Joey – or Joseph as he is more formerly addressed – comes from a long line of investors and traders. His family has been in the investment banking business for generations (more than 150 years), and he himself has been a private banker for more than two decades.

Today Joey pulls back the curtain on “Build America Bonds” – more accurately dubbed “BILK America Bonds” – and explains why they are a threat to your wallet and your sovereignty. Thoughts, comments, questions? Send them in and I’ll forward them on to Joey: justice@taipandaily.com.

I just finished an article in The Wall Street Journal discussing what its writers considered “excessive” fees on municipal bond underwritings. I followed along with their train of thought until something dawned on me. Worrying over a very insignificant amount of money, even as states continue to plunder their citizens, is a little like worrying about the cost of the rope around your neck… just prior to the trap door in the floor falling out from beneath you.

The discussion that spurred these morbid thoughts was based around a specific type of bond, called Build America Bonds. I prefer to call them “Bilk” America Bonds. Currently, Bilk America Bonds are being touted by the Obama administration as one of the major successes of the American Recovery and Reinvestment Act (otherwise known as ARRA, which I pronounce as “Error”).

Inflated Profits, Inflated Debts

And while the BABs, as they have been coined, have been wildly accepted by the investment community and the issuers (municipalities) from coast to coast, the reason has NOTHING to do with some master stimulus plan and everything to do with alert bankers identifying profit opportunities and municipalities with an insatiable appetite for debt.

And as evil as these bankers have been portrayed in the media, their actions are driven 100% by our federal government’s massive attempt to inflate anything and everything. This time they’re inflating the already bloated municipal government’s debt burden. (A municipality, in the broadest definition, is any political governing entity that isn’t the federal government. In other words, it can be cities, counties, school districts, utility districts, agricultural districts and so on.)

In this two-part report, I’m writing to expose this “ARRA” success story, to identify this obscenity of our federal government power grab and, hopefully, to alert you to what may be yet another encroachment on your state’s sovereignty, and, ultimately, your liberty.

Anyone who knows me (as Taipan readers will soon discover) understands that I believe that, in every disaster (which this does qualify as), there is an equal if not greater opportunity. While I do hate these debt instruments – hence the name Bilk America Bonds – there is an opportunity with them that I will highlight in the second half of this report.

BABs Defined

I am intimately aware of these securities because I help communities use them to borrow. In fact, I created one of the first! In other words, I’m an insider blowing the whistle.

For the record, I will alert readers to these BABs, point out the flaws and the problems, and encourage you to fight against them. I will be doing the same. However, I will also continue to use the tool created by the Obama administration in certain ways as long as it favors my clients.

So what exactly is a BAB, you ask? In some ways it is just a municipal bond like any other. The majority of municipal bonds are issued with interest being paid semi-annually to investors that is tax-exempt. In other words, all of the income off the investment is delivered to you without Uncle Sam taking a cut. That is why municipal bonds can be GREAT investments overall, and have proven themselves safe since before the Depression. In fact, they may be the only true “buy and hold” investment available!

So BABs are issued like other bonds, but they are NOT TAX-EXEMPT, which results in substantially higher interest rates paid by the municipality.

However, to help defray the higher cost, guess who has promised to send them a 35% subsidy check every half-year? You guessed it: Our friend President Obama.

With that little 35% kicker, stolen from us taxpayers, the issuer (borrower) of BABs gets a slightly lower interest rate than what it would have cost them had they sold regular municipal bonds.

BABs, like municipal bonds, are used to build public projects. Anything from a new city hall or bridge, to a new sewerage treatment facility or public pool, can be financed with bonds (BABs or normal municipal bonds). With the subsidy, the issuer gets about a one-half of one percent lower interest cost than they would have received borrowing with tax-exempt bonds.

Yet Another Hidden Bailout

Unfortunately, what’s being sold to the American public is the notion that “BABs are great for everyone.” Once again, this is why I call them BILK America Bonds.

The first problem is that, ultimately, BABs cost far more than regular tax-exempt borrowing. They feed us a line of bull that because the government gets the taxes on these, the subsidy paid is really a break-even proposition for the taxpayer.

In reality, a great many BABs have gone into retirement accounts, insurance accounts and other tax-deferred entities, and so the federals are collecting little of the tax sought from the annual interest paid. Adding insult to injury, at least one in 10 BAB purchases go outside the United States – and with it, so do our tax dollars (by way of the built-in subsidy).

And, as crummy as it is to pay too much for a project, it gets worse when you realize that YOU ARE AGAIN BAILING OUT SOMETHING. I’m getting pretty tired of cutting a check for one failed program after another. First the auto industry, then the banks followed next, than the unions… and now we are footing the bill for 35% of the interest cost for municipalities that, instead of cutting back, are simply borrowing more!

A Tax-and-Spend Power Grab

It probably won’t surprise you to hear that California has been the largest borrower using BABs. You may recall that, in early ‘09, in an attempt to pay for the already bloated government, the state went to the voters, who rejected every tax increase on the ballot (bravo California).

So what did Arnold do to make an end run around ordinary Californians? He borrowed using BABs. Literally $6.86 billion in BABs. Now remember, he’ll get 35% of his interest cost paid to him by the Feds (i.e. via taxpayer dollars, supplied by you and me).

What NO ONE is aware of is that there is no rule that says the 35% interest subsidy must go to reduce the interest cost. So the governor can take what could amount to hundreds of millions in subsidies and use them to pay for expenditures Californians refused to approve!

The very nature of the type of BAB issued, what’s known as a General Obligation of CA, requires that taxes be raised, without limit, to cover the principal and interest (with or without subsidy).

In effect, if the governor diverts the interest subsidy, all his state will get is an unapproved tax increase. It’s pretty neat trick, in a sick sort of way.

No Representation for Your Taxation

If the backdoor tax increase isn’t bad enough, then how do you feel about paying for new municipal projects – through the taxpayer-funded subsidy – where you had no say in how the money was to be spent? No representation for your taxation.

In other words, how would you feel if, say, San Francisco decided to build abortion clinics and you’re a pro-lifer… in Florida. Or, how about New York using BABs to build a church community center and you’re an atheist… in Texas. It’s not too hard to think of hundreds of examples of projects I want no part of, in states I’ve never lived in!

BABs have turned out to be exceptionally popular with investors and borrowers. They provide higher-than-normal returns and have nice flexibility for the issuing municipality. Unfortunately, the taxpayers, as usual, are the ones taking it on the chin.

There is one more piece of worrisome news. The government’s true goal, I suspect, is the complete elimination of tax-exempt bonds and, along with that, the ability of local municipalities to control their own finances. It is another power grab by the feds that could end local and state sovereignty – at least with finances – for good.

