, geopolitical tensions and, most of all, a deep bear market in residential housing.

Battaglia was Right on the Money; Now What?

Only two Wall Street investment strategists accurately predicted the bear market that began in 2007. One is Merrill Lynch’s David Rosenberg and the other, Joseph Battaglia at Stifel Nicolaus.

I’ve followed the careers of both market seers over the last 20 years and have a deep respect for their market views and prescient forecasts, usually right on the money.

Joseph Battaglia, chief investment strategist at Stifel Nicolaus, was the first Wall Street veteran who warned that subprime would morph into a full-blown credit crisis and advised investors to avoid stocks and bonds and head into cash. That warning was first issued in August 2007.

In an interview this morning on CNBC, Battaglia remains cautious and believes the consumer will remain challenged in 2009. He’s also unconvinced the housing market and the economy will form a bottom this year, a view widely embraced by investment strategists predicting the economy will rebound the second half of 2009.

The bulls point to massive government spending this year, including a $775 billion dollar spending plan supported by president-elect Obama. Combined with the Fed’s unprecedented efforts to stimulate credit growth and its plans to initiate quantitative easing (e.g. government monetization of Treasury debt), the economy will eventually respond to massive stimulus. That might be the case but stimulus will only buy the economy one or two quarters of growth, not more.

Battaglia, however, points to housing as the key driver influencing future domestic consumption; until residential housing prices stabilize – down over 23% year-over-year through October, according to the S&P/Case-Shiller Index of 40 cities, it’s premature to predict a market bottom at this juncture. Housing is the key to an economic recovery.

I’m in agreement with Battaglia. The bear market rally we’ve seen since the November 20th low remains another in a series of traps for investors. Every preceding rally since late 2007 has been met by a new wave of selling taking stocks to newer lows. On November 19th the S&P 500 Index crashed to an 11-year low or the same price level as 1997. Indeed, investors in U.S. and global stocks are sitting on losses over the last ten years.

Underlying economic data everywhere – including the United States, remains bearish. The market does act as a discount mechanism and historically has rallied in the face of bad economic news as investors begin to discount the worst. But again, this is not a normal bear market; it’s a credit-inflicted crisis that will take more time to heal.

My view since October is that investors should focus on high quality investment grade corporate debt, mortgage-backed securities (agency debt) and TIPS, or Treasury Inflation Protected Securities. Income will rule in 2009. Gold prices should also top $1,200 an ounce this year as more investors grow disenchanted with paper currencies – all subjected to competitive devaluations in the face of sharply contracting GDP growth and plunging exports.

Why take a shot at risky stocks that will succumb to another round of selling, including a deluge of dividend cuts when high grade bonds yield in excess of 7% and offer the scope for big capital gains? Gold looks especially attractive as well because the dollar now yields almost zero in interest while gold – also a non-yielding asset – harbors fundamental value that is no one else’s liability, unlike the dollar and other currencies.

Investors continue to underestimate a credit unwinding. This bear market is totally unprecedented because nobody alive has seen the devastation caused by the last credit bear market of the 1930s. It would be unwise to surmise a new bull market for stocks lies ahead with the consumer stuck in reverse, housing in a freefall, unemployment rising sharply and credit still largely unavailable even to the biggest companies. These are not the prerequisites for a secular bull market.

Finally, investors have not discounted how government intervention and regulation will affect capital markets. A whole new set of securities legislation lies ahead in 2009, not unlike what occurred in the 1930s. I’m not sure how investors can be bullish on stocks when the government owns a fair chunk of GDP (finance, housing, autos) and will introduce a new wave of securities laws restricting capital innovation, leverage and overall finance.

Call me bearish, but I see no other investment position in this environment of incredible uncertainty.

My 2009 Mini Q&A

Over the last several weeks I’ve received numerous questions from Sovereign Society subscribers, including individuals who frequent this daily blog.

As we start 2009, I thought this would be an ideal forum to collect some of these important questions and attempt to give you my best conclusions. I can’t reprint all of these inquiries; yet I’ve compiled several I think are excellent questions from our members.

Overall, I don’t like forecasting. I generally believe it’s a total waste of time and most consensus estimates ahead of 2008 ended in the basement with the majority of analysts dead wrong about the economy, the market and just about everything else.

I have to admit that I never expected the markets to crash, the banking system to go bust or the dollar to skyrocket in the midst of the worst financial crisis in 75 years. To be fair, I think most pros failed to make accurate predictions.

Question: I’m a retired investor living on income. Prior to the big rally in Treasury bonds, I held most of my savings in short-term Treasury’s and bank term deposits. But with short-term rates under 1% and government bonds yielding a pittance, I’m nervous. What should I do to supplement my income?

Comment: This is perhaps the most challenging environment for retirees in more than a generation. With money-market funds yielding almost nothing, Treasury bonds yielding around 2% and bank CDs paying under 1%, retirees must supplement their income.

My advice is to take a small portion of your savings, say 20%, and scatter that sum across a dozen or more investment grade corporate bonds. I emphasize “investment grade” and not junk debt. Investment grade debt includes anything rated BBB or better in my book and, to make it easier, I would stick to issues rated A- or higher.

The Dow Jones Corporate Bond Index now yields 6.90% -- down from its post-crash high yield of 8.87% in early October. Still, investors can tap into non-financial bonds like IBM, Johnson & Johnson, Wal-Mart and Kraft Foods – all paying 5.5% or more. Or, look at corporate bonds issued by America’s largest banks, including JP Morgan Chase, Goldman Sachs, Well Fargo and US Bancorp. These banks won’t default.

