Election Day. Pity The Poor Fellow Who Wins.

Bill Bonner - Tue 04 Nov, 2008

It’s a war. It’s worldwide. It’s going to catch almost everyone in the crossfire – business, investors, consumers, retirees.

London, England Tuesday, 4 November 2008 Election Day. Pity the poor fellow who wins.

A Swiss banker wrote to tell us that according to his proprietary indicator of World Economic Health “conditions are now are shown to be some 2.5 times worse” than the last recession which occurred in the 1990s.

We would say that they are worse than any we can recall. First, we have never seen such a violent, worldwide correction. Second, we have never seen such a foolhardy effort on the part of the world’s governments to prevent a correction.

It’s a war. It’s worldwide. It’s going to catch almost everyone in the crossfire – business, investors, consumers, retirees. And it’s going to end in a worldwide depression. (We’re going to change our designation of this coming depression to WDI – Worldwide Depression I to make it easier to remember. )

But wars take time. Most likely, Mr. Market’s blitzkrieg of September and October will give way to a calmer winter campaign. It may even appear that we have entered another period of peace in our time...like the “Great Moderation” the world enjoyed for so many years. If so, dear readers are advised to use this as another opportunity to get out of stocks and other speculative positions.

The time will come to buy back into the stock market...but maybe not for a long time. The average dividend yield of the Dow stocks has risen (because prices have fallen) to 3.7%. When we can get a safe dividend yield of 6%, it will be time to buy back into the stock market.

Yesterday, the Dow and gold both held steady. Oil slipped $3.90 to $63.91. And the dollar rallied to $1.26 per euro.

For the moment, Mr. Market is winning this war...and Mr. Market likes cash.

“I called my mum over the weekend,” said an English colleague. “I explained that with her old savings account she had outperformed practically every investor in the world in the last quarter. She seemed quite happy about that. ”

Eventually, Mr. Government will have his day. . Governments’ attempts to stop the correction...and re-inflate the credit bubble...will eventually create another bigger, worser crisis – a monetary crisis. Then, cash will be trash. When that happens, you will want to have gold coins in your safe, not pieces of paper. You’ll want to be looking at images of Canadian maple leaves and American buffaloes...not dead, green presidents. Yes, when the shooting stops, and the dust settles, the last thing standing will be gold.

But that day is somewhere in the future. Here in the present, cash is king and the dollar is golden, as Mr. Market blasts away at the whole structure of the global economy.

Chinese manufacturing just suffered its worst contraction on record, according to today’s paper.

America’s factory index is also at a record low.

In China, manufacturing is critically important. Without it, hundreds of millions of people will lose their jobs. What will happen when Chinese factories go silent and Chinese workers go hungry? We don’t know... We don’t even want to know...

In America, factories are less important. The US economy depends on the slurp consumption, not on the hum of factories. Of course, if they’re going to consume, Americans need money. And there’s the rub; they don’t have any. They have no savings. Credit is getting tight. And now....whoa!...the job market is tightening too.

As a result, US consumer spending is not just declining...it’s collapsing.

Auto sales, for example, are running at their slowest rate in 17 years.

Circuit City says it is closing 155 stores.

And oil consumption in the US is slipping more than analysts believed possible – down 9% from last year.

So you see, dear reader, markets work. Raise prices and, ceteris paribus, you will reduce sales. Increase production and, ceteris paribus, you will lower prices. Bring on a correction and people will change their feckless ways.

But one scam gives way to another. During the Great Moderation we were assured that our financial authorities had found the magic formula; henceforth, enlightened economic management, along with sophisticated, risk-dispersing financial instruments, would practically eliminate recessions and crashes. There was no need to save for a rainy day, we were assured; because it would never rain! But now we have a downpour...with markets crashing and the world facing its biggest slump ever. And now we are told that markets have failed. Now, we need Barney Frank, Ben Bernanke and Hank Paulson to run our financial system.

Wait a minute...we don’t recall Ben Bernanke warning that the world faced a meltdown when he took over at the Fed in Feb. 2006. And wasn’t Barney Frank the chairman of the House Financial Services Committee even as Wall Street was running amok, inflating the biggest asset bubble in history? We don’t remember him holding hearings about the dangers it presented until after the thing blew up. And Hank Paulson...while all this was going on, wasn’t he the head of one of Wall Street’s most go-go, derivative saturated, billion-dollar-bonus-driven firms?

Well, never mind...

But now we are supposed to believe that markets don’t work...and that these well-meaning public servants are going to save us from the evils of capitalism...and that bureaucrats will be able to fix prices and allocate capital better than Mr. Market.

Deception gives way to hallucination...correction is followed by depression.