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"They [the Federal Reserve] want to see how the tug of war between the cyclical tailwinds and the structural headwinds plays out..."
- Pimco CEO Mohamed El-Erian

U.S. Stocks and Cyclical Tailwinds Attracting Investors

In a matter of months, from an investing perspective, the world has turned into a dangerous place and the U.S. is now looking like a safer place to invest. And not so long ago, the outlook for the U.S. (and the dollar) was much more scrutinized. Although there are still many attractive global opportunities, for the time being U.S. stocks are being viewed as a relatively safe asset class to be invested in.
Now, inflation and the after-effect of all the printed dollars and government stimulus dollars are still heavy concerns to be dealt in the future. In the opening quote, Pimco’s CEO is referring to these issues, among others, as “structural headwinds.”

Although there are still many mixed signals coming out of the ongoing slew of economic data, the bias is toward steady improvement. This positive bias is also prevalent among the comments from company executives as well as from the data from the almighty consumer.

So while real risks to a sustainable economic recovery exist, I believe the “cyclical tailwinds” are strong enough to make good money investing in U.S. stocks. In my opinion, for 2010, certain U.S. stocks still are a pretty solid, safe and appealing place to be invested.

Seeking Stronger Returns in a Strong Market

As we happily know, the market is up sharply (+51%) over the past year and off the market’s March 2009 bottom. So you might be asking how attractive U.S. stocks still are after such strong gains. Is there that much more upside?

Yes, in a few Taipan Daily writings, I have talked about how the broader market is close to being fully valued. But that was the overall market. Within that big market of more than 500 companies, there are surely attractively priced (e.g. cheap) stocks that have 25-75% upside over the next 12 months.

Making Things: America’s Competitive Advantage

The capital goods and industrial sectors have been impressive performers relative to the market. And historically, investing in these stocks when the economy looks the bleakest typically produces significant gains. That happened last year as the recession hit trough.

A large number of industrial stocks have been up anywhere from 100% to 1,500% (e.g. TRW Automotive Holdings) in the past 12 months including names like Caterpillar, Terex, Nacco Industries, Flow Industrials, Ford Motor and Manitowoc, to name a few.

Despite the run-up, many industrial-related stocks still have more legs to run with. The next upside gains probably won’t be as much as this past year’s move, but still impressive. Why? Let’s analyze two angles.

First let’s take a simple look at the macro picture. The chart below shows where industrial production and capacity utilization levels are relative to history and past recessions. Regarding the Industrial Production Index (blue), the most recent data finally showed positive year-over-year growth. The index had been getting “less worse,” but if we are to have positive economic growth, then the Industrial Production Index will show year-over-year growth for many years, as it has done historically.

The Capacity Utilization Index (red), currently at 72.5, is also way below its historic average of 81, so there is a lot more room for manufacturers to increase their production levels, something companies have been hesitant to do.

View Larger Chart

Secondly, let’s look at the valuation of some of these stocks.

I did a screen of capital goods stocks that had the met the following criteria: Yield greater than 2.0%, price/sales ratio of less than 2.0 and price/earnings growth (PEG) rate of less than 1.5 times. The PEG rate is the ratio of the forward price/earnings multiple to the estimated future earnings growth rate of the company. The lower the ratio, the cheaper the stock. Lastly, for liquidity purposes, the market capitalization had to be over $750 million.

View Larger Chart

A lot of these companies have not had the super price moves like the market and some of their industrial peers. There are also high-quality names like Dover, Illinois Tool Works, Lincoln Electric, Briggs & Stratton and Eaton Corp. (which happens to be in the Safe Haven Investor portfolio). I’m actually surprised by some of the names on this list that are still cheap compared to the market.
For reference, the price/sales ratio and PEG ratio of the S&P is 3.1 and 2.1 respectively, far above the levels of these stocks. And of course, as one who pays attention to yield, all of these stocks pay above-average dividends.

Lastly, not all of these companies are the highest-quality companies and meet my “significant six” criteria I like to look at. But many times with investing in stocks and sectors, a rising tide (in this case further economic recovery) lifts all ships. I will be closely looking at these stocks for new ideas, so stay tuned. And in the meantime, I hope you’ll take a closer look as well.

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Why have commodity prices been weak as of late? Paradoxically, the answer can be found in Chinese inflation.

You may have noticed something strange lately. Though the bulls have been stampeding, commodities just haven’t been getting the job done.

All the old relationships seem to be out of whack. For example, less than two weeks ago I wrote to you about “the great decoupling,” i.e. the growing disconnect between crude oil and stocks. As I write, stocks are modestly higher, yet oil is cratering.

You can see the disconnect of stocks and crude oil stocks in the chart below of the Reuters/Jefferies CRB index:

The CRB index tracks a basket of major commodities. Right now, the price action in CRB is middling at best. The 50-day exponential moving average is close to flat. What’s worse, prices are headed in the wrong direction, having failed twice to retake the average or break previous resistance.

The weak price action in commodities comes against a backdrop of renewed equity strength. Financials, banks, homebuilders – all have ripped higher in recent days.

Theoretically at least, renewed optimism for the U.S. economy should be inflationary. If things are getting better for consumers and the banks, then monetary velocity should be picking up. Stagnant pools of lending dollars should be flowing again. All this should be bullish for commodities (and prices in general).

Why isn’t it?

One potential reason is Chinese inflation.

Slamming on the Fiscal Brakes

China’s economy is showing signs of overheating. This, in turn, has led to concern over what the PBoC (People’s Bank of China) may do in response to keep inflation in check.

If China taps on the brakes too hard, as the CEO of Caterpillar so memorably put it, the result could “send everyone through the windshield.”

Chinese authorities have stated with confidence that things are still under control. But this isn’t really news, because what else would they be expected to say? Evidence on the ground suggests otherwise.

“China’s accelerating inflation has started to erode household savings,” Bloomberg reports, “threatening to spur purchases of property and stocks and fuel asset-price pressures.”

Chinese consumer prices rose the most in 16 months in February. Food prices saw some of the biggest gains. “A potentially troublesome sign for Beijing,” The New York Times notes, “given that the Chinese on average spend a third of their income on food.”

“Inflation may top the 3 percent policy target by April, which is bound to trigger further monetary tightening,” says Dariusz Kowalczyk in Hong Kong.

Inflationary Boom Psychology

The open questions here are 1) whether China will wind up doing “too little, too late” in its inflation fighting efforts, and 2) whether China will have to recreate the Volcker experience to get a handle on things.

Once the ball of inflationary expectations gets rolling, it can be very hard to stop. On every continent save Antarctica, the phenomenon has played itself out over and over again.

In China it might look something like this:

• Mrs. Wen notices that food prices are rising faster than her annual rate of deposit.
• In a bid to avoid the erosion of purchasing power, Mrs. Wen looks to either borrow or invest.
• If she borrows, she does so with the conviction that prices will be higher tomorrow than today.
• If she invests, she is hoping to outpace inflation by capturing a higher rate of return on her assets.
• This borrowing and investing activity feeds the accelerating inflationary boom.

