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DERIVATIVES, BANKS, AND BAILOUTS

DERIVATIVES, BANKS, AND BAILOUTS

We at Guild Investment Management have mentioned the problems with derivatives 31 times in the five years between 2003 and the present in our market commentaries, yet people did not listen.

If the U.S. Fed, U.K. central bank, and other central banks continue to protect all of the institutions, all of the shareholders, and all the depositors, the crisis will actually be more prolonged and more difficult to come out of than if they let a lot of the smaller institutions go broke.

Thus far, it is obvious that the Fed and the U.S. and U.K. administrations want to make the government the lender of last resort and make it a world where mistakes are not punished.  We go on record saying that this is a mistake…the example of Japan comes to mind.

The Japanese market peaked in 1990 at about 40,000 on the Nikkei 225 just as their banking crisis began.  Japan did not confront their banking crisis. They kept a lot of ‘zombie’ banks alive and did not write off the bad loans.  The banking system languished and the Japanese stock market bottomed down over 75% from its highs when it got to about 9,000 in 2003.  Today it is still only at 13,000.

Is that what you would like to see in the U.S. and Europe?  If so, then go ahead and continue with what looks to be the current Federal Reserve and U.S. Treasury strategy of keeping weak institutions operating ‘as if’ they were healthy and able to lend.

FANNIE MAE AND FREDDIE MAC…A BIG BAILOUT HAPPENED THIS WEEK AND IT WILL CREATE GLOBAL INFLATION

As we all know, these two institutions were in effect taken over by the U.S. Federal Government, which will supply their equity and guarantee their debt for the time being. The government intervened because much of the two agencies’ $5 trillion of endangered debt is held by foreign central banks.  This is a bailout and it will create a lot of liquidity which will be thrown into the system.  An end result of the bailout is that it pumps massive liquidity into the system.  This new liquidity is on top of all the other liquidity, foreign and domestic, that is piling into the system…thereby further fueling inflation in commodities, raw materials, foods, energy, transportation and services, and of course precious metals.

In our opinion, inflation will be the game, not deflation…unless they are unable to flood the economy and banking system with enough money to rebuild liquidity.  They will continue to try, but if they cannot do this within three or four years, then we expect deflation can take hold.  In the meantime, we are planning on inflation for the next few years and higher gold and food prices…and a lower dollar.

For our clients, we have been shifting out of some gold ETF’s and into some big cap gold stocks, which can perform better if there is a quick run in the gold price.

WHAT WE KNOW

1) In the United States (as is already the case in most developed nations), the federal government will control the residential mortgage business.  The U.S. Government will be more conservative than the old Fannie Mae, Freddie Mac, and the savings banks…and much more conservative than the investment bank and commercial bank loan re-packagers.  Thus, the residential mortgage business will be the bailiwick of the national government, and loans will be harder to get.  The result is bad for real estate values in the U.S.  The residential real estate recession will be longer and stronger than most had thought.

The reduced availability of capital for real estate will cause prices to continue to fall in the U.S. and in most other countries in the developed world.  Thus, I look for lower real estate prices in two years.  Real estate will not be a big driver of the developed economies for years to come…(As an aside, real estate values will continue to rise in the oil exporting states of the Middle East, China, and probably Brazil, where big investment flows into the economies will keep prices high and rising.)

2) Fed Chairman Bernanke has agreed to let the dollar fall.  Investors will move to foreign currencies, especially those with strong current account surpluses or strong export profiles.

3) Global money supply is strong and growing, so inflation expectations will push non U.S. currencies up and the U.S. dollar down.  Inflation will follow and investors will focus on gold, food related and energy investments.

4) Financial stocks in the developed world continue to need to correct bad loans and need to replenish capital.  They will be underperformers while commodity related sectors and commodities will outperform.

SUMMARY-INFLATION IS IN THE FUTURE

Don’t listen to the PR programs on financial TV about the rally in financial stocks and how great they are going to be.  The plain fact is that if you look at the quality of the assets and debt on their balance sheets of most financial companies in all countries of the developed world, they are in trouble.  They need equity, and they need to get the toxic debt off of their balance sheets.

In our opinion, it will be unwise to buy them.  They are doing a big sales pitch on financial TV and in the press because they want to sell more equity to investors…and they can’t do that until people believe that things are getting better.

The U.S. dollar is in danger and will fall a lot in coming years.  In our opinion, gold is the safest bet along with food stuffs and foreign currencies of well managed countries.  This is not a recommendation, but you may want to take a look at the currencies of Australia, Canada, China and Norway.  However, be careful to monitor their current account surplus or deficit and their short term interest rates relative to the U.S.  In our opinion, changes in short term interest rates versus the U.S. and changes in current account versus the U.S. will determine currency fluctuations.

BIOFUELS OUT…NUCLEAR IN

Today, many media reports are circulating that the European Union is reconsidering its biofuels policy.  I am amazed it has taken so long.  Europe is coming to the realization that we have been mentioning for years.  Biofuels are expensive, they force the price of grains up and they consume a lot of fuel to create.  They are a vote-buying exercise with a few benefits, but many other alternative fuel options contain more benefits for the average citizen.

How much longer will it take the U.S. to realize the same thing?  To put it another way, how strong is the U.S. farm lobby in congress?  An alternative energy source that both U.S. presidential candidates endorse is nuclear.  We look for biofuel programs like ethanol (which are popular with farm voters but expensive for all other voters) to be reduced, and nuclear (which does have some dangers, but also has many benefits) to be advanced.  Many environmentalists who formerly opposed nuclear energy now realize that their approach may have been unwise and that nuclear may be more attractive than bio fuels and fossil fuels.

Thanks for listening.


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