One day, a fertile iron mine in the heart of Stuart runs out of ore. So Hancock Steel, the nation’s largest integrated steel producer, must turn to other sources. Unfortunately, the next great domestic iron deposit rests 2,000 miles away. Transcontinental rail freights aren’t cheap. Hancock’s production costs rise. To stay profitable, management pushes these costs to the end-user. Steel prices double.

The Garland Motor Co. depends on Hancock’s refined cold-rolled products to produce lightweight body panels for its automotive fleet. Steel prices dramatically affect the auto industry’s bottom line. Higher domestic prices force Garland to import less expensive steel from Hamlin producers.

Hancock’s sales plummet. Layoffs ensue. Steel workers with mouths to feed form a union. They lobby their national politician. The politician needs their vote. He asks for a few favors. Within days, the Democratic Nation of Stuart slaps a tariff on Hamlin steel. Garland Motor reverts back to Hancock. The steel union celebrates.

The SUVs rolling off Garland’s assembly lines now cost more to produce. Car prices double. Unfortunately, most consumers can’t absorb the price hike. They turn to cheaper imports from Hamlin. Garland’s sales drop. The company cuts costs. Once again, layoffs ensue.

Unemployed autoworkers quickly lobby political support. Their politician acquiesced on the steel pact. Now he demands mutual legislative support. Stuart slaps Hamlin with another tariff.

Now the good citizens of Hamlin get testy. For years, trade between the two countries prospered. But Stuart’s protectionist ways inflame national pride. The citizens of Hamlin demand retaliation.

You see, for years, Hamlin has reaped the benefits of Stuart’s abundant forests, forsaking local producers. But no more… The Independent Republic of Hamlin retaliates with a massive tariff on imported timber. Hamlin’s high-cost producers rejoice.

Unfortunately, construction costs rise nationwide. New home sales fall. Layoffs now engulf mortgage brokers and construction workers. The entire Hamlin economy slows.

Meanwhile, Stuart’s logging industry contracts. The cycle continues. Prices on all economic goods and services (steel cans, cars, houses, etc.) continue rising the world over. Both economies contract. Unemployment rates rise. A global recession results.

Once again, the world turns to politicians for a solution. Elected officials in both countries reach for the quick fix. They appease the unemployed via subsidies (taxpayer money).

Unfortunately, there’s no such thing as a free lunch. For the sake of maintaining a balanced budget, subsidies require more government revenue. More revenue means more taxes. Higher taxes inhibit domestic growth. Less growth means fewer jobs.

Unemployment rates keep rising. The citizens of Stuart and Hamlin find themselves back at square one.

However, a Stuart-educated economist – let’s call him Cain – steps up to save Round Hill from total economic meltdown. He suggests that massive deficit spending (on public works) will increase aggregate demand. Laidoff workers from the mills, factories and forests will build roads, bridges, schools and dams. The unemployed will effectively be hired in service to the state. They’ll use their wages to buy houses and cars. In turn, these industries will demand more iron, steel and lumber. The whole economy prospers. The recession ends. The government effectively solves the paradox of full employment.

It’s simple, Cain explains. Think of deficit financing as using a credit card to get you through a rough month.

Stuart’s legislative body takes the bait. Stuart’s treasury revs up the printing press. Within weeks, the government awards contracts to engineering firms nationwide. With the push of a button, corporate bank accounts are overflowing. The construction industry takes off. Everyone in Stuart receives a paycheck. Cash seemingly falls from the sky.

The first two years are bliss. But eventually, the 1-1 gold parity of Stuart’s currency (the bandit) feels the heat. The printing press has injected too much paper money. M3, Stuart’s fullest measure of the base money supply, keeps growing at a 12% per year clip. The market now requires two bandits for a single ounce of gold – effectively lowering the bandit’s value by 50%. Prices for milk, bread and eggs start rising. In fact, they begin rising faster than domestic wages. Inflation fears start to percolate.