This is the pattern that existed in the late 1970s. Consumers were borrowing like crazy, knowing the thing to do was leverage up and buy now, paying back the debt in cheaper dollars tomorrow. Investors were also going crazy with inflation-linked asset plays, plunging headlong into oil and gas partnerships and the like.

Volcker On Steroids?

The U.S. inflation and stagflation of the 1970s led to huge profits for some. But it was bad news for America’s economy on the whole. Fed Chairman Paul Volcker finally stepped in and “broke the back of inflation” by raising interest rates sky high over a multi-year period.

The economy experienced painful recession under Volcker. But it was widely agreed that something had to be done.

In seeking to rein in inflation, Chinese authorities may have an easier time of it than Volcker did. This is because they have more control. Whereas Volcker could not give direct orders to the major banks, Beijing can do just that.

Any move on China’s part to “break the back of inflation” could still be painful, though. Slowing down a runaway economy is no easy task. It is less like conducting an operation with precise surgical tools, and more like hitting a mule over the head with a sledgehammer. In order to slow the mule down, you have to swing hard enough to make an impact on his thick skull. But if you swing too hard, of course, you risk knocking the mule out cold.

The evidence suggests Beijing may be forced to move sooner rather than later. This fear of China’s next actions – how hard they come down on inflation pressures – could be the main thing holding commodities back. A slam on the fiscal brakes for the world’s No. 1 growth story would lessen the attraction for hard assets, at least in the near to intermediate term.

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It was Travers who went to the office of a company and asked to be allowed to see the books. The clerk asked him, “Have you an interest in this company?”and Travers answered, “I sh-should s-say I had! I’m sh-short t-t-twenty thousand sh-shares of the stock!”

– Reminiscences of a Stock Operator

Going short – that is to say, taking a position that profits on a decline – is like using Betty Crocker cake mix. There are all kinds of recipes you can whip up, each one unique.

Today we’ll keep it simple, and look at the basics of two popular ways of going short.

Short Approach #1: Individual Equities

The first (and perhaps most widely known) way to go short is with individual equities. This is where you pick a specific stock, or perhaps a basket of stocks, to be short. You then “borrow” the shares and sell them in the open market, with the intention of buying them back later at a lower price. The difference between your initial sell price and your later buy price is your profit (or loss, if the shares rise rather than fall).

In some ways, being short individual equities is the most aggressive way to go. The play being made here is concentrated on the fortunes of one company or one industry, as opposed to being spread out over a broader range.

The risk in shorting individual stocks is that the fortunes of the company don’t always align with the fortunes of the broader market. If a specific company gets taken over, reports better-than-expected earnings, or sees its stock subjected to a “squeeze,” the end result can be painful.

But of course, the rewards that offset that risk are also potentially great. It is only by shorting individual companies that one can find stocks that fall from, say, $60 per share to less than $1, as Fannie Mae (FNM:NYSE) did in 2007 and 2008.

Many hedge fund players make what one might call “investment shorts.” The idea here is that a company or an industry is assessed with the same metrics that one would use in determining a normal investment. What are the prospects? How is the cash flow? How is the debt load? Is the business model sustainable? Is the franchise strong? And so on.

The difference is, while normal investors look for companies with bright futures and a good chance of being rewarded with long-term capital appreciation, the “investment short” concept seeks out the opposite. A good candidate for being shorted over a long period looks like the opposite of a value stock – most likely overvalued and overleveraged (too much debt on the books)... quite possibly overhyped (too much “blue sky” built into the price)... and, if at all possible, a franchise in ill health that looks subject to the ravages of competition.

Fraud and obsolescence are two key concepts that drive “investment shorts.” Hedge fund managers will often short a stock with an eye for long-term decline if they believe the numbers are phony. The most notable case of this was short-seller Jim Chanos and his bearish bets on Enron, back when the company was still a high flyer. Nobody but Chanos saw the fraud at first, and Chanos made a killing as Enron imploded.

Obsolescence is about the loss of competitive advantage as a company’s products go out of style or its technological edge is lost. A powerful example of this is Eastman Kodak. Kodak, the long-time leader in camera film, saw its franchise essentially gutted by the rise of digital cameras. Paul Simon once song, “Momma don’t take my Kodachrome away.” Momma didn’t take it, but the marketplace did, replacing it with something better.

Short Approach #2: Exchange-Traded Funds (ETFs)

The second most popular way to go short is through the use of ETFs, or exchange-traded funds.

ETFs have been around for a long time, but their rise to market dominance has been a relatively recent phenomenon. Many observers think ETFs are only going to grow in popularity, eventually posing a big challenge to mutual funds in terms of attracting investor dollars.

A big advantage of shorting an ETF is the lowered risk of being blindsided by individual company news. With an ETF, your position is not subjected to the highs or lows of individual news items. Instead, your fortunes rise or fall on the “basket” of equities represented by the ETF.

Let’s say, for example, that you had a low opinion of solar stocks (just to give a hypothetical example). For whatever reason, your analysis tells you that the solar space on the whole is likely to do poorly over the next few quarters.

With this conviction in hand, you could find a few individual solar stock names to go short. Or you could simply short TAN, the Claymore Global Solar Energy ETF, and get exposure to a basket of solar names in one fell swoop. (“TAN” as in sun tan, get it? A lot of ETFs go the cute route – there is an agribusiness ETF, for example, with the symbol MOO.) Anyhow, using an ETF like TAN lowers your transaction costs and improves the odds that the trade will reflect the fortunes of the solar industry on the whole, rather than the peculiars of any one stock.

Watch Out for Weightings

Probably the biggest thing to watch out for with ETFs is the risk of poor construction. Before going long or short an ETF, it’s always a good idea to look at the “top 10 holdings” to see how that particular ETF is built. (You can find out the top 10 holdings right through a simple left-hand link on the Yahoo Finance page.)

As an example of holding discrepancies, consider the two most popular “consumer retail” ETFs – RTH and XRT.

If you look at the top 10 holdings for RTH (which you can get from this link), you’ll notice that RTH is weighted roughly 20% toward Wal-Mart, 12% toward Home Depot, and 10% toward Amazon.com. That’s pretty lopsided. In a way, RTH is a big bet on just three companies – Wal-Mart being the biggest component of them all by a large margin.

Now consider the top 10 holdings of XRT, another big consumer retail ETF. (You can see those holdings here). It’s easy to see that XRT is put together very differently – and much more logically. There is no single company in the XRT “basket” that accounts for more than 2% of the total.

The above comparison shows why I much prefer XRT over RTH as a trading vehicle. It’s more of a true representation of the general retail space, as opposed to being tilted toward three big companies. If I wanted to make a specific play on Wal-Mart or Amazon, I would just go with Wal-Mart or Amazon.

It’s interesting to dig through the holdings for various ETFs to see what you get. For example XLE, the popular energy ETF, has more than 31% of its weighting toward just two names – Exxon and Chevron.