A good strategy to keep things simple is to buy a laddered portfolio of corporate bonds ranging from two years all the way to seven years. This should at least give your nest-egg a boost and if you feel comfortable with this formula, then increase your position to say 35% of your portfolio. But remember, don’t go whole-hog; at some point over the next 12 months, perhaps later, Treasury bond prices will get smashed and long-term rates will head higher as the government expands credit to the Moon. Keep your powder dry.

Question: Do you think we’ll avoid another Great Depression? Despite all the money thrown at the markets since late 2007 we’re still in the midst of a severe credit contraction and the global economy has literally fallen off a cliff since October.

Comment: I think we’ll avoid another Great Depression but only because government will nationalize or partially nationalize key industries. Without government intervention, the free market would have resulted in massive failures and a total collapse of the banking system and the broader global economy. There’s no doubt in my mind that the government made a big mistake not rescuing Lehman Brothers last September. Once you’re bailing out major banks, then do it right. But in all honesty, we don’t know what transpires behind the Fed’s walls or the Treasury’s. There’s some crazy buddy system in progress with special interests influencing government policy. The government doesn’t give a damn about you or me. What they care about is protecting their interests. That’s why we must protect our assets and, in the end, I believe gold will triumph above all paper money, especially against the dollar.

I don’t advocate government intervention; but these are not normal times and the consequences might have resulted in the death of capitalism and perhaps the emergence of a new social order, similar to what occurred in post-Weimar Germany in the 1920s. Harsh economic times usually result in a new socio-economic regime. If the Fed and Treasury fail to rescue the credit system, then we might face similar consequences. The world as we know it will come to an end.

It’s hard to know exactly what goes on behind the Federal Reserve’s closed doors and at the Treasury’s. Thus far, government efforts have been bold since the October crash, including major central banks worldwide. Major credit indicators have indeed improved since November but the housing market – the crux of the crisis – is still in a freefall. Housing must stabilize before this severe recession ends.

In my eyes, it seems that bailouts and backstops are not addressing the real problem; most TARP money is ending up in bank coffers again and, in most cases, these institutions aren’t lending. The core of this credit crisis lies with the consumer and with housing. If you’re going to fork out several trillion dollars to fix or remedy this crisis then give the money to the consumer – not the banks. The consumer is in a severe bear market with personal assets plummeting over the last 18 months, including real estate, stocks, most bonds and now, possibly his or her job might be next on the chopping block.

Give consumer households $50,000 or more and allow them to clean-up their busted balance sheets, keep their homes (service mortgages) and pay off installment debt. You might not agree with me and, in all fairness, it’s against the tenets of the Sovereign Individual; but what good will all this money do if it’s basically squandered by government and ending up in the pockets of reckless bankers again? I have serious doubts about how the government is dealing with this crisis and I don’t think Obama’s spending package will help much at all despite perhaps growing the economy for a few quarters.

Question: What about the banks? With governments now standing behind their biggest financial institutions, is the worst over?

Comment: The global banking system, for all intents and purposes, is effectively bust or bankrupt. This is especially the case in the United States, Europe and, to a lesser extent, in Japan. More than a dozen emerging market banks are totally bust, including Iceland, the Baltics, Hungary, Romania, Bolivia, Ukraine, Ecuador, Argentina, etc. Not a pretty picture.

I think we’re more than 75% through the worst at this juncture. Governments now stand behind the largest banks in each country and, in some cases, even guarantee entire deposits until 2010 (e.g. European Union). I wouldn’t worry about the largest banks failing at this point. The worst is now behind us.

Question: I know you’re a big gold bug, but isn’t the euro a strong currency and do you think it’s a better hedge against the dollar than gold? Is it too late to purchase gold coins and, if not, where would you suggest I buy coins?

Comment: I have absolutely zero faith in the U.S. dollar and other currencies, including the euro or yen. In the end, all currencies will decline vis-à-vis gold and, in fact, since 2005 the world’s currencies have been losing their relative value to gold bullion. Despite big moves by the yen and euro over the last several years, they pale against gold.

Increasingly, the average man in the street will realize that paper money is not protecting his purchasing power and will revolt against fiat money. At Sovereign Society, we’ve driven home this message since our first year of publication in 1997. Gold is the only asset in this world that isn’t someone else’s liability; with U.S. interest rates effectively at 0%, paper money now competes with gold, which also pays 0% interest. In a zero percent world, which asset would you rather own? I think the answer is obvious.

The government’s enormous spending plans to rescue the financial system and bailout almost every ailing industry assures dollar destruction because the Fed is now on course to print money like never before to quash deflation. We all better hope and prey that the Fed can drain excess bank liquidity very quickly when this credit crisis ends. If not, we’ll have some serious inflation – much worse than what we saw prior to July 2008.

I think every investor should hold at least 10% of his assets in physical gold. This means coins, wafers or bars. Getting gold coins today is difficult because the U.S. Mint has stopped selling Eagles since last summer while other dealers are complaining about tight supplies amid booming investor demand. I suggest KITCO (www.kitco.com) or First Federal Coin Corporation (www.govmint.com).

Also, I would not hold or store all of my physical gold at my home domicile. I strongly suggest parking some of your gold in Switzerland, too. Remember, you must report assets outside of the United States and Canada.

I’m convinced we’ll see some sort of government confiscation of gold again just like we did in the 1930s. Back then, FDR did allow Americans to hold a maximum of 100 ounces. I’m not so sure the next confiscation will be so generous.

I hope you found this helpful. See you tomorrow.