Dear Reader,
I heard a story recently about a federal DEA team that stopped at a Texas ranch and told the owner they planned to search his property for illegal drugs. The rancher looked at the fed's credentials and said "Okay, but do not go in that field over there."
The lead DEA agent showed the rancher his badge again and said it allowed his group to go anywhere they wanted, anytime they wanted, whether anybody liked it or not. The rancher apologized for having questioned their authority and went back to his chores.
A short time later the rancher heard loud screams and saw the DEA agents running for their lives chased by the rancher's huge Santa Gertrudis bull. The rancher turned toward the agents and yelled, "Your badges! Show him your BADGES!"
The story about the DEA and the bull is a humorous way of illustrating how little federal authority means in the natural world. Nowhere is this more apparent than when the government attempts to change the fundamental laws of economics. No matter how much Washington may try to keep recessions from correcting the excesses of a boom, at some point all debts will be satisfied, all malinvestments will be eliminated, and all manmade distortions will be corrected. There are no exceptions and no special favors, not even for the Fed.
We need to keep this immutable rule about economic laws in mind as we try to determine how strong –and how long— the recovery will be.
The biggest question is whether the Fed's stimulus money is jump starting the recovery or just keeping the growth going. If the answer is jump starting, the economy will start to run on its own and be self-sustaining. In that case, the recovery could last a couple of years.
On the other hand, if the Fed's money is simply keeping the recovery alive, it will die when the funds run out.
In my opinion, the underpinnings of the economy are too weak for it to run on its own when Washington's money injections stop. Unemployment is too high, too many debts are draining resources, many state and local governments are insolvent, and both housing and manufacturing are on the floor.
In addition, many prime mortgages, commercial properties, regional banks, and small businesses are on the ropes. There just isn't enough fuel in the tank for the economic engine to run once the starter stops turning.
Whenever it is that the recovery falters, the real trouble will begin. All the problems that were pushed aside by Washington's stimulus and bailout programs will come rushing back to be addressed, and the recession will be on again. Phase II of the economic emergency will be a very unpleasant time for the unprepared. I don't intend to let you be part of that group.
Unfortunately, the public is not being warned about the second part of the economic reckoning that's on the way. On the contrary, government officials, the media, and many business leaders are making a full court press to convince everyone that the recession is over. Newsweek even put the happy fiction on its April 19 cover (see illustration). Halleluiah and pass the credit cards!
Misleading the public about the recovery is criminal. People who think the economy is healthy again are spending money they should be saving. They are opening businesses that have little chance of success. They are buying houses that will drop more in price, and so on.
If you know any such people, please tell them why the apparent upturn is a trap. When it falls apart, everyone you helped will think you are the smartest person on the planet.
What we in the western world are about to learn is that there is no such thing as a Keynesian free lunch.
-Niall Ferguson, author, The Ascent of Money:
A Financial History of the World.
Still to come is a dollar crisis that will affect every part of the economy, including many popular investments. Most people have no idea how much the quality of their lives depends upon the quality of their currency – but they will find out. Once again, however, the problems will be accompanied by good ways to profit. I'll bring you up to date about new currency opportunities on page 4.
Lastly, the added blow of a failing dollar on top of America's existing economic troubles will aggravate the political crisis that is already nearing the boiling point. It will not take much more economic pain to push many people over the edge. I strongly suggest that you plan for what could be a very ugly time.
All in all, the turmoil that we can expect over the next four to eight years won't be much fun. However, we are taking steps to turn the threats into advantages – not just for profits, but also to directly improve our lives.
When the rough transition period is over we should end up with a revitalized America that is once again powered by the eternal truths upon which the country was founded. It's the most encouraging future that I can imagine. I'm thankful that it is happening in our lifetimes. A new chapter in American history is being written, and we are part of it.
I've been saying for months that the so called recovery will be stronger, and will probably last longer, than most investors expect. So far, my prediction is proving to be correct. However, five potential problems could kill the rebound very quickly and send the economy back down again.
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The first black swan1 is an end to the balance that currently exists between the forces of inflation and deflation.
