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A Financial War With No Winners
By Bill Bonner | Published  02/18/2008 | Currency , Futures , Options , Stocks | Unrated
A Financial War With No Winners

As we left you on Friday, we were worried that too many people are predicting hard times ahead for the U.S. economy. For its part, the stock market is not saying anything. Stocks are down only slightly, not enough to signal serious economic problems.

Friday saw another small drop in the Dow, minus 28 points for the index.

Bonds too, are maintaining a silence. Some days they are up. Some days they are down. If trouble were really on the way, you’d think the bonds would see it and raise an alarm. Instead, if they do see trouble on the horizon, they’re keeping mum about it.

And what’s going on with retail sales? If consumers really were feeling the squeeze we think they ought to be feeling, they’d start spending less money right away. But the evidence is mixed. Some numbers show a big drop in consumer spending; others show consumers still opening their wallets.

What to make of it? We don’t know, but as usual, ignorance doesn’t prevent us from having a theory, or even two.

One obvious takeaway is that the future isn’t going to be as bad as analysts seem to think. If the economy were really sinking, the optimists say, these indicators would tell us.

A less obvious takeaway is that it will be much worse than expected. Mr. Market is an old trickster. What if he were setting us up to believe the economy would bounce back when, really, it is headed down forever? As we parted company at the end of last week we suggested that the top might be in, not just for housing and stocks, but for the United States itself. Who wants to believe it? No one. But everything eventually peaks out...and every empire, no matter how great, is eventually scuttled.

It seems perfectly plausible that all-time highs may have come and gone for the US of A. Asians, Russians, Arabs – they are all offering more competition than Americans ever faced before. And in this new contest, Americans have not one, but both arms tied behind their backs. They no longer have enough energy to power their economy; they no longer produce enough food to feed themselves; they spend more than they make; they have higher debts than anyone, higher fixed costs, older equipment, and an older population. And they have an entitlement culture that cannot readily adapt to a more challenging environment. Instead of warning Americans that they need to cut costs, save money, and compete with the rest of the world, voters are being told that they can buy even more stuff, and that, by some magic as yet never explained, they will be protected not only from fierce global competition, but also from the consequences of their own errors.

But if our guess turns out to be correct, maybe never again will U.S. property prices – in real terms – be as high as they were in 2006. Never again, will U.S. stock prices be as high as they were in 2000. And never again will the United States enjoy such a lopsided advantage in wealth and power as it did at the end of the 20th century. Of course, it’s much too early to tell. We won’t know for 20...50... or even 100 years.

But if this were true, why aren’t the markets giving us a heads up?

We have a theory for that too.

What we are watching in the financial markets is a war. But it is a war like the war between Iraq and Iran in the 1980s. Henry Kissinger once remarked that “it is a shame both sides can’t lose.” In fact, both sides did lose. Millions of people were killed, at huge expense. Neither side gained a significant advantage. Of course, the same could be said for a lot of wars...maybe most wars. WWI left all the major combatants in worse shape than when the war began – with one exception, the United States of America. The rest were battered almost beyond recognition. Nations were bankrupted, currencies collapsed, empires fell, ruling families – Hapsburgs, Romanoffs, Hohenzollerns – were eliminated, the map of Europe changed...but scarcely anyone was better off.

The present war between inflation and deflation is going the same way. One side gets beaten up. Then, the other side gets walloped. Even when one gets an advantage, it comes at a high price.

Why is the stock market not falling more decisively? Can it not look ahead? Maybe it is looking ahead. And maybe it sees victories by both sides. In other words, maybe it doesn’t see growth and prosperity at all. Maybe it sees a war without a winner, a slump, and consumer price inflation too.

M3 is the fullest measure of the money supply. And prices tend to be set by dividing the available goods and services by the mass of money in circulation. The more money, the higher the prices. Ideally, M3 and GDP (a measure of goods and services) go up at about the same rate and prices are stable. But currently, M3 is increasing about six or seven times faster than GDP. One explanation for the retail sales figures is that they are increasing largely because the prices of necessities are going up. In other words, consumers still have to spend more money – just to get the basics. Wheat prices are up 3 times in the last 12 months. Consumers still want bread and now they have to pay a lot more for it.

So, maybe the stock market is looking at this situation, too. And maybe it sees stocks as a protection from inflation...maybe it’s guessing that an investment in a profit-making business is a better place for money than a bank account. Maybe it wants to go up because of inflation and wants to go down because of a coming slump. In the end, it goes nowhere.

And maybe the bond market sees the same picture. Maybe it sees a slowdown, which would be good for bond prices, but rising rates of inflation too, which would be bad. What should it do? It doesn’t know any more than anyone else. So, it bides its time, waiting to see how the war will turn out.

*** Meanwhile, nobody knows anything. As soon as you think you know something, along come new facts to prove you don’t.

One thing we were pretty sure about was that you couldn’t make any money by following trends. As soon as you caught on to the trend, we reasoned, it was probably ready to reverse. You’d always be getting on board the wrong train, going in the wrong direction, at the wrong time.

“You can be a contrarian; or you can be a victim,” as our old friend, Rick Rule, puts it.

But what’s this? The Financial Times tells us there’s a new train schedule. A couple of professors at the London Business School decided to test trend following as an investment approach. They imagined that each month, going back to 1900, an investor had simply bought the 20 stocks that had performed the best over the last 12 months – drawing only on the 100 largest stocks on the market. Said investor would have made a compounded annual rate of return of more than 15%, they concluded, compared to a rate of return for the market as a whole of less than 10%.

Well, what if they’d done the opposite, we contrarians want to know. What if they’d taken the 20 worst performers instead of the best? Turns out, they anticipated our question. They found that the worst performers only produced a compound annual rate of return of 4.5%, barely a third of the winning formula.

Go figure.

Bill Bonner is the President of Agora Publishing. For more on Bill Bonner, visit The Daily Reckoning.