And more thoughts, opinions, and obiter dicta...

*** “I went to a celebration on Halloween,” said another colleague in the London office. “I don’t know who organized it, but they had built a platform in the shape of a coffin...and it was marked ‘capitalism.’ They were dancing on capitalism’s grave. I don’t know what the significance of it was, but everyone seemed to having a good time.

*** “Whoever wins the US Presidential election, America is in big trouble,” writes Ben Traynor. “ It will be hard to resist calls to whack up tariff barriers, and protect domestic jobs from foreign competition. A weakening dollar may help US exports a bit... but the US is in a bind.

“If the dollar falls too much, foreign dollar holders (eg China and the oil-rich Gulf nations) will start dumping it. The US does well out of being the world’s reserve currency. Such a move would threaten that.

“So what will the US do? It could pursue a strong dollar policy.... But that would hit exporters, and hit jobs. So, in response, some bright spark will start banging the drum for protectionism.

“You see, those foreign dollar holders can see the currency’s fundamentals are weak. They’re sitting on all this money whose value is in the hands of a monetary authority (the Fed) and a government whose sole concern right now is fighting the downturn. The Fed has slashed rates, and there’s a strong chance the printing presses will soon go into overdrive.

“So why are foreign dollar holders playing ball? Because, as things stand, it’s still in their interests to do so. Why would they want to antagonise a nation they do so much business with? Why would they impoverish their best customers?

“But throw protectionism into the equation, and the incentives change. This is particularly true in the case of goods exporters like China. Overnight, the US market is less important to them.

“Now, will this be enough to tip the balance? Will it reduce their incentive to co-operate enough so that they take their ball back and stop playing? Hard to say... but I think we’re going to find out.”

*** It could be that America no longer needs Smoot and Hawley. China’s sales to the US are falling, simply because Americans no longer have the money to buy them. The Middle Kingdom has no choice, it has to shift production towards its own domestic market. One way or another, US sales will become less important and China will have less of an interest in financing US consumption and less interest in supporting the US dollar.

*** Old friend, Steve Sjuggerud writes with an investment idea – buy corporate bonds.

“A high yield spread over Treasuries of above 10 percentage points (1,000 basis points) has historically been a good buy... it bottomed there in the last two recessions. We've just blown past that now...

“Getting close to the point where it's worth considering... Yields of 18% today... Add that income up over two years and that's a big tailwind, a nice cushion against defaults.

“Default rates haven't spiked up yet. Currently around 3%. Forecast to go to up to 8% next year. In the last two recessions default rates peaked at over 10%.”

*** Another old friend (with whom we’ve been preparing a special Emergency Report on the financial crisis and how to survive it) Jim Davidson, sends his thoughts on the election outcome:

“Notwithstanding some tracking polls which show McCain inching back against Obama in key states, it is likely that Democrat Barack Obama will claim the presidency...

“One of Obama's prime campaign planks has been his promise to mercilessly raise taxes on the "rich," a group initially defined as those making more than $250,000 per year. This was later dropped to $200,000 per year, and more recently has been defined as those Americans making more than $150,000 annually.

“Setting aside the precipitous downward slide in the definition of "rich," there is ample reason to suspect that Obama's tax changes portend much higher, if not confiscatory taxes on the most productive Americans. Obama has strongly argued for higher taxes as a way employing government to alter the pre-tax distribution of income, which he believes has concentrated too much of the gains from productivity in recent years in the hands of the very rich.

“He seems to think that the "very rich" are a closed caste of more or less fixed membership which changes little from year-to-year. This figures in his concept of "fairness," which supposes that it is perfectly just to burden a small fraction of the population with a majority of the costs of running the Federal government. This was detailed in a New York Times article on "spreading the wealth" by David Leonhardt. He wrote of Obama:

"He would then pay for the cuts, at least in part, by raising taxes on the affluent to a point where they would eventually be slightly higher than they were under Clinton. For these upper-income families, the Tax Policy Center's comparisons with McCain are even starker. McCain, by continuing the basic thrust of Bush's tax policies and adding a few new wrinkles, would cut taxes for the top 0.1 percent of earners -- those making an average of $9.1 million -- by another $190,000 a year, on top of the Bush reductions. Obama would raise taxes on this top 0.1 percent by an average of $800,000 a year. "It's hard not to look at that figure and be a little stunned. It would represent a huge tax increase on the wealthy families. But it's also worth putting the number in some context. The bulk of Obama's tax increases on the wealthy -- about $500,000 of that $800,000 -- would simply take away Bush's tax cuts. The remaining $300,000 wouldn't nearly reverse their pretax income gains in recent years. Since the mid-1990s, their inflation-adjusted pretax income has roughly doubled.