But currency devaluation brought some unanticipated benefits. Stuart’s export industry re-emerges. The cheap bandit means cheap exports sail from Stuart ports. More exports create more jobs. More jobs mean more votes. Political pressure to keep the money flowing keeps rising like the waters that carried Noah.

Stuart’s president, Robert Chatham, faces a dilemma. On one hand, unemployment rates have reached historic lows. The economy keeps humming. On the other, inflation fears keep mounting. Saving the bandit will ensure the emergence of inflation’s ugly cousin: deflation (the opposite of inflation, promising a decrease in the general price level). Recession will surely follow.

Chatham’s dream of a second term falls like a dead leaf in a dry wind.

Meanwhile, across the sea, cheap imports from Stuart cripple Hamlin’s industrial base. As Stuart’s economy takes off, Hamlin’s unemployment rate soars to record highs.

Hamlin’s politicians have no choice. They quickly follow Stuart’s lead. Seemingly overnight, Hamlin precipitates currency devaluation. Depreciation ensures currency parity once again. Imports from Stuart subside.

In a perfect world, the two countries would save their respective currencies. But they live in an imperfect world. As do we.

Regards,Christopher Hancock
June 12, 2008

P.S. Just like Christopher’ s story, the US economy is going through volatile times with inflation, energy and politic issues all while embarking into a recession.  It’s highly inevitable that we will see waves of layoffs… leaving pensions and 401k’s in jeopardy…

The World of Stuart and Hamlin was originally featured in the Penny Sleuth.

Have you picked up a five-pound bag of flour or a dozen eggs lately? Both staples are up more than 40% since January 2007 — among the worst price hikes. In effect, your paycheck must increase 10% just to keep as much food on the table in 2008 as you had in 2007.

Of course, that’s assuming there’s a paycheck to spend. The Labor Department reported on April 3 that new applications for unemployment insurance jumped 38,000, to 407,000, at the end of March, a two-year high. Some analysts estimate the unemployment rate may reach 5.5%.

If that weren’t enough, oil has topped $110. Prices at the pump hit $3.28, another all-time high. Meanwhile, the nation’s truckers prepare to strike. According to reports, many truckers are operating at a loss when diesel prices rise above $4 per gallon. To protest rising fuel costs, a group of big rig operators engineered a massive traffic jam on the New Jersey Turnpike. They monopolized all lanes, geared down to 20 mph and crept from the Big Apple like floats in a holiday parade. Similar protests clogged Chicago and Atlanta. It feels, dear reader, like an emotionally debilitating chapter from Atlas Shrugged.

We take these protests very seriously. After all, the health of the American economy rests on the ability to move goods to and fro. Like shipping, trucking still serves as the world’s economic circulatory system. This business connects the world in ways high-tech never will. Trucking is, and will remain, irreplaceable on the world stage. We cannot live without it.

Trains and planes, by nature, have limited reach. Railroads lead to rail yards. Airplanes fly to airports. Ships, for their part, carry goods to the to the tidewater’s edge, but no further. In each case, commerce depends on the truck to finish the job.

Truckers will demand higher wages to offset higher costs. Higher wages will require the goods they haul to be sold at higher prices. You get the idea. And this scenario discounts a major disruption to world oil supplies. A militant group truly determined to thwart the American dream wouldn’t have to leave the Middle East. Ask policymakers which asset they covet more: The Green Zone or Saudi oil production?

Treasury notes and bonds yielding 3-4% may appear a safe haven in today’s market environment, but they are a long-term investment I would strongly advise you to avoid. It’s better to own a diversified portfolio of stocks — especially stocks that have the ability to pass through price increases and those levered to long-term investment cycles, like energy, natural resources and infrastructure stocks. They might be rocky in the short term, but they should far outpace bonds over the next five-10 years.

Therefore, we argue that it never hurts to hold a major refiner.