International ETFs in particular – the iShares for various countries – are where you really need to pay attention to the weightings. For instance, the iShares Spain ETF (EWP:NYSE) has more than 40% of holdings in just two big players, Banco Santander and Telefonica SA. That’s hardly representative of the entire country as the name suggests.

As usual, we’ve only scratched the surface here. The next time we visit this topic, we’ll talk about two other popular means of shorting – options and inverse ETFs.

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Five of the many reports cluttering up my desk this morning claim to be pertinent to the price of gas this summer.

As regular readers may recall, I track these things closely for two reasons. First, there is the effect gas prices have on the economy. Inflation may be the disease, but gasoline is one of that disease’s chief vectors, the agent that carries it deep into our economic body – and our wallet.

The second reason I track crude oil and natural gas is to make as much profit off the damn stuff as I possibly can. Just think of it as getting a little of our own back.

Red Sky in the Morning?

The first report comes to us from AccuWeather’s Joe Bastardi, who apprises us that his outfit’s slide-rule types are looking for the Atlantic and Gulf of Mexico to enjoy an unusually active hurricane season this year, both in terms of quantity and ferocity of storms.

In 2009, we saw the weakest season in a decade, nine named storms that never actually came on shore here in the U.S. In 2010 we are told to expect an above-average season, some 16 to 18 storms with at least two or three gob-smacking the homeland.

They credit this to “a weakening El Niño in the Pacific.” Apparently, this cyclic Pacific warming cycle protected us last year, and may fail to do so this year.

Or Not

Meteorology may very well be the oldest true science (I’ve always had a hunch that some of those scratch marks on the Lascaux cave walls were simply counting how many damn days in a row it had rained). But it still has a hard time with stuff like whether or not we will get three inches or three feet of snow here at Seven Oaks Farm.

Still, Colorado State University’s Tropical Meteorology Project has also called for 16 named storms, WSI is calling for 13 storms, with eight slated to hit Category 3 or higher on the Safir-Simpson Scale, Commodity Weather Group is calling 11 storms all told with five hitting hurricane strength, and most in the trade suspect that the May report out of the Fed’s Climate Prediction Center will fall in line as well.

This whole guessing game is germane to energy prices in that some 27% of our crude oil and 15% of our natural gas come out of the very shallow Gulf of Mexico. Should any of these storms rip through the Gulf, we could expect to see said supplies cut off with an attendant price increase. Heck, just the treat of same is enough to start a speculative frenzy in downtown New York.

China Wants Your Gasoline

Next up, we have a slightly more concrete issue brewing in China. It seems that the world’s fastest-growing economy has passed a critical threshold in February, when its demand exceeded internal supply, and it became a net importer of oil and associated product.

If these numbers are to be trusted (and that is always an issue when dealing with Beijing – and Washington too for that matter!), it appears that Chinese demand is up 58% year over year, with China purchasing some 1.8 million more barrels a day.

Now even here we see some rather odd caveats: JPMorgan Chase’s Brynjar Eirik Bustnes claims that some of this may be linked to low refinery utilization during the month of the Lunar New Year.

Still, one can easily imagine how this too is whetting speculators’ appetites.

OPEC Upgrades Demand – Again

Again we go to the pile on my desk, and find that OPEC is expecting to pump 880,000 more barrels per day (roughly 1.04%) this year than it did in 2009, if it has any hope at all in keeping up with burgeoning demand from both China and recovering Western economies.

The caveat here? This current call has been upgraded by some 80,000 barrels over last month’s prediction, and may yet be upgraded again in a similar manner. OPEC’s most recent statement warns that “questions remain as to how long governments will be able to support their economies.”

Which brings to the furor brewing in Washington over the Federal Reserve’s commitment to an “extended period of low rates.” It seems that a vocal minority of voting board governors feel that this pledge is boxing them in a bit.

Talk, Talk, Talk

They don’t actually want to change rates, mind you. When pressed, they concede that “the U.S. jobs market remains weak, with unemployment rate near 10% and job openings scarce.” But they would like that “extended period” phrase that was used in the last four FOMC reports changed to “some time” in the next statement. This way, investors will understand that the Federal Reserve will “not refrain from raising rates well beyond what is prudent.”

And we believe them, because the Federal Reserve has such a strong track record of fiscal prudence, right?

Your Nightmare Is a Speculator’s Dream Come True

Let’s string the dots together one more time: flood of cheap dollars (and yes, they will start getting cheaper again, now that that whole euro funk is passing) chases limited supply of crude oil… crude oil goes up… everything that travels by truck train or plane gets more expensive… inflation!

Oh, and here’s one last item of the heap: It seems that the supply of crude oil stateside is declining substantially faster than “the experts” were expecting. The call was for pretty much no change this week, with an even balance between imports into the plenums and use by refiners. Instead we see a 2.96 million barrel drop in the plenums.

This shortfall delighted the aforementioned speculators, who responded by jacking July crude oil futures to $84/bbl.

There is only one minor difference between my prediction for the economy and some of my dour compadrés’: they are calling for a double-dip recession to take down crude oil. I figure that crude oil will take the economy down into the next recession.

Both ideas stink. But mine offers a shot at some cool gains along the way.

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Chuck Prince, the deposed CEO of Citigroup, has a quote that will haunt him for the rest of his life.

In the summer of 2007, the subprime mortgage crisis had not yet blown up. The warning signs were there, and plenty of observers were alarmed… but Wall Street was still fat, happy, and oh so complacent.

In July of that year, for an interview with the Financial Times conducted in Japan, Prince uttered the words he will forever regret.

“When the music stops, in terms of liquidity, things will be complicated,” the onetime Citigroup CEO said. “But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

The chart above shows you how well the whole “still dancing” thing worked out.

When the subprime crisis hit with full force, Citigroup – one of the largest, most powerful financial service firms in the world – saw its balance sheet blown to smithereens. Citigroup’s share price went into terminal meltdown in result, plummeting from the lofty heights of $50 to a lowly buck fifty per share.

Thanks to Prince (and other Wall Street CEOs like him), $100K worth of Citi stock purchased pre-meltdown would barely buy a used car today.

Chuck Prince got canned, but his golden parachute ensured a cushy landing. After blowing up their respective franchises, he and Stan O’ Neal (the CEO of Merrill Lynch) walked away with tens to hundreds of millions. Citi, meanwhile, only survived courtesy of taxpayer-funded injections, to the tune of hundreds of billions.

The moral of the story? Tap dancing through mine fields is a pretty stupid thing to do. (Unless, of course, you know there will always be some other sucker, er, generous soul to bail you out and pay the tab.)

Puttin’ on Their Dancin’ Shoes

As the stock market goes into full-on euphoria mode, your bemused editor can’t help but shake his head and chuckle. Investors hear that sweet, sweet music, and they are tap dancing once again.