"To put it another way, the wealthy have done so well over the past few decades, with their incomes soaring and tax rates plummeting, that Obama's plan would not come close to erasing their gains. The same would be true of households making a few hundred thousand dollars a year (who have gotten smaller raises than the very rich but would also face smaller tax increases). As ambitious as Obama's proposals might be, they would still leave the gap between the rich and everyone else far wider than it burdensome on the young entrepreneur who was making his first millions as it would on the aging plutocrat who actually had enjoyed the prosperity of the past-quarter century since Reagan cut marginal tax rates.”

An October 13 editorial in the Wall Street Journal clarifies the mysterious arithmetic of Obama's sweeping claims to cut income taxes for millions who currently have no income tax liability and pay no taxes.

"For the Obama Democrats, a tax cut is no longer letting you keep more of what you earn. In their lexicon, a tax cut includes tens of billions of dollars in government handouts that are disguised by the phrase "tax credit." Mr. Obama is proposing to create or expand no fewer than seven such credits for individuals:

"- A $500 tax credit ($1,000 a couple) to "make work pay" that phases out at income of $75,000 for individuals and $150,000 per couple.

"- A $4,000 tax credit for college tuition.

"- A 10% mortgage interest tax credit (on top of the existing mortgage interest deduction and other housing subsidies).

"- A "savings" tax credit of 50% up to $1,000.

"- An expansion of the earned-income tax credit that would allow single workers to receive as much as $555 a year, up from $175 now, and give these workers up to $1,110 if they are paying child support.

"- A child care credit of 50% up to $6,000 of expenses a year.

"- A "clean car" tax credit of up to $7,000 on the purchase of certain vehicles.

"Here's the political catch. All but the clean car credit would be "refundable," which is Washington-speak for the fact that you can receive these checks even if you have no income-tax liability. In other words, they are an income transfer -- a federal check -- from taxpayers to nontaxpayers. Once upon a time we called this "welfare," or in George McGovern's 1972 campaign a "Demogrant." Mr. Obama's genius is to call it a tax cut.

"The Tax Foundation estimates that under the Obama plan 63 million Americans, or 44% of all tax filers, would have no income tax liability and most of those would get a check from the IRS each year. The Heritage Foundation's Center for Data Analysis estimates that by 2011, under the Obama plan, an additional 10 million filers would pay zero taxes while cashing checks from the IRS.

"The total annual expenditures on refundable "tax credits" would rise over the next 10 years by $647 billion to $1.054 trillion, according to the Tax Policy Center. This means that the tax-credit welfare state would soon cost four times actual cash welfare. By redefining such income payments as "tax credits," the Obama campaign also redefines them away as a tax share of GDP. Presto, the federal tax burden looks much smaller than it really is."

“After all the sloppy definitions are parsed, one point remains clear. The top 5% of U.S. income earners, who presently pay 60.14% (2006 figures) of all income tax are destined for a huge federal tax increase under Obama.

“One of Obama's specific proposals is to raise the capital gains and dividend taxes to 25%, which will sharply increase capital confiscation as increasing percentages of "gains" will reflect inflationary depreciation of the currency. In the U.S., an investor must pay tax on the difference between the sales price of an asset and its purchase price, with no adjustment for inflation. Consequently, when the tax rate and inflation are high, a large portion of the "capital gain" is illusory. Any asset that appreciates by less than the rate of inflation will result in its owner losing purchasing power and having to pay taxes on the illusory gains. At Obama's higher tax rates, (he has suggested that capital gains and dividend taxes should be hiked to as much as 25%,) capital confiscation would result from modest levels of inflation.

“And the Great Credit Crunch implies that inflation will be far higher than in recent experience.

“Setting aside whether it is moral or equitable to force a small fraction of the population to essentially pay for the whole cost of government, much of which entails the shuffling of checks to purchase votes of various aggrieved groups, there is a bigger question. Can it be wise for the whole fiscal regime to stand on the shoulders of a small group, like a pyramid tottering on its point, so that any tribulation which undermines the prosperity of those who pay would promise to bankrupt the state?

“It is a worthwhile question to ask if you have considerable assets. In light of the worldwide credit crunch which has deflated assets of all kinds, the prospect of burgeoning prosperity at the magnitude required to enable one-in-20 Americans to become "Super Rich" benefactors of Big Government is vanishingly small. There won't be enough rich people to fill the role assigned to them in Obama's scheme. The result to be expected, in addition to confiscatory taxation, is a dramatic shortfall of revenues. This, in turn, implies surging deficits and deficit financing requirements that will rapidly swamp the capacity of the Treasury to borrow.”