America’s limited refining capacity ensures tight supplies. It’s no secret that the U.S. hasn’t built a new refinery since 1976. Why? Keep in mind that historically speaking, oil markets thrive on volatility. OPEC can effectively manipulate the price overnight. Consequently, many industry executives remain wary of risking the billions in capital investment needed for such expansions. Even as gas prices soar, companies wonder: What about five years from now? What about 10 years down the line? How will alternative energy affect the demand for petroleum products?

Others argue that tangible growth in offshore refining capacity can offset a lack of U.S. expansion. Maybe so. Or maybe Southeast Asian growth will absorb any and all extra supply. Maybe a decrepit old American refinery will explode or succumb to fire, restricting capacity even more. And maybe sound judgment will prevail, and the illogical, economically unfeasible solution better known as corn-based ethanol will lose its proverbial steam.

Whatever holds for 20-40 years down the road, our present situation remains inescapable: The world consumes about two barrels of oil for every new barrel it finds.

To think this can continue in perpetuity is delusional, a naiveté of convenience and nothing more. No amount of rationalization can convince a sober mind that one plus one equals three. If and when carbon-based fuels are replaced, we think the substitute will be just about anything but ethanol. But for now, the world still runs on oil.

But the real problem, dear reader, isn’t the absence of oil. It’s the absence of cheap oil.

Until next time,

Christopher Hancock
April 11, 2008

P.S.: My colleague, Byron King, is the true expert on anything that comes out of the ground, specifically oil. He just found a way for his elite Energy and Scarcity Investor to cash in on the oil rally. In fact, he has one way to actually tap an American oil reserve that’s three times the size of Saudi Arabia’s.

Trucking and the Absence of Cheap Oil was originally featured in the Penny Sleuth.

The Fed injected $400 billion last week. It capped its cash infusion on Palm Sunday with a 25 basis point cut to the discount rate ordinarily charged on direct loans to banks, but now also extended to securities dealers.

But $400 billion couldn’t save a mighty Bear. J.P. Morgan Chase, backed by benevolent Ben, stole Bear Stearns, Wall Street’s fifth-largest investment bank, for $2 per share Monday. “The building [itself] is worth $8 per share,” a midlevel Bear Stearns executive told The Wall Street Journal.

So it goes.

The Dow “plunged” on the news.

Thankfully, Messrs Goldman, Lehman and Morgan fared much better. Their shoes, for the moment, are still varying shades of white. The survivors beat the street by 25%, 13%, and 45%, respectively, Tuesday. The Fed quickly threw fuel into the fire. It slashed rates another 75 basis points later that day.

Mr. Market, that duplicitous little imp, smiled. The Dow Jones industrial average rocketed by 3.5%, or 420 points, its largest gain in more than five years, on the day’s events. He, like our friends at The Daily Reckoning, knows America’s central bank now bestows greenbacks at about half the rate of consumer price inflation.

We said the Fed had a choice: a debilitating recession or destructive inflation.

We vote for recession. Bernanke, however, opts for inflation.

Inflation benefits debtors at the expense of creditors, since debtors can pay back their borrowing in a less valuable currency. Wise investors flee bonds and their negative real returns. They often buy stocks, or better yet, stocks tied to tangible assets (commodities).

But what thou giveth thou can taketh away. The Dow fell 293 points Wednesday. Commodities also took the plunge. Oil retreated $5 per barrel, its greatest one-day fall since Jan. 17, 1991 — the day the first Gulf War started. Wheat and gold also took a dive. Commodities as a whole, as measured by the CRB Index, dropped 5.7%.

Profit-taking? Perhaps? Up, down and all around, nobody knows where the market may land. That’s because Wall Street keeps holding its cards close to the vest. No one really seems to know which financiers owe what, and to whom.

The market, unfortunately, can’t shrug. That’s because, for better or worse, the financial services industry has morphed into becoming the harbinger of the American economy. Our friends at The Economist point out: “The American financial services industry’s share of total corporate profits [rose] from 10% in the early 1980s to 40% at its peak last year (see chart below). Its share of stockmarket value grew from 6% to 19%.”

