The Room – 03/16/2009

Dear Reader,

This week I tripped over an old musical favorite, I'm Your Captain, by Grand Funk Railroad, which is what I'm listening to as I begin this weekly missive.

While the song has a little rust on it, for those of you who haven't taken a ride on Grand Funk Railroad of late, it's a nice enough trip. You can listen to it here.

Now, on to what seems important this week.


This week Vikram Pandit, the CEO of Citigroup, a bank that has managed to lose $38 billion over the last five quarters, sent around an internal memorandum in which he said he was "encouraged" by the company's performance so far in 2009.

This fig leaf was enough to light the fuse to a pretty decent rally in U.S. stocks.

Looking at the Citigroup stock chart over the last three years, I have a hard time believing that there is anything left to be discouraged about.

The government's efforts to keep the mega-bank afloat to date have been nothing short of herculean, with infusions of over $45 billion in new capital. As important, the Treasury and its many agencies have agreed to cover losses from over $300 billion in toxic paper held by Citi. (With the new TALF plan, they can go much, much higher than that, if required.)

With that sort of support, it is safe to assume that the bank has been chosen by Team Obama to survive... though in a form that may be less than satisfying to existing shareholders.

Several things jump off the page when reading the biography of Vikram Pandit, the aforementioned CEO of Citi.

The first is that he is an impressive guy: lots of degrees, directorships, and high-level work experience... all of the right sort of credentials. You know, the sort possessed by the very same best and brightest who helped bring Wall Street to its knees in the first place.

Second, he seems to lack certain restraints when it comes to OPM (other people's money), witnessed by the fact that it was he who stubbornly insisted on going forward with the purchase of a new $50 million private jet for the company – this after receiving the aforementioned bailout. (Not to mention that the jet was to be of French manufacture, adding a measure of salt to American wounds.)

Most importantly, however, is that he clearly has a knack for making good deals for bad assets. Case in point, he sold Old Lane Partners, an underperforming hedge fund with just $4.5 billion under management, to CitiGroup for $800 million -- a truly ridiculous amount. He personally made close to $200 million on the deal.

And now, it seems, he's trying to engineer the same sort of buy-out for CitiGroup... but this time the buyer is... you!

Specifically, Citi has offered to convert the preferred shares held by the Treasury into common stock, effectively finishing the process of seeing the bank nationalized. Quoting Financial Week...

    The Wall Street Journal reported today that Citi's proposal would not cost taxpayers more money. But under the terms Citi has reportedly offered, the Treasury would convert its preferred shares to common at a huge premium to Citi's stock price. If, in fact, conversion took place instead at the current price, taxpayers would wind up with 90% of Citigroup's shares, not the 40% Citi's plan reportedly proposes. And shareholders would be diluted by more than twice as much as they would be under Citi's reported plan.

    That led some analysts to complain that Citi was asking taxpayers for terms far more generous than it would receive under the Treasury's new program. "Another *&%# for taxpayers," observed Henry Blodget on the financial website, Tech Ticker.

The fact that an internal memo from a drowning bank in a crashing economy can ignite a strong rally tells us that at least some investors are tiring of the bear market, and are willing to throw down cash in the hope that it's time for the bull to run again. So, we could see the market rally for a bit longer, but the odds remain good that it's a bear market trap.

In the case of Citi-Mae – my suggestion for the company's post-nationalization name – we the people will soon be responsible for the company's mountain of dubious debt from tens of millions of credit card accounts, mortgages, commercial paper... and that's just for starters.

No wonder Mr. Pandit is so enthusiastic.

Wen Is Enough?

This week, we had a swarm of China-related stories. In one, China's premier Wen Jiabao took time during his annual press conference to express his concern about the safety of China's holdings of Treasuries, warning the U.S. government, in so many words, that China is now paying close attention to its financial affairs. The implied threat being that, should the constant currency abuse escalate, they might consider taking their renminbis elsewhere.

"Nonsense," say the punditry, explaining authoritatively that China doesn't have any option but to continue propping up the dollar. After all, selling their Treasuries would devastate the value of their hundreds of billions of dollar-based holdings. A weaker dollar would also make China's export-reliant economy less competitive, pushing said economy even further onto the reef.

"True," I answer, speaking aloud to no one but my sleeping dog. "But it's worth harking back to April 2001 and Hainan Island in the South China Sea."