The “land mines” in this particular environment are many and varied. What’s more, they seem to be popping up with ever greater regularity. For instance, the following examples were all taken from just one 24-hour news cycle:

• Brazil Retaliation Threatens a New Trade War.“Brazil moved to raise tariffs on a wide range of American goods on Monday,” the Financial Times reports, “potentially igniting a trade war with the US over cotton subsidies after eight years of litigation at the World Trade Organization.”

• China Sounds the Alarm Over Local Government Debt. “China plans to nullify all guarantees local governments have provided for loans,” Bloomberg reports, “…as concerns about credit risks on such debt increases. The Ministry of Finance will also ban all future guarantees…”

It seems that China’s local provinces are going crazy with what they perceive to be “risk-free” infrastructure projects, building empty shopping malls and bridges to nowhere like it’s going out of style. Sooner or later, maybe sooner, China’s banks are going to be hit by an NPL comet – NPL stands for “non-performing loans – and when that happens the great China real estate bubble will burst.

• Carnegie Economist Predicts “Virtually Inevitable” Greek Default. Noted economist Uri Dadush, currently with the Carnegie Endowment and previously with the World Bank, believes it all but guaranteed that Greece will “either default or need a bailout of some sort.” European political responses to the Greek crisis thus far have been the height of idiocy. At some point it will become clear to the world that the eurozone is financially ungovernable, with hot air promises floated one day and nixed by waffling the next.

• State Tax Revenues Take an $87 Billion Hit. As we will cover in more detail in a future Taipan Daily, the “state of the states” is one of absolute peril. Local tax revenues have just registered their biggest year over year decline in history. Record tax hikes will be the response. As the majority of U.S. states have balanced budget amendments, there is no allowance for deficit spending. This means services will be slashed, property and business taxes will rise, and consumer and small businesses will take the blow hardest.

• The Fed Is Set to Embark on “A Tightening Cycle Like No Other in Its History.” That exact phrase, “a tightening cycle like no other in its history,” was recently used in a speech by Brian P. Sack. And just who is Brian P. Sack, you ask? He is the “executive Vice President of the Markets Group at the Federal Reserve Bank of New York.” In other words, an insider’s insider. Sack is rumored to be the guy who runs the “Plunge Protection Team,” for those of you who do not doubt the PPT’s existence. This connected insider is warning us that the mother of all tightenings is coming.

Once again, the above “land mines” were not cherry picked from weeks’ worth of news. They were taken from a single 24 hour news cycle. And there are plenty more where that came from.

Won’t Matter ‘Til It Matters

“Who cares about all that stuff,” investors seem to be saying now. “It won’t matter til it matters.”

And you know what – that’s absolutely true. But the important thing to understand is, this is the exact same mentality Chuck Prince and his buddies had, circa summer 2007, when they justified their intent to “keep on dancing.”

As mentioned in recent weeks, we continue to see a slugfest between the forces of “top down” and “bottom up.”

On the “bottom up” side, we are coming off a period of mass-stimulus injection unprecedented in all of financial history. These injections, coupled with a resilient corporate sector that has responded to the crisis by getting “lean and mean,” have created the powerful appearance of gradually spreading recovery.

But now a curious calculus is coming into play. Just as investors’ expectations of full recovery are getting fully priced into the market, the stimulus injections are about to be withdrawn… and the tightening cycles are preparing to begin.

“Normal Cycle” or Supercycle’s End?

In a bigger-picture sense, there are two views of what is happening now.

The first, more or less unspoken view is that the global financial crisis, while hairy and scary, was not much different in scope or impact than any other “cyclical” downturn. By way of this view, the world will be headed back to “normal” soon – and the problems of the past few years will simply melt away, like the foggy fragments of a soon to be forgotten bad dream.

The other view, which your humble editor holds to, is that the market ain’t in Kansas anymore. Much as the willfully naïve optimists might wish, we can’t simply click our heels three times and whisper “there’s no place like home.” Instead, we must face up to the following facts:

• The West is at the tail end of a 25-year leverage and debt “supercycle.”
• The great task before us – the need to “deleverage” – has hardly begun.
• All we have done, thus far, is transfer private leverage into public hands (via government stimulus and taxpayer funded bailouts).
• The ability of sovereign governments to carry more debt is near the limit.
• Stimulus will end – and a new hiking cycle begin – just as unrealistic market expectations hit their peaks.

How many times have we seen this cycle play out now?

Mr. Market gets severely bummed out and panics. Then things improve – often with the help of aggressive stimulants – and as the picture gets better, Mr. Market swings from depressed to euphoric. Manic downside becomes manic upside. Then reality hits Mr. Market in the face with a frying pan, and we get another brutal downswing again. Due to our inability to learn the first time around, the second dose of harsh medicine tastes even more bitter than the first.

It’s the same movie, over and over and over again. It’s right there, in all the market history books (including recent history). On an individual level, the human capacity for learning is most impressive. On the level of masses and crowds – the level at which the market operates – we NEVER seem to learn.

Don’t Be Like Chuck

Mutual fund managers have a dirty little secret. Like poor old Chuck Prince, they have to keep tap dancing through the land mines, no matter what. That is because every mutual fund manager has a nasty little demon sitting on his or her shoulder that goes by the name of “career risk.”

This demon whispers all day into the mutual fund manager’s ear, saying things like “You’d better stay fully invested, because if your performance isn’t as good as your peers then you’re dead!” It’s like a knock-down, drag-out race to “keep up with the Joneses,” where those who fail to keep up get fired from their cushy jobs. The only problem is, it’s not THEIR money being risked in this race. It’s yours!

Of course, you don’t have to clear out all your investments and get the heck out of dodge. Instead, you can protect yourself – and hedge against the inherent risks of being long in such an overextended, precarious market – by considering the different ways and means of going short.

We’ll talk more about that on Friday.

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There are a lot of smart guys in the investment world. There are outstanding money managers who have produced impressive returns for their clients. They can be found investing money for mutual funds, hedge funds or institutions. They are considered what is called “smart money.”

In addition, there are also a lot of folks who pay close attention to, and who write about, the moves of these top money managers. People like you and me want to improve our investment successes by keeping track and learning from these pros. Investing isn’t a zero-sum game – we all can make money, have big winners or retire comfortably.

Of course, following these professionals doesn’t mean automatic success, and many of the supposed best and brightest have failed, but in general, it can be very helpful to pay attention to their actions.
Last week I talked about Warren Buffett and Berkshire Hathaway. His record speaks for itself, and if over the years you owned the stocks that he did, you would have also done quite well. But clearly, there are a lot of great investors worth following besides Buffett who have similarly impressive track records.

Investors like George Soros (Soros Fund), Bruce Berkowitz (Fairholme Capital), Seth Klarman (Baupost), and Carl Ichan (Ichan Partners) have great investment records, to name just a few of the better-known ones.