In the ‘60s, Americans made widgets. Tangible assets bought and sold on the world market. Today, we make the structured products, and increasingly complex financial instruments whose tangible value often depends on the merits of an untested equation. The devastation at Long-Term Capital Management should have taught us that equations, like humans, are often flawed.

But Mark Twain once said: “History doesn’t repeat itself, but it does rhyme.” That’s certainly true. But we doubt even he could imagine our tendency to repeat the same foolish behavior so quickly.

A dichotomy exists in the American economy. We’ve substituted financial services production for real production. And we’ve done this by aggressively playing with debt. Risk, in the minds of financial wizards, was not a four-letter word.

U.S. financial assets as a percent of GDP keep growing at a seemingly interminable pace:

The S&P 500 depends a great deal on the financial service industry’s success. Financials serve as the S&P’s largest component (nearly 20%). In fact, 40% of the S&P depends on big banks, Big Oil and big discretionary spending:

We believe those three will have a tough time running together much longer. High oil and overall spending can’t go on forever. Less spending means fewer financial transactions. In other words, the ripple effect could be rather painful for S&P holders.

Despite conventional wisdom, rising tides do not raise all ships. It’s no secret that certain sectors can carry a market. Nathan Lewis, author of Gold: The Once and Future Money, notes that during the great bull market of the late ‘90s, most stocks actually fell.

“The stock market,” Lewis points out, “as measured by popular market indexes, headed into stratosphere from 1997-2000, but most stocks actually fell, and most businesses stagnated. At the end of 1999, the year the S&P 500 gained 19.5% and the Nasdaq composite index 85.6%, a full 70% of NYSE-listed stocks were lower than they were the year earlier.”

We believe big banks and Big Oil have carried this market the last five years. See this chart of the S&P 500:

Going forward, we believe the S&P will need something else. In the ‘90s, it was dot-coms. This decade offered big builders and big banks. Going forward, another sector must carry the flag.

Perhaps health care will take the lead. There are plenty of baby boomers that need plenty of attention.

Materials, specifically those destined to fix our public roads, bridges, schools and dams, are another place to look. It’s no secret that American infrastructure keeps crumbling…collapsing bridges, exploding steam pipes, Cajun levees.

The American Society of Civil Engineers now warns that the United States has fallen so far behind in maintaining its infrastructure that it would take more than $1.5 trillion over five years just to bring it back up to standard.

It’s a win-win for Wall Street, too. The municipal underwriting business takes off. Banks now repackage municipal debt like mortgage debt. The fees keep rolling. Seven-figure-bonus days are here once again.

The banks knew that if disaster struck, as it has, someone else (usually taxpayers) would bear the cost. Washington facilitates the deal. And the game goes on.

Good Friday,

Christopher Hancock
March 21, 2008

Watch Out for this Market was originally featured in the Penny Sleuth.

My friends and I exited the train onto the long, cracked concrete platform. A drainage stream littered with rusty steel barrels trickled by. On the northern bank, a concrete wall backed by an even more daunting barbed wire fence served to support the numerous lookout posts dotting China’s most traversed southwestern border. This wasn’t the Rio Grande.

Hundreds of mainland Chinese scurried by. The rush for customs ensued. The soldiers, dressed in their long pea-green military topcoats, suspiciously surveyed the masses, nudging to and fro, hoping to find the most expedient line to re-enter the mainland, like cattle in a stockyard.

We, on the other hand, patiently held back. Lo Wu is called a “control point.” I imagine the Chinese authorities used the Korean DMZ as a suitable inspiration. Consequently, I saw no dicernable need in drawing the army’s attention. My friends, Western journalists from Hong Kong, certainly weren’t the red-carpet type.