Newshounds among you will recognize the time and the place as the location of what the media likes to call an "incident" between the forces of China and the U.S. Specifically, after colliding with a harassing Chinese military jet, a damaged U.S. spy plane was forced to land on Hainan Island where it was captured by the Chinese military.

And there the plane, and its crew of 24, sat for almost two weeks. Despite the U.S. government's most strident diplomatic efforts, including getting really red in the face, the Chinese simply refused to release the crew or the plane. It was only after the U.S. government bowed to China's unswerving demand that it issued an official apology – which it did on April 11, that the crew was allowed to leave, on April 12.

The spy plane, however, was not allowed to leave until mid-July... and then only in the pieces that Chinese engineers left it in after dismantling it and going through it with a tortoise shell comb.

At the time, the Chinese government was exporting over $100 billion a year of product to the U.S. Didn't seem to concern them in the slightest at the time that the U.S. was making all sorts of hollow threats about the spy plane.

So, now that Chinese exports to the U.S. are about three times the level they were in 2001, are the Chinese three times more likely not to want to cause trouble for the U.S. today?

Didn't seem that way when, this week, five Chinese boats harassed a U.S. spy ship operating in international waters, 75 miles off China's coast. My favorite part of the incident was when one of the Chinese ships got so close that the U.S. Navy ship, U.S.S. Impeccable, opened fire with a water cannon. In response, the Chinese crew stripped down to their underwear and enjoyed a mid-week shower.

It reminds me of the classic scene in Monty Python and the Holy Grail, when the crusaders demand the surrender of the French castle.

Why, look, thanks to the wonders of YouTube, you can watch it here!

The point, however, is simply this: people are people wherever you go... but they have certain cultural idiosyncrasies. The Afghans, for instance, possess a strong national pride about having taken on – and defeated – the masters of the universe at any given time. Denny Crane from Boston Legal would sum up their martial confidence by intoning, "Never lost, never will." And so, we can expect them to rise up every time they are invaded.

Likewise, the Chinese have a reputation for not allowing themselves to be dictated to by foreign governments, unless, of course, said foreigners arrive with an army, as did the Japanese in WWII.

Thus, should the current administration conclude in their many weighty calculations that the Chinese have no choice but to scrape and bow to the mighty dollar, they risk making a gross miscalculation... in this case, one that could bring what's left of the U.S. economy to its knees.

It is worth pondering, however, whether the Chinese may begin to march to their own drummer, no matter what the U.S. does or doesn't do, at this point. I say that because, whether out of national pride or the realization that the debt-fueled economic engine of U.S. consumption is terminally broken, there is little question that China is turning its attention to stimulating its own economy by inward-looking spending. Versus, say, investing that money in non-yielding U.S. Treasuries, especially of the riskier long-dated variety.

The situation is directly analogous to the build-out of the interstate highway system here in the U.S., a topic I touched on in passing recently. The build-out of that system, which finally got underway during Eisenhower's administration in 1956, cost about $100 billion to complete. While I don't have time to go deep here, there is little argument that the interstate highway system helped grease the skids of commerce, paying back the government's investment many times over through a variety of transport-related taxes and overall improvements in GDP.

In constant dollar terms, the U.S. GDP in January of 1947 was $1.570 trillion. By January of 1957, as the interstate highway system was getting built, GDP had risen to $2,300 trillion, a 46% increase. By January of 1966, however, GDP had reached $3,372 trillion, a 60% increase over the preceding ten-year period. While I can't attribute the additional gain to the growing highway system, there is little question it was a contributor.

The point I am trying to make is that the Chinese leadership is very capable of figuring out the benefits of better and more highways, ports, dams, electrical lines, and other infrastructure improvements ... and of deciding that continuing to lend to the world's biggest debtor won't pay off nearly as much, over the long run, as using their pile of cash to finish building out their own key infrastructure.

Nothing stays the same in this world, except human nature, that is. The Chinese, with their hundreds of billions in reserves, and 1.4 billion people, are not going to stay in place. At the point when they decide it is time to look inward, and that point may be now, the world's financial regime will begin to change.

Sure, the U.S. monetary hegemony could be maintained for awhile longer, and likely will. But there are no guarantees, and to dismiss the Chinese as whipped dogs could be a very big miscalculation.