As I have been advising for several months, I believe inflation is most likely to win the contest. However, another big round of foreclosures, business failures, layoffs, and wage reductions could tip the balance the other way. That's especially true since powerful deflationary forces are already ravaging the economy. Don't let anybody tell you that deflation isn't a threat, at least near term.2
Technically, higher inflation is already here because the money has been created by the Fed. As a practical matter, however, inflation is measured by the rising cost of living. So far, most price increases have been mild because the bulk of the Fed's money got no further than the banks.
At some point the banks will loosen up and the economy will be up to its ears in funds. Then the price of nearly everything will start to move up. Nevertheless, I don't believe the increases will become troublesome until mid 2011, or perhaps a bit later.
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A much more immediate problem is rising interest rates. Contrary to popular belief, they can go up even if inflation remains tame and the Fed keeps its own rates low. That's because fixed income investors are free to demand higher returns to compensate them for taking greater risks – and that is what they are starting to do.
Until two weeks ago, for example, Greek bailout bonds were a pariah because they carry a high risk of default. Investors didn't reach for their checkbooks until the interest rate on Greek bonds rose a whopping 12 percentage points above those issued by Germany.3 In a market where an eighth of a point increase makes traders nervous, a 12 point leap was like an asteroid strike.
In the U.S., mortgage rates are also moving up due to increasing worries about risk. That's understandable because foreclosures are rising again. If mortgage rates continue to increase, we can wave bye bye to a housing recovery.
I wish it were possible to give you a definitive outlook for inflation, deflation, and interest rates – but it can't be done. We are living in the most volatile period since WW-2. Economics, politics, international relations, and most investments are all on a knife edge. Whiplash reversals are common. Any advisor who won't acknowledge this uncertainty is playing fast and loose with your future – not just your money. I refuse to do it.
What I have been doing all along is tell you about the most likely changes and opportunities, and what to do about each of them. I wish life were simpler, but it isn't. As one of my mentors told me many years ago, “Death is simple, life is hard. Which one do you want?”
Rising interest rates will also impact car sales, credit card purchases, business loans, and nearly everything else.4 As with inflation, however, I don't expect rising interest rates to become a serious problem until the middle of next year.
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China has a real estate bubble that should be in the Guinness Book Of Records. It's a black swan on steroids. If the bubble bursts, the world will feel the concussion.
I'm especially nervous that Chinese real estate prices are following the same trajectory we saw in Japan in the 1980s, and in the U.S. from 2000 to 2007. In both cases prices crashed and took their country's economies down with them.
The Chinese real estate bubble could do even more damage than the collapse did in Japan or the U.S. That's because property development –not exports, manufacturing, or consumer spending— accounts for about 50% of the Chinese economy.5 Fifty percent! If China's property bubble goes poof, the country will have a severe recession.
It gets worse. In China –which has evolved into a fascist country— most real estate development is underwritten by the government. This business has become the primary way that all levels of China's bureaucracy make money. Even the People's Liberation Army (PLA) has real estate investments. Talk about tough landlords.
Unfortunately, China's hot property market seems to be entering the blow-off stage. In the major cities, where the building boom is in high gear, the average Chinese couple makes about $7,000 to $8,000 a year.6 The apartments being constructed for them now cost from $100,000 to $150,000 – and they don't come furnished.
No matter how you crunch the numbers, most Chinese couples can't afford to buy an apartment. But that's not stopping them. Many new owners never intend to move in. Instead, they immediately flip their apartments for a quick profit. As we recently saw in the U.S., however, flips can become flops very quickly, and prices will plunge.
Chinese officials understand the real estate threat. Never-the-less, they can't get off the development treadmill, the government needs the money. Beijing can only hope that raising down-payment requirements, transfer taxes, and mortgage rates –as it is doing now— will stop the boom without causing a crash. It's a smart move. But if it doesn't work, the world will have another economic tsunami to deal with.