So how do you keep track their moves? Quarterly, all large asset managers and hedge funds with more than $100 million in assets are required to disclose, among other information, their long equity holdings to the Securities and Exchange Commission, the beleaguered government oversight body. These disclosure documents are called 13F filings.

The filings show what these funds are buying and selling. But the filings lag the actual moves of these investors by a quarter. So within that three-month lag there could be pertinent shifts in their portfolio that are not disclosed. Yes, this does reduce the reliability of tracking their moves but still, the insights are pretty valuable – especially when tracking the moves of those managers who have low portfolio turnover (longer-term investors).

As you know, I’m the editor of Taipan’s Safe Haven Investor, which is geared toward safely building wealth for the long term. Prior to my taking over as editor, part of the investment thesis for Safe Haven was based on finding stock ideas that were found in 13F filings of some of the better money managers.

I have continued to keep this concept intact as one of the investment variables that I consider when finding great ideas for the Safe Haven investment portfolio. There are many investment considerations when selecting stocks for the portfolio, but for me, it is valuable to know whom I am investing “alongside of.”

For several of stocks in the portfolio, it is helpful knowing certain investors had positions in what were to be Safe Haven recommendations. Stocks like Eaton Corp. (ETN:NYSE), Olin Corp. (OLN:NYSE), Key Energy Services (KEG:NYSE), Otter Tail Corp.(OTTR:NASDAQ), General Electric (GE:NYSE) and Clorox (CLX:NYSE), to name a few, are examples of where smart money is invested along with Safe Haven.

As I mentioned earlier, several firms and blogs track the moves of the most respected investment professionals. One list I came across is the Goldman Sach’s VIP list. VIP, in this case, stands for Very Important Positions by fundamentally (as opposed to technical or trading) oriented funds. Goldman looks at over 400 funds and screens for the top common holdings among them.

Here are the top 25 holdings thanks to Goldman Sachs and Marketfolly.com:

One observation I would make is that it appears that quality and size matter. In this fickle market, where high-quality names underperformed in 2009, investing in larger industry leaders should be a profitable endeavor for 2010.

You can take this data and analysis one step further as Goldman does by looking at the top 10 largest new positions that were in the quarter (i.e. fourth quarter 2009). A variety of names show up, including Mead Johnson Nutrition, Wells Fargo (WFC:NYSE), Citigroup (C:NYSE), Amazon (AMZN:NASDAQ), Hewlett Packard (HPQ:NYSE), WellPoint (WLP:NYSE) and CVS Caremark (CVS:NYSE).

It looks like financials and healthcare are of high interest to money managers. Both those sectors have been beaten up for obvious reasons, but I would agree that at some point the dust will settle and confidence will return to these sectors and improved earnings visibility is on the come.

As another example, another well-respected manager, David Stemerman, recently initiated several new positions in consumer-oriented and retail-based stocks such as Polo Ralph Lauren (RL:NYSE), Abercrombie & Fitch (ANF:NYSE), Estée Lauder (EL:NYSE) and Visa (V:NYSE). Stemerman, like me, is bottom-up, long-term-oriented investor and looks for quality companies and management to invest in.

I’m happy to see him increasing his exposure to the consumer because I also believe that the American consumer is on the path to recovery; thus I have been investing accordingly for our Safe Haven readers. This is a good example of the value of 13F filings and paying attention to what the professional guys are doing. There is extra comfort in knowing that a successful investor like Stemerman has similar investment thoughts as myself.

Overall, following the smart money can influence your investment decisions but shouldn’t be the dominant factor in selecting stocks or managing your portfolio. For me, of the many variables I take into consideration during my investment research and investment analysis, 13F filings is one of them. But it is certainly a value-added exercise, and one that can be a very informative and I get some comfort knowing I’m investing with some of the best in the business.

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How do you do well in markets? Easy – just buy low and sell high. Make sure the trend is your friend, then cut your losses and let your profits run. If you can just remember that it’s mind over matter and practice makes perfect, in no time at all you’ll be on easy street.

Okay, enough of that. Ugh.

The point of that opening paragraph – sarcasm, as you’ve surely now realized – was not to impart timeless pearls of market wisdom. It was meant to demonstrate the tired, worn-out nature of the hoary old trading cliché.

Now, granted, many of the old sayings have stuck around for good reason. There are certain truths that apply just as much today as they did 100 years ago. Woe betide the trader who forgets or neglects those truths.

But some popular trading and investing clichés are little more than a waste of breath... a lazy man’s substitute for clear thinking.

Here is one your editor has never, ever liked: “The market is always right.”

What the Heck Does That Mean, Anyway?

When traders use this phrase – “The market is always right, you know!” – they never define their terms, or bother to address the clear exceptions to the rule.

For instance: Was the market “right” in the early 1970s, when incredibly valuable franchises like the Washington Post were trading for something like a half or a third of conservatively estimated intrinsic value?

Was the market “right” in January of 2009, when high-quality oil service companies with low debt and ample cash flow were trading at an insanely cheap three times earnings?

And was the market right in 1999, when various “dot-bomb” stocks were priced at multiples of infinity (because actual earnings were zero and “burn rates” were sky high)?

No, the market is not always right. There are clearly times when the market goes off its rocker, in both directions. And because prices are always changing, one could just as easily say “the market is always WRONG.” (Some traders do, in fact, operate profitably off such a principle.)

I can hear the objections: “Now just hold on a second JL, you’re not being fair. Traders who say ‘the market is always right’ don’t deny that valuations can run to high or low extremes. They are just trying to point out that, for the trader (if not the value investor), arguing with the market is generally a bad idea.”

Yep. Fair enough. Your editor still maintains, though, that “the market is always right” is an exceedingly poor choice of words. If what you really mean is “don’t argue with the market,” why not just say “don’t argue” instead?

And yet we still have a problem. Every position is an “argument” in the sense that it represents a disagreement with the prevailing market judgment. The purpose of buying or selling, be the intent to hold for three years or 30 seconds, is to make a profit. That implies a belief that, for whatever reason, the market has a better than sporting chance of moving favorably in the direction one anticipates.

But this amounts to disagreeing with the market’s current assessment of what the future holds, does it not? Were the market not in error, where would the opportunity come from?

How, then, can anyone truly think “the market is always right” without being 1) vague on meaning, or 2) a useless academic (i.e. a believer in the efficient market hypothesis)?

It’s one of those sayings that only works if you don’t think it through.

The Parable of Three Umpires

For a better alternative, consider the following anecdote.

Three baseball umpires are sitting in a bar watching the game. The discussion comes round to defining the strike zone – what counts as a “strike” and what counts as a “ball.”

The first umpire says: “I just call ‘em like I see ‘em.”

The second umpire says: “I call ‘em exactly the way they are.”

The third umpire drains his beer and replies: “They ain’t nothin’ until I DECIDE what they are.”

The market is like that third umpire. The price ain’t nothin’ until the ump makes the call.