Since we're on the topic of China's infrastructure build-out, Simon Black and Fitzroy McLean from Without Borders have uncovered a China-based cement company that is uniquely well positioned to profit. To learn how you can profit from the remaking of China's infrastructure, visit this link.

Before moving on, I came across the following chart I thought you might find of interest. It presents a breakdown of what it is the Chinese sell the U.S. so much of. Looking the chart over, it's easy to conclude that Chinese exports to the U.S. are only going to come under more pressure (not a lot of furniture changing hands just now, I suspect). That lessens the importance that the Chinese will attribute to their U.S. relationship in the future.

Speaking of Exports

I don't watch much television but do make an exception for Survivor on CBS every Thursday night. I like the show because it offers the voyeuristic experience of watching members of the Homo sapiens species as they cavort around in more primitive tribal settings. With much of the bling and bluster stripped away, what's left to observe is the hominid mind at its most calculating as it schemes to climb over the heads of its fellows to win a million dollars.

Last night, as I waited for the show to begin, I was treated to a spot of local news, the top story being that the Burlington City Council had rewarded a bridge rebuilding contract to an out-of-state construction company. Members of the local citizenry were interviewed and were uniformly outraged. "There are local companies desperate for work, and they give the job to a company from Maine! Unbelievable!"

It's an interesting philosophical conundrum. After all, the land and the people of Vermont and neighboring Maine couldn't be any more homogeneous. Okay, so maybe they eat lobster with more regularity... but other than that, it's mostly about some lines on a map and small differences in local ordinances.

Live and let eat, I say, but I suspect most of the tribe would disagree. At least if you pay attention to all the "Buy Local" bumper stickers being sported around these days.

(Sometimes, the sloganeers try to show a broader mind, expanding the phrase to "Think globally, act locally"... which is really just a dressed-up way of saying the same thing.)
As is well demonstrated on Survivor, when things are going well around camp... say, after having won a reward challenge against the other team and finding yourself surrounded with sundry food items and maybe a few beers, then humanity is all good cheer and generosity.

But lose a string of challenges, resulting in a depleted food supply and sleeping in the rain under poor shelter, and the human character soon forgets all sense of charity and each individual looks with steely eyes to their own needs.

The broader economy is much the same, if for no other reason than it is really nothing more than the sum total of human action.

While the connection may be hard to see at this moment, this week it was reported that both imports and exports have fallen yet again. According to Bloomberg...

    March 13 (Bloomberg) -- U.S. imports and exports both slumped for a sixth straight month in January in what may be the biggest collapse of world trade since the 1930s, raising the threat of protectionist measures to shield domestic industries.

    The U.S. trade deficit narrowed in January to $36 billion, the lowest level in six years, on tumbling American demand for everything from OPEC oil to Japanese automobiles, Commerce Department figures showed today in Washington. The Labor Department said prices of imported goods dropped for a seventh month in February, another byproduct of the global recession.

    American exports have slumped at a 44 percent annual pace in the most recent six months of data, with imports shrinking 51 percent, probably the most since the Great Depression, according to Morgan Stanley analysts. The figures may add to pressure on the Obama administration to rework international agreements and include protections for U.S. workers and the environment.

Echoing the theme of this section, there was also this...

    "The global volume of trade has collapsed," said Christopher Low, chief economist at FTN Financial in New York in an interview with Bloomberg Television. "When you add protectionism on top of that, that further reduces both the volume of trade and also efficiencies. It tends to hurt both sides."

Reducing these matters to a more understandable level, we come back to the case of Burlington and the Maine-based bridge builder. Or, to a positively human scale, by looking to the weekly lesson provided by Survivor. To wit, the world is beginning to wonder where its next meal is coming from, and they are not about to let some other person/state/country beat them to it.

The U.S. has already let its intentions be known by passing the "Buy American" provision in the new stimulus package.

The Swiss this week made their intentions clear by announcing that they were going to actively intervene in the foreign exchange markets in an attempt to weaken their currency and therefore make their products more competitive to consumers in other nations. They will do so by buying up the currencies of their largest trading partners. The Japanese have tried this move, as have the Chinese and others. Soon, everyone will be doing it.

In its write-up on the Swiss move, the Wall Street Journal opined...

    Analysts said the move was likely to increase talk that countries were set to engage in a bout of competitive devaluation.