I must warn you that a severe recession in China could destabilize its huge population. The last time the Chinese pot boiled over, Mao Tse Tung (now spelled Mao Zedong) was swept into power and the world was put on the edge of nuclear war for nearly 30 years. It can happen again. For more insights about the potential for another Chinese catastrophe, please see the May issue of the Early Warning Report edited by my colleague Richard Maybury.7
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Two months ago I warned that Washington and Tel Aviv might attack Iran's nuclear facilities. That's because many people in Washington believe the strike would take the public's attention off the economy. It would also protect Israel, prevent a Middle East nuclear arms race, and restore the Iran/Iraq balance of power.
In addition, because Americans "don't change horses in the middle of a stream" a war could help the Democrats retain their majority in Congress in the upcoming elections.
An attack would be risky because Iran would probably retaliate by attempting to shut down the Strait of Hormuz that provides access to 55% of the world's oil.8 If Iran is successful, we will see another oil price spike. As you may painfully recall, the high oil prices we had in 2008 helped kill the boom. The economy today is much more vulnerable than it was then.
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I warned about the spreading debt and currency crisis in Europe in the March GCOR, and there is little I need to add here. I think the EU will be able to stop the contagion from destroying the union and the euro - this time. But the instability built into the EU is a black swan that we much watch closely.
The problem the supporters of an attack on Iran face is that the public must be convinced that it is necessary. After so many years of war in Iraq and Afghanistan, taking on another conflict will be a hard sell.
Of the possible reasons the public would accept as sufficient cause to invade Iran one stands out: the nuclear threat. But there is no clear proof that Iran is developing the bomb. Tel Aviv says it is, the UN says it isn't, and so on.
There is one event that would convince everyone that Iran is developing a nuclear arsenal: if it conducts a successful test. The blast would shock the world, and terrify most countries in the Middle East. Israel would almost certainly launch an immediate attack, probably with support from Washington.
As monstrous as it would be, I think Washington or Tel Aviv might decide the threat from Iran justifies forcing the issue by detonating a small nuclear device in a desolate part of the country. Nearly as good would be a large conventional bomb with enough radioactive material mixed in to give it an atomic signature. The job could be done with a single ground-hugging cruise missile.
Iran's leaders, of course, would immediately deny that they were responsible for the blast. But given Tehran's history of threats against its neighbors, who would believe them? In any event, a quick retaliatory raid by Israel or Washington would render the issue a moot point.
If planting nuclear “evidence” in Iran sounds farfetched to you, please recall the phony Gulf of Tonkin attack, the manufactured proof of WMD in Iraq, and other deceptions that led the U.S. into wars that Washington wanted.
The best way to play the inflation vs deflation uncertainty is to favor the most likely winner. In my opinion, the chance of inflation is 80%, and 20% for deflation. I use that ratio when choosing my investments.
Inflation will benefit precious metals, rental residential real estate, useful tangibles, blue chip stocks, commodity currencies such as Canadian and Australian dollars, Treasury Inflation Protected Securities (TIPS bonds) and the other hedges I discussed in recent issues. See the quick reference table on page 6 of the April GCOR for a list.
Deflation favors cash, cash, and more cash. What does especially well is cash. (Not to put too fine a point on it.)
On the other hand, deflation will probably stop the stock market advance in its tracks. One exception should be blue chip stocks that pay reliable cash dividends. As money becomes more valuable, so will any other investment that produces it.
Timing is important. If we have a deflationary hit it will almost certainly be followed by an inflationary spiral as the government tries to spend its way out of trouble. We know that's what the Fed will do because it's the strategy they have been using nonstop since the Great Recession started. When it comes to fighting deflation, the Fed is a one-trick pony.
Rising interest rates will drive down the value of long term bonds. You can avoid the problem by sticking with short term bonds and CDs, and just keep rolling them over as rates go up. It's a simple strategy but it can pay big rewards. See the box on the next page for details.
To see how profitable it can be to buy bonds and other fixed income securities when interest rates are high, take another look at the inflation chart on page 2. The chart also mirrors interest rates changes over the same period.