“Hold on,” some of you say. “Isn’t this the same as saying ‘The market is always right’”?

Nope. Not by a long shot.

How many umpires do you know who have never made a completely screwy call? How many times have you seen that agonizing slowroll video footage showing how badly blown a decision was, or heard groaning sports fans (perhaps including yourself) lament the lack of replay footage in the first place?

The umpire always has final say, but that isn’t the same thing as being right.

And this particular ump (Mr. Market) can’t be fired, despite his crazy tendencies. Sometimes he shows up to the ballpark drunk. Other times he’s hopped up out of his mind on stimulants. Still other times, our beloved ump gets morbidly depressed, or decides to redefine the strike zone based on some wacko new theory from his favorite astrologist.

He Sobers Up Eventually

The guy does have at least one redeeming quality though. He always sobers up eventually.

The key qualifier here being “eventually.” You can’t always know how long it will take. So you keep a close eye on the old ump... you get to know his habits, his tendencies and quirks. Eventually you develop a feel for when he is out to lunch, and when he’s starting to come back around.

Admittedly, “the market is a drunken umpire” may not be as pithy or straightforward as “the market is always right.” It will probably never make it onto that hallowed list of trading aphorisms that never die.
But your humble editor considers the umpire metaphor an upgrade nonetheless, because it manages to encapsulate a subtle yet important trading and investing principle. Arguing with the market in the short term is an exercise in futility – all it gets you is frustrated, or maybe even thrown out of the game. At the same time, though, there is no reason to assume the market is infallible. Authority and omniscience are far from the same thing.

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If you wanted more proof that Washington and Brussels are clueless, here it is (via Bloomberg):

The U.S. is asking hedge funds not to destroy trading records on euro bets, according to a person with knowledge of the requests, as Europe and the U.S. step up scrutiny of the funds’ role in the Greek debt crisis.

The Department of Justice sent notices to save the records to at least some of the hedge funds whose executives attended a dinner hosted by New York-based research and brokerage firm Monness, Crespi, Hardt & Co. on Feb. 8, said the person, who declined to be identified because the information is private.

The European Commission said [on March 2] it will investigate trades in sovereign credit-default swaps in the wake of the Greek crisis, which has pushed the euro lower and prompted officials to warn hedge funds they shouldn’t try to profit from the woes of the region’s nations.

As a U.S. taxpayer, this “scrutiny” absolutely sickens me. As a trader, this news indicates the euro’s decline is likely not done, and may well just be getting started. (Politicians get shrill and angry when cornered – and if all other measures look hopeless, they blame the speculators.)

NOW We Get “Scrutiny”?

As we walk through the logic, first let me put on my ticked-off taxpayer hat. My extreme annoyance at the DOJ’s “investigation” here boils down to this. The hedge funds being investigated did not receive a single penny of taxpayer-funded bailout money.

And yet, the too-big-to-fail Wall Street entities that ROBBED TAXPAYERS BLIND – after getting bailed out with hundreds of billions in taxpayer funds – were never investigated at all.

There is nothing illegal, or even remotely illegal, about buying and selling large quantities of an international currency. Commodity and currency markets have no restrictions as to “inside information.” There isn’t any such thing.

So why the DOJ (Department of Justice, no relation) is poking its nose up hedge funds’ skirts, I have no idea – except maybe as a sop to Brussels. But what I really want to know is, why didn’t anyone take a good hard look at the way the big Wall Street houses (ahem, Government Sachs, cough cough) managed to rob taxpayers blind on more than one occasion?

The evidence on the AIG fiasco is plain as day and enough to make you sick. Treasury Secretary “Turbo Timmy” Geithner gives all appearances of being in it up to his neck, regardless of claims to the contrary, with his Wall Street buddies being on the receiving end of billions in ill-gotten gains. Worse still, later evidence showed Goldman Sachs to be the epicenter of toxic asset creation – the very swill that Goldman stuffed down clients’ throats, turned around and shorted themselves, and nearly blew up the financial system with.

Yet none of that – nothing involving the clear and direct misappropriation of hundreds of billions or even trillions in taxpayer funds – gets truly “looked at.” No, the DOJ doesn’t have time for that. Instead, they have to go poke around a couple of guys who never took a penny from the government and had the bad form to give their opinion on a currency trade over dinner. Good grief.

No Crying Allowed

In the movie A League of Their Own, Tom Hanks has a great line. “Are you crying? There’s no crying in baseball!”

I’d like to similarly grab the whiners on the European Commission and yell, “Are you crying? There’s no crying in forex!”

Look. The euro is a “big boy” currency. It should be able to fend for itself. Furthermore, speculators did not create this situation. Greece did. And the whole eurozone did.

The currency markets are the biggest, deepest markets in the world. We’re talking trillions of dollars in transactions, of every stripe imaginable, every single day. And the euro is not some podunk little currency. It is (or once was) No. 2 to king dollar... a contender for the world reserve currency throne. The euro-weenies crying wolf over a couple of hedge funds need to grow a spine.

It is, of course, true that major speculative interests are “attacking” the euro. We flat-out predicted this would happen some time ago. But here is the thing: Speculators don’t attract strong targets. They only go where there is weakness... where the attack is justified in the first place.

To understand the logic in this, imagine if the evil speculators decided to “attack” Berkshire Hathaway and drive the share price down 50%. What would happen? Buffett would laugh out loud. He would delightedly borrow every nickel he could to buy back shares at their artificially depressed price, and the speculators would get carried out on a gurney.

It’s the same thing with currencies – especially big, liquid, world-reserve-candidate currencies. You can’t manipulate a market like that for long without getting your head handed to you.

In other words, the euro isn’t vulnerable because George Soros and his pals decided to beat up on it. It’s vulnerable because countries like Greece have been racking up huge debts and perpetrating acts of gross fiscal irresponsibility for years and years.

On an even bigger picture level, the euro is vulnerable because it is based on an impossible business model. The eurozone as a concept – the monetary union of 16 disparate countries without political or cultural union – simply doesn’t work.

It gives the appearance of working in good times, but that’s not what matters. What matters is how well the model holds up in bad times. Before now, the euro had never truly been “stress tested.” And now we can see: Just as many predicted, the result of the euro’s first true stress test is a big fat “F.”

A Greek Bailout Will Not “Resolve” the Problem

All of the above is obvious for anyone with eyes to see and ears to hear. That’s probably why European politicians are so freaked out. They know the euro’s problems run much, much deeper than just Greece.

There has been a lot of chatter in the financial press about a potential “resolution” to the Greek debt crisis. There has further been plenty of assumption that, once Greece’s problems are “solved,” the euro’s problems will be solved too.

Nope. No way. Not by a long shot.

Greece is not a standalone problem. It is more like the tip of a very large iceberg – an iceberg of runaway spending, broken promises, and the creeping specter of deflation.