    "Let the currency wars begin," said Chris Turner at ING Financial Markets.

As the U.S., while wounded, is still the world's single largest market, it's likely to be the currency against which most others try to depreciate (the Swiss are likely to focus on the euro, however).

Paradoxically, to some extent the U.S. is a willing "victim" in this manipulation, as the greater buying pressure on the U.S. dollar allows the Fed to print, print, print without having the debasement of the currency become apparent.

Of course, it will hurt U.S. exports if the currencies of our major trading partners fall in comparison to the dollar, but for the time being, a strong dollar helps to reduce the cost of energy imports and other such essentials. And it masks the prolific spending now underway, and further envisioned, by the Obama administration.

The problem, of course, is when all those dollars begin to flow back this way... for example, when the Fed finally crosses the line and governments around the world decide it is now in their best interest to rid themselves of the greenback.

It won't happen overnight or probably anytime real soon... but at this rate, it is all but a given.

Snippets from the Swamp

Donald Grove, our stalwart Washington correspondent, took time out of his busy day to shoot over a couple of updates on the never-ending machinations now underway in the corridors of power. ..

    Making Friends with Crisis

    Judd Gregg (R-NH), ranking member of the Senate Budget Committee, tells us that the president's so-called "budget" may be a lot of things, but "a budget, by any sense of the word, it is not." He describes it as "a game plan for an explosive expansion of the size and intrusiveness of the national government based on a belief that bureaucrats can more effectively manage large segments of our economy and our daily lives than the private sector or the individual."

    How could this happen? Has anyone noticed? It should actually come as no surprise given a certain disturbing and recurring mantra from the Obama administration. White House Chief of Staff Rahm Emanuel told the Wall Street Journal, "You never want a serious crisis to go to waste." Even before that, Shaun Donovan, then New York City housing development commissioner and now Obama's new secretary of housing and urban development, told a New York audience: "A mentor of mine said, 'A crisis is a terrible thing to waste.' In fact, we have an opportunity, despite the terrible things that are happening in neighborhoods because of the subprime crisis." Friday last week, Obama's Secretary of State Hillary Clinton, speaking at the European Parliament, said "Never waste a good crisis ... Don't waste it when it can have a very positive impact on climate change and energy security."

    Maybe Judd Gregg has the best explanation: "It is as if someone down in the basement of the White House has said, ‘Let's use this time when everyone generally agrees we need to spend to turn around this economy as a chance to lock in spending and the expansion of the government for as far as the eye can see.'" Well said, Senator.

    Feeding Frenzy

    The smell of blood is in the water. Word is out on K Street that the government is handing out free money. Close on the heels of the $787 billion stimulus bill and his $3.3 trillion budget, the president held his nose and signed H.R. 1105, the "imperfect" $410 billion Omnibus Appropriations bill, containing the nine FY2009 appropriations bills left over from the last Congress and over 8,500 earmarks totaling $7.7 billion. I admit that I don't much care about the earmarks. As I have noted before, it's all pork. Despite the fact that $7.7 billion may already be spoken for, there is clearly still plenty of money up for grabs. An endless stream of hopefuls are moving from congressional office to congressional office, trying to convince their legislators that their own special needs must be met.

    The promise to give voters what they want and make someone else pay for it is hard to resist. Everyone wants their share of this largess, but whose money is it really? Oddly, a lot of it came from the very constituents whose lobbyists are now sitting down with congressional staffers trying to get some of it back.

    As Casey Research Chief Economist Bud Conrad so astutely observed in the December Casey Report, the Treasury has been enjoying unprecedented domestic demand for its debt instruments, so much so that Treasuries now give investors almost nothing in return. Bud discovered that the Treasury has handed a huge chunk of those proceeds from selling its debt instruments over to the Fed.

    Bernanke told an Austin, Texas audience last year that the Fed's balance sheet "will eventually have to be brought back to a more sustainable level. However, that is an issue for the future; for now, the goal of policy must be to support financial markets and the economy." That was on December 1 last year. Are we now approaching Bernanke's "future," or do we still have time before those chickens come home to roost? By bailing out of "risky" investments, putting their money into "safe" U.S. Treasuries, and then queuing up for their share of the government's apparent largess, Americans are essentially trying to stave off starvation by drinking their own blood.