As you can see, investors who purchased 30-year Treasury bonds in 1980-81 were able to lock in 12.5% annual returns. Those checks would have been very welcome during the low yielding Greenspan and Bernanke years when interest rates were close to zero.
It will probably be awhile before the interest rate peaks again. I'll let you know when it's time to start changing our fixed income strategy from short to long term.
At the same time you plan to profit from rising interest rates, please remember they will decline if deflation occurs. Therefore, if you agree with my 80/20 inflation/deflation odds, 20% of your fixed income investments should be in long-term securities. It is essential to remain diversified in these volatile times.
If China's real estate bubble pops, or starts to go hiss, Beijing will begin a king-sized bailout program that will rival the one we are seeing in the U.S. In what would be one of the world's biggest currency reversals, China will need every one of the approximately 1.2 trillion U.S. dollars it has in its central bank. Perhaps that's why we haven't heard Beijing make any disparaging remarks about the greenback recently. In any event, as the demand for dollars goes up, so will their value.
Of course, a Chinese real estate collapse will be highly deflationary for their economy because a great deal of money will disappear. That will push up the value of the renmimbi – just as the U.S collapse aided the dollar. In that event, the renmimbi accounts that I recommended in the February GCOR will do even better than I expected.
But don't get greedy. If China's real estate takes a big hit, Beijing will be forced to borrow a page from Uncle Sam's game plan and print a flood of money to bail itself out. Once investors see this happening, the renmimbi will start back down again.
What a roller coaster! It happens in every country that relies upon fiat money that politicians can create at will. Fortunately, the cycles move slowly enough for us to profit from them, as we have been doing for nearly three years.
Energy and commodity prices will also head down temporarily if China's real estate bubble bursts. That's because China's insatiable appetite for natural resources will end if the country needs to use more of its funds to rescue itself. Oil, copper, iron, and everything else will almost certainly drop in price.
Precious metals will probably follow the other commodity prices down, just as they do during U.S deflations when people need to raise cash quickly. However, when China begins to fight the recession by creating renmimbi's out of thin air, they will flock once again to “Mother Gold and Father Silver” – as they have for 3,500 years. Behind the red flags and ridiculous communist slogans are 1.3 billion natural born capitalists. From Mao to von Mises, what a journey!
Chinese investments: China has such a huge population, and so much of the country is yet to be developed, its economy could expand for decades. However, growth never occurs without corrections – one of which appears to be long overdue.
If you have Chinese investments, and you aren't willing to hold them during what could be a very steep downturn, I think you should do some selling. At this point, I believe that China offers investors more risk than promise.
An attack on Iran would immediately benefit U.S defense stocks. Measured by the size of the contracts they were awarded in 2009, the top five companies are, Lockheed Martin (LMT - $31.3 billion), Boeing (BA - $20.9 bn), Northrop Grumman (NOC- $16.1 bn), General Dynamics (GD - $15.8 bn), and Raytheon (RTN - $15.0 bn).9 Happily, we own all of them except Boeing, which isn't a pure-play.
The European debt crisis is hammering the euro. When I saw early signs of the weakness late last year I took you out of the currency. I then recommended the U.S. dollar that is now rising due to heavy European purchases. I think both developments have further to run.
A new defense investment that also looks promising is the latest generation of unmanned aircraft.
The drones, as they are usually called, are extremely sophisticated. Most of them, such as the updated Predator and its successor the Reaper, are operated remotely from half way around the world. Young soldiers who grow up using video games make superb operators.
Many other drones are fully automated. They fly to predetermined points using GPS coordinates, where they take photographs, listen to electronic communications, make maps, and do other surveillance work. Some of the automated drones can remain aloft for as long as 36 hours.
The latest drones are no larger than model airplanes. With their miniaturized electronics they can often do the work of much larger aircraft, and are much less likely to be spotted. One electric drone being tested is no bigger than a robin. The “bird” is completely silent. You would not want one coming after you.