With the Greece situation, the financial base has been remarkably off base in their reporting. Every time the euro-weenies, er, European politicians move closer to a “deal,” the press gets excited, as if the close to the crisis were at hand. And yet the talks keep running into a brick wall – Germany.

Angela Merkel, the German Chancellor, does not want to give a single euro to flailing Greece. She is willing to extend friendship, diplomacy, verbal support, the whole nine yards of empty talk... everything but the goods. This is because German citizens are dead-set opposed to bailing out irresponsible eurozone members.

The prudent and sober Germans look to Greece and see a country that threw lavish spending parties for years, went to great lengths to hide the true extent of its debts, and doesn’t even have a functional tax collection system. Beyond that, the Germans know that if they give Greece a check, they may soon have to write another check to Portugal. And another, to Ireland. And yet another, to Italy. And then there is the big daddy of them all, Spain.

This chorus line of bailout candidates means no easy way out. If Greece gets a bailout check, the other guys line up for checks. If Greece doesn’t get a check, they go to the IMF (International Monetary Fund) – and IMF involvement makes the eurozone look like a failure. (The Argentine peso springs to mind...)

The Supreme Irony

The supreme irony is that a lower euro would actually be GOOD for Europe. Why? Mainly because a cheaper currency makes exports more competitive. (This is exactly why China holds down the value of its currency, so it can sell more goods abroad.)

Politicians hate speculators as a general rule, but that is true for a simple reason. Politicians are always and forever fighting the forces of Mother Nature, and speculators make a living carrying out nature’s work. The reason you rarely find animal remains on a forest floor is because those remains get recycled back into the ecosystem so quickly. Feeding on market dislocations, speculators have a similar sort of job. “I’m just the undertaker,” Soros once said.

If it makes sense economically, politically and logistically for the euro to be trading at a much lower valuation – say, back to $1.25, or even all the way down to a buck in $USD terms – then speculators will see that imbalance as an opportunity and get to work. And it certainly makes sense for the euro to be trading lower in this case.

On a continent-wide basis, the eurozone is struggling. An overly strong currency makes it hard for exporters to do their part in bringing about economic recovery. The too-strong euro is also slowly strangling the weaker members of the eurozone, who have no palatable options for dealing with the threat of deflationary downward spiral other than taking crushing levels of debt.

Worse still, the traditional IMF medicine of deep spending cuts and painful austerity measures generally leads to one thing: Mayhem in the streets, of the sort Greece is now experiencing. Angry pensioners facing down cops in riot gear is not a pretty sight.

Hey Idiots

As Mark Twain once remarked, “Suppose you were an idiot – and suppose you were a member of Congress. But I repeat myself.” Across the pond, Twain’s sentiment holds just as true. The European politicians frothing at the mouth over an “attack” on the euro fail to realize that a less expensive currency is perhaps the one thing that increases the eurozone’s chances of survival.

Again, a lower euro means less pressure on countries struggling with debt-depressed economies and deflationary headwinds. It means more revenue for exporters and bigger reported profits for European banks with substantial operations abroad. And it means a more accurate reflection of the euro’s longer-term prospects, given the severe loss of credibility at the ECB (European Central Bank) and the heavy fiscal housecleaning that now must take place in the euro zone.

All the above explains why supposedly evil speculators are “attacking” the euro. It’s because the speculators understand basic economics... believe that the euro should be structurally lower for a whole host of reasons not of their own making... and are looking to profit through a little forced awareness and common sense.

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As long as we’re having throwdowns on the whys and wherefores of the market these days, I may as well put in my two cents’ worth.

First, I want to preface by noting that the entire reason we are having these arguments is because U.S. stocks are pretty much the same price today as they were some six months ago. Indecisive runs like this are by definition the result of mixed news, or perhaps more precisely, mixed understanding of the facts on the ground on the part of investors.

It’s a funny little supply and demand problem. The lack of consensus creates demand for the one thing that is in shortest supply: a clear vision as to what’s really going to happen next. As with any shortage, analysts see this need and scurry about marshalling their favorite statistics into predictions that never quite happen the way they figger.

Short-Term Aberrations…

Really the most sensible technique (as my compadré Justice has pointed out repeatedly of late) is to assemble a series of probable scenarios based on those aforementioned facts on the ground, historical memory and perhaps a little horse sense.

That said, I have to (collegially) disagree with Justice as to the supposed decoupling of oil from stocks.

First of all, I believe that external currency perturbations have affected the short-term price of oil. That’s a fancy way to say that it is going up, and pretty much in lockstep. But the whole PIGS crisis threw that trend off for a couple of weeks by creating aberrant short-term value in the U.S. dollar.

Mid-Term Corrections…

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As I sit to write to you today, we hear that Greece will knuckle down and cut spending, bringing this aberration to an end (at least for the nonce), and allowing crude oil to resume its climb up and over the critical $80/bbl threshold.

Now, there are a few interesting historical correlations to note about $80 futures, be they oil or dollar contracts. Back in September of 2007, Dollar Index futures were moving down through $80 (just as they are today!) and on their way to $70 or so. Oil on the other hand, was moving up through $80 on its way to $140.

And S&P 500 futures were about to attempt 1,600 for the final time before plunging nearly 60%.

Long-Term Inflections…

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Another peculiar area of disagreement between Justice and me concerns Washington’s fiscal policies. He thinks that Washington is beginning a campaign to actively withdraw excess liquidity from the market in an attempt to stymie nascent inflation.

That might just be the prudent, competent thing to do. Unfortunately, it has never happened, at least not in modern memory.

I think that Washington is throwing smoke, and will never withdraw any significant liquidity until they are absolutely forced to do so by outraged voters who are being eaten alive by rampant inflation.

The One Thing We Always Agree On

I call this disagreement “peculiar” because if there is anything Justice and I do agree upon, it’s that Washington is populated almost entirely by venal, imprudent, self-serving incompetent bureaucrats.

(Note to subscribers: If you happen to actually be a Washington bureaucrat, please assume that I am grouping you into the wise, prudent, competent minority that probably does most of the work around the joint.)

Because I am willing to assume that excess specie will still flow unabated, I am also compelled to warn that we may be at a similar inflection point to September 2007, wherein the dollar will continue to fall, oil will continue to rise, and U.S. stocks will begin to roll over.

A Dangerous Scenario

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This would gibe neatly with Scenario Three on my Master Chart, wherein the S&P 100 (OEX) declines the blow-off top traps of both previous historical cycles, and instead cuts directly to “Slump Mode.”

As Justice has warned, most scenarios seldom survive the actual war, but they still can be quite useful. Perhaps we might think of those brave young men who clear the roads of improvised explosive devices in Iraq and Afghanistan.

The fact that they removed a particular type of mine from a given location on Wednesday does not necessarily mean that they will find a similar bomb in the same location on Thursday. But it’s still a real good idea to be looking out for the damn things as we drive down the pike.

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