    Regards, Don

Gold Stocks – a Knock at the Door

While it is not much of a payoff for the one hour that our own Louis James, editor of the Casey Investment Alert and International Speculator, spent on the phone with the reporter, the fact that Barron's did an article at all on the attraction of investing in junior gold explorers is worth noting.

You can read "Thar's Green in Them Thar Gold Stocks" via the link here.

Then there was the article from Newsweek, also this week, titled "Cash in a Mattress? No, Gold in the Closet." While the author is clearly a skeptic – which I think is healthy, frankly – the fact that gold is beginning to show up more and more in mainstream media will only add to its luster.

Here's an excerpt from the piece...

    The price of gold is near an all time high—it topped $1,000 an ounce on March 13—yet the number of Americans who are taking delivery of gold coins and bars is rising. According to the World Gold Council, Americans bought 600 tons of gold bars and coins in 2008, a 42 percent increase over 2007. That's not as much as in Europe, where gold mania has become epidemic—but significant given the metal's high price. An uptick in the U.S. economy, and buyers are likely to find they've been part of a giant, golden bubble.

And for those of you with more time on your hands, here's a link to the full article.



  • The Greater Depression -- How Did It Come About? As I was going to press, I received this link to a Saturday Night Live skit that gave me a couple of chuckles. As we can all use all the chuckles we can get just now, here's the link. (And, please, for those of you who are from either side of the political spectrum who may take offense, please don't... satire is as American as running a trade deficit.)

  • Mea Culpa. In the current edition of The Casey Report, we included a chart showing the performance of various recent short recommendations, compared to the S&P 500. None of our recent shorts has been nearly as profitable as that of GE from our December article, "Shorting the Big Debtors." The only problem is that we equivocated on that recommendation, then in January, due to concerns over the possibility of government action, and actually formally announced we were not going to recommend making the short.

    Thus, the graphic was wrong and could rightfully be misconstrued as misleading. The simple fact is that while we were right in bringing GE to readers' attention as a short candidate when it was trading much higher than it is today... we didn't follow through with a formal recommendation, and so we cannot claim it.

    I won't go into a long explanation of how this screw-up happened, other than to say that it was an honest mistake by a researcher and a lack of attention on my part as managing editor. It has now been fixed in the edition.

  • Phyle News. By all accounts, the recent phyle meeting in Toronto where Louis James, Jeff Clark, and Doug Hornig stopped by was a big success. Angus, thanks for inviting the team to participate, and thanks to the group as well.

    Meanwhile, the Calgary Phyle, which hosted the very first meet-up of Casey Research subscribers, will be getting together at the Cadence Coffee, 6407 Bowness Road NW on April 7 at 7:00 pm. You can get questions answered, or RSVP, by emailing . Alex, the owner of Cadence Coffee, is the organizer of the phyle. If you can't make it to the April 7 get-together, stop by any time and introduce yourself as a fellow subscriber.

  • Argentina in Las Vegas. For those of you heading to our sold-out Crisis & Opportunity Summit, I wanted to mention that David "Santiago" McIlvaine from Doug's La Estancia de Cafayate project in Argentina, as well as Jack Zehren, the lead architect and land planner for the project, will be at the event. Property owners can catch up on the latest, and anyone interesting in learning more can do so.

And that, dear readers, is that for this week. As I sign off, I see the stock market is about flat, but still well up on the week. Gold has had a good day, topping $930, but coming back slightly. As you may remember, as I was writing this missive last week, I took a quick break to short the broader market... and was well up by the end of the day. A little while before the market closed, I got distracted long enough to miss the window to sell and lock in my profit, and then stubbornly hung on... the net result being a good thwacking as the stock market soared this week. Fortunately, I also bought some GLD as the gold market briefly dipped below $900 and so my net losses are minor, and I'm still holding both my short and my GLD as the week comes to a close.

While I do think the stock market could rally more here, I just can't see a sustained rally at this point. Could happen, but if it did, I'd be okay, because I am not leveraged or playing (a good word) with money I can't afford to lose.

The markets remain unpredictable and dangerous at this point. So caution is the word...

Until next week, when I'll be writing from Las Vegas, thank you for reading and for being a subscriber to a Casey Research service.


David Galland
Managing Director
Casey Research, LLC.

Posted 03-16-2009 12:55 PM by David Galland