Even large drones can now be made nearly invisible. It was once possible to spot them by watching for their silhouettes against the sky. Now their undersides can be covered with tiny LED lights that match the intensity of the background. Unofficially the new aircraft are called "noseeums." Some are intended to be used inside America10, but that's a topic best left for another time. Meanwhile, I'm going to get up and close the window. A odd looking robin keeps trying to get in.
Sophisticated telecom links and onboard controllers are the key technologies for the new unmanned aircraft. Everything from broadband satellite links to artificial vision systems are used, and they must all be coordinated.
Very few companies can supply what the drones require. The leader of the pack is Harris Corporation. I first recommended the company in the Oct-09 GCOR for its impressive new combat communication systems. The company is now winning many contracts for the new radios, and it should be awarded many more. With the new drone technologies coming online, I think Harris looks even more attractive.
At the time I recommended Harris it was selling for $33.37. It is now $50.42, a 51.1% gain in six months. The company is profitable and it pays a dividend. The P/E is a modest 11.7. I think Harris is still a buy for long term accounts.
| Fundamentals For Harris Corporation | |||||
| Recent Price: | $50.42 | Shares Out: | 130.6M | Market Cap: | $6.6B |
| Forward P/E: | 11.7 | Profit Margin: | 4.1% | Return on Equity: | 14.3% |
| Revenue: | $4.9B | EBITDA: | $955.4M | EPS (Diluted): | $1.53 |
| Total Cash: | $314.4M | Total Debt: | $1.2B | Current Ratio: | 1.86 |
| Book Value: | $15.57 | Short Ratio: | 4.4 | Current Yield: | 1.70% |
A recent poll by the Pew Research Center revealed that 58% of Americans think the country's political system is incapable of dealing with the problems we have today.11 Only people who live in the rarified atmosphere of Washington, DC are surprised by that figure.
I agree that the government is ineffective, but not because the system itself is broken. The federal structure that the Founding Fathers created has served America well throughout most of its 223 year history.12 Sure, there were liars, thieves, influence peddlers, and other skunks all along the way. But in a limited government, they didn't have enough power to get away with very much.
What went wrong is the federal bureaucracy grew into a self-serving colossus in which the wishes of its officials took precedence over the needs of the nation. Whatever feeling of political responsibility that was once present in Washington, has all but disappeared. Without that underlying commitment, changing the political process won't improve how the government works.
For people to achieve their full potential I believe they must break their chains of dependence, which is why America needs a limited government and a free market economic system. The pursuit of a political ideal or an economic ideology is not enough.
Self-reliance promotes the development of individual talents, self confidence, integrity, and responsibility – which also lead to better societies. America's greatest achievements have always come when everyone needed to roll up their sleeves and take charge of their lives.
For libertarians and conservatives, the need to be self-sufficient is no threat. We don't want the government to take care of us. However, even independent people will need to deal with some serious challenges as government services are cut back. In particular, we will need to provide for our own safety as the criminal justice system becomes less effective.
I think the future we face will be similar to what we saw in Argentina during its political and financial crisis ten years ago.
Argentina's economy didn't collapse. Instead, everything functioned at a very low level that decreased the quality of life for nearly everyone. Inflation reduced the value of wages and savings. Countless jobs were lost. Millions of people were in distress.
Not surprisingly, the crime rate soared. Understaffed police forces could only respond to the most serious offences, and rarely in time to catch the criminals. Only the worst predators the police managed to catch could be sentenced to the country's overcrowded prisons. Food subsidies and medical programs were slashed, and so on. Nobody in their right mind would go out at night. Home break-ins and kidnappings became epidemic.
In addition, few municipalities were able to fix their decaying infrastructure. After storms, electric services often remained out for weeks. Countless schools closed, others were on double shifts. Nearly everything became dysfunctional.
Are you starting to have twinges of recognition? If so, it's because our country has already started down the same path. Few people realize that the slide is the beginning of a long-term trend. It reminds me of the well-known fable about the frog that boiled to death because the water temperature rose slowly.
To live well over the next few years, we must remain better informed than the public. We must provide for our needs before everyone realizes they should do the same and the process becomes more difficult and expensive.