My fire engine red North Face duffel bag drew some stares, but Western garb doesn’t facinate as much in Shenzhen as it would in the more remote, rural regions of northern China. That’s because I should probably thank the thousands of Chinese hustling all around me for stitching it together. That’s probably also true for just about every item of pure Americana attached to my priveleged self. And if the Chinese didn’t construct the authentic item, they could easily point me to an alley where I could haggle for a repro.

Shenzhen, Deng Xiaoping’s first attempt at capitalism, Chinese-style, received the elevated status as China’s first Special Economic Zone (SEZ) in 1980. Seemingly overnight, factories popped up along the hot, humid delta like a nasty uncontrollable weed. Naturally, more factories required more transportation. Shenzhen became the world’s fourth busiest port by 2005.

Within 20 years, market reforms turned a relatively remote city the size of Green Bay, Wis., into an industrial and financial powerhouse on par with Chicago.

Wal-Mart shelves and Christmas mornings in the West have been built on a 90-hour, six-day work week in the East. The last 20 years of growth have produced more than 90,000 export-oriented processing firms on the mainland, with nearly 70,000 based in Shenzhen’s Guangdong province alone.

It’s no wonder Chinese officials fear what ramifications a slowdown in the export economy may bring. Domestic growth and stability have risen with Chinese workshops. And make no mistake, the first three long-term domestic priorties on Beijing’s list are and will remain stability, stability and more stability.

The yuan-dollar peg has gone a long way in ensuring constancy. Chinese economic growth — we would argue, all economic growth — ensues under the auspice of a stable currency.

But ties to the greenback have recently come with a price. American policymakers have facilitated a weak dollar. For China, a weak dollar makes critical imports (wheat, corn, iron and soy) more expensive. Expensive imports mean higher prices. Higher prices mean more inflation. More inflation means less stability.

“The primary task for macroeconomic regulation this year,” said Chinese Premier Wen Jiabao, addressing the equal and opposite reaction on the other side of the planet, “is to prevent fast economic growth from becoming overheated growth and keep structural price increases from turning into significant inflation.”

In his annual policy speech to China’s legislators, Wen clearly labeled rising commodity prices and the subsequent food shortages as China’s No. 1 policy issue for 2008.

So Beijing finds itself in a bind.

Going forward, yuan appreciation would certainly help alleviate rising prices (commodity imports would be cheaper). Export dependence, however, has thwarted this policy. On the other hand, protecting the export industry by enforcing a close yuan-dollar peg only intensifies further inflation as the dollar contines to slide.

In the meantime, Beijing has turned to price controls. But price controls are nothing more than a short-term solution (“stopgap” would be a better word). Price controls disincentivize ample production. Shortages ensue. Prices, therefore, rise even higher.

Beijing may have hope. China’s appetite for consumption keeps growing. Meaning Chinese dependence on an export economy to support sustained GDP growth looks to be waning:

According to The Economist, “The World Bank’s latest China Quarterly Update suggests that net exports contributed only 0.4 percentage points to GDP growth in the year in the fourth quarter of 2007 (see chart above). Overall GDP growth slowed only modestly (to 11.2%) because of faster growth in domestic demand, which contributed an impressive 10.8 percentage points.”

Meaning the Chinese economy appears to be transitioning into a sustainable form of adolescence. Achieving a more proper balance between domestic production and consumption should enable Beijing to gradually allow more currency appreciation as a means of fighting inflation.

What that will mean for the American consumer remains to be seen. Political threats of more American protectionism combined with a rising yuan won’t do much to alleviate John. Q Public’s pain. If anything, he’ll have to spend more of something he already doesn’t have.

On the other hand, companies with assets denominated in Chinese yuan should see a boost. Companies racing to construct Chinese infrastructure shouldn’t fare too badly, either.

A stronger yuan will mean a great deal to companies around the globe. The question is how will your portfolio react when the yuan starts flexing its muscles?