What we will need most during the long emergency is enough money to insure our security. We will also need many essential supplies that may be impossible to obtain in the future. Both subjects have been ongoing topics in this newsletter for several years.
Fortunately, we have done very well in the money department. The four recovery portfolios that I recommended last April are now up 118.2%. By contrast the Dow rose 51.5% over the same period. Here are the details:
- Our conservative Food and Agriculture group is ahead 35.3%. I think this strong performance shows how promising the industry is becoming. In a hungry world where shortages are now common, this group should continue to do very well. With its 64.6% gain, Coca-Cola (KO) is currently leading the pack.
- The Basic Needs Suppliers are up 23.2%. Colgate Palmolive (CL) did the best with a 39.9% rise.
- Our Oversold Giants and Former Giants jumped 250.4%. The runaway winner is Ford (F) that delivered an incredible 623.0% gain. What a ride! (Pardon the pathetic pun.)
- Our most aggressive portfolio of Oversold Banking Companies shot up 164.0%. Sure, they are bandits – but they are our bandits and they share the loot. They also profitably support the lives and businesses of millions of people around the world, which is the biggest reason we should own them. The portfolio leader is Bank of America (BAC) with its impressive 357.0% rise.
Speaking of bandits brings us to Goldman Sachs (GS), a company I added to our banking portfolio last September. As you undoubtedly know, the SEC is accusing Goldman of creating securities that it expected to fail, and sold them to pigeons clients who expected them to appreciate. It may be more than a simple case of two parties disagreeing about the outcome of a security, which is at the heart of every Wall Street transaction.
I don't know how the Goldman Sachs story will turn out. Many security attorneys believe the government's position is weak. However, there is intense public pressure on the Obama administration to hang at least one of the big banks that helped push the U.S. into a recession. Politics may trump the law in this case.
On the positive side, the company's first quarter earnings leaped an impressive 91%. Since profits are literally the bottom line on Wall Street, if they continue to grow, as I expect they will, this world class trading company should recover and go on to new highs. If you are a long term investor, I think you should hold Goldman Sachs.
Because budget cutbacks are reducing effective law enforcement in most areas, people and businesses are turning to private firms to keep them safe.
In my research to find the most promising security investment, I soon discovered that the industry is heating up. Broadview (CFL), a home security company that Brinks spun off in 2008, is being purchased by Tyco (TYC). The deal should be concluded later this year.
Broadview's main competitor, Protection One (PONE) started entertaining buyout offers last week. An acceptable bid seems likely. Several regional security firms have also been bought out. In addition, several mergers are occurring. It is clear that many companies that track America's social and economic trends realize the private security industry has a bright future.
In the business protection area, I think the most promising investment is Brinks Company that can trace its origins to 1838. Over the years, Brinks evolved into a business that offers armored car transportation, ATM servicing, currency and coin processing, bank deposit services, and secure air delivery of high-value cargo. The company also transports and maintains safes and provides document destruction services.
After doing well for many years with its services to banks, retailers, and government agencies, Brinks decided to enter the post 9/11 market. The company now protects several airports, utility companies, offices, and public venues. In addition to supplying guards, the company installs electronic surveillance and access control systems.
I think Brink's biggest asset is its strong brand name and long history of operations. They allow the company to attract customers in an industry where reliability is a key success factor.
Brinks has excellent numbers. It has a strong balance sheet, a low P/E, and a good return on its assets. I think the company will perform very well in long term portfolios.
| Fundamentals For Brinks Company | |||||
| Recent Price: | $28.40 | Shares Out: | 47.9M | Market Cap: | 1.36B |
| Forward P/E: | 6.74 | Profit Margin: | 6.39% | Return on Equity: | 52.3% |
| Revenue: | 3.14B | EBITDA: | 303.6M | EPS (Diluted): | 4.22 |
| Total Cash: | 143.0M | Total Debt: | 195.6M | Current Ratio: | 1.00 |
| Book Value: | $11.00 | Short Ratio: | 3.0 | Current Yield: | 1.40% |