Until next time,

Christopher Hancock
March 7, 2008

As China Continues To Grow, They Watch For Inflation was originally featured in the Penny Sleuth.

We vote for recession. Bernanke, however, opts for inflation.

We shrug. So does Mr. Market. The Dow tumbles. Oil surges to a record $102.59. Gold jumps $15.50, to $970. Wheat, cotton, rice and corn follow suit. Before long, the dollar menu at McDonald’s will require a Jefferson, instead of a Washington:

Meanwhile, Americans keep lining up for unemployment insurance. The Labor Department reported that new applications for unemployment insurance benefits rose 19,000, to 373,000, last week.

It gets worse. More than 405,000 homeowners lost their homes to foreclosure last year. The Pentagon strategically braces for $225 oil. Drivers are paying 19 cents more per gallon than they did just two weeks ago. Some experts think the price will go to $4 before the summer comes.

“You’re adding an oil shock on top of a crunch on credit and a housing collapse,” said Nigel Gault, an economist at Global Insight. “Even the U.S. economy cannot withstand all of that at the same time.”

So how will John Q. Public pay for a Happy Meal? We’re not sure.

But the day of the American consumer keeps fading wistfully into the night.

So what does that mean for you, dear reader?

We believe investors should be very cautious of stocks reliant on American consumers. We suggest you take special note to exercise caution regarding companies like Apple, Starbucks or P.F. Chang’s China Bistro.

We have no particular prejudice against any particular one. In fact, I work on an Apple, drink Starbucks and eat at P.F. Chang’s. Sometimes I do all three simultaneously.

However, if John Q. Public lost his house and credit card, we imagine he’d use his last $20 to buy toilet paper, Folgers and a pack of smokes.  He’s not going to make another dinner reservation on his 2008 iMac while sipping a $3 cup of joe.

Furthermore, these companies aren’t cheap:

As for what to buy, ask yourself: Can a company raise prices?

Think of things you need. Beer and cigarettes come to mind. Well, you may not need these items, but I’ll use them to illustrate a point.

When’s the last time you actually looked at the price of one beer versus another? I’m not talking Heineken versus Pabst Blue Ribbon, mind you. I’m talking about Heineken versus Corona…or Bud Light versus Miller Lite. Customers in this sector buy on preference. And they buy a few more cases when the price is cheap.

One could make the same case for shampoo and bandages. The point: When times are tight, we’ll still continue (hopefully) washing our hair and binding our wounds.

You also want to ask yourself: Can a business control its basic costs? When 1.2 billion Chinese start demanding a protein diet, can P.F. Chang’s easily pass on its input costs (higher meat prices) to a cash-strapped consumer? Will margins suffer?

In the case of a discretionary item like traditional Chinese cuisine, the switching costs are very low. In this business, consumers have many choices. Reprising the menu could easily suppress demand. That’s one reason we avoid the restaurant sector. Restaurants don’t possess a very good (if any) economic moat.

On the other hand, comapies that own tangible assets, base metals or natural resources should prosper. Companies well positioned to service the world’s immedaite need for infrastructure should also do quite well.

That’s one reason we made the case for a Mexican cement producer in Free Market Investor.

We believe it has been unfairly punished as a “housing sector” stock.

First, the company’s revenue stream isn’t as dependent on American sales as sellers seem to think. It boasts operations in more than 50 countries across five continents —diversifying the income stream enough that a slowdown in any one particular country shouldn’t affect the company all that much.

Furthermore, public construction — particularly infrastructure projects such as streets, highways and bridges — not housing, represented the most cement-intensive sector. Infrastructure accounted for 47% of total U.S. cement consumption in 2006.

So when housing construction was at its peak, infrastructure still stole the show. We expect this trend to continue. Analysts estimate that worldwide infrastructure spending over the next 23 years will require $41 trillion — a figure roughly equal to the 2006 market capitalization of all shares held in all stock markets in the world.

Our advice: Sell the Apples and buy the basic needs…

Until next time,

Christopher Hancock
February 29, 2008

Keeping the Needs for the Basics Ahead of the Wants for the Apples was originally featured in the Penny Sleuth.

“Taxation is a pivot upon which economies, countries, governments and empires rise and fall. It can mean the difference between war and peace, prosperity and ruin.”

— Nathan Lewis

President Bush proudly signed off on a $170 billion stimulus package last week. Congress willingly approved. The two peacefully joined hands for the first time since they surmised to free Mesopotamia.

This time, however, they focused their do-gooder righteousness on the struggling American consumer. In a last-ditch effort to avoid the big “R,” Washington procured no less than $300 ($600 in most cases) for every man, woman or child who earns a paycheck or receives Social Security.

Mr. Market smiled. The cadence of the buy-now-pay-later American generation lives to see another day.

Morality aside, dear reader, you must forgive us for spoiling the fun. But from where exactly does this $170 billion magically come?

The last time we checked, Congress doesn’t produce widgets for Chinese consumption. It doesn’t sell government land. Nor does it rent its legislative acumen to some chaotic third-world country. It’s up to its ears in debt. The latest budget promises only to borrow much more. So where exactly did Congress find $170 billion?

We assume the deal went something like this…

The U.S. Congress turned to the U.S. Treasury. The U.S. Treasury turned to foreign buyers (China). Foreign buyers should (and will) require a higher rate of return for holding a depreciating fiat currency. But they shrugged. They knew that money would make its way back to China through a Wal-Mart near you. So they acquiesced. They lent Hank more money. Meanwhile, the juice keeps running.

Unfortunately, before long, Washington will receive a bill. It’s postmarked “Beijing.” Government opens the little white envelope to find it owes the Chinese $170 billion big ones, plus interest. It sighs…

So once again, Congress will turn to the U.S. Treasury. The Treasury balks. Chinese loans aren’t an option.

Hmm… It scratches its head.

Then, like a child playing one parent against the other, Congress runs down the street and knocks on the other benevolent banker’s door.

But “Helicopter Ben” squirms.

Lower rates inject more money, he muses, but there’s only one way that money will make it to Washington’s bank account.

The endgame: Congress must tax.

At first, Washington turns to tariffs. “Tax the foreigners,” it shouts. “Secure our borders! They’re the ones who stole your jobs… They’re the reason we’re in this whole mess!”

China grimaces. Projection doesn’t work. It waves its finger like a parent whose cookie-obsessed child comes home with a toothache.

“Tread lightly,” Beijing warns. “More than a trillion or so American IOUs don’t need a new home, do they?”

Uncle Sam agrees. He’s left with no option. He must now tax every man, woman and child who received a check. If that weren’t enough, every $300 handout will now require $330 in return.

Unfortunately, Americans are tapped out. They were told to spend their windfall, not save it. The magical $170 billion now sits in a Chinese sovereign wealth fund. In return, 50-inch plasma TVs, flawed diamonds and a fresh coat of paint adorn the American landscape.

So Washington turns its guns on another time-tested villain: The rich. It preys on John Q. Public’s fear and greed… It vilifies the top 1%.

“Make them pay,” it screams. The rich…they’re the ones to blame.

The masses quickly jump on board. A button-down, neatly tucked family of four adorns the balcony for the State of the Union. The legislators gasp. The president puts forth a multibillion relief package. Congress applauds. “Save the middle class,” it cheers. The spin machines anxiously assemble outside the great hall. They crave their pound of flesh. They eagerly ingest the doctrine spewed inside. They pontificate about the great command. Ratings rise.

By spring, big business and big money get slapped with the so-called “relief” tax.

And like the Chinese, big business gives a grimace. It’s seen this trick before. It’s no dummy. It passes the tax like a hot potato.

Prices rise. Consumption wanes. Before long, production falls. Eventually, cutbacks ensue. Workers lose jobs. More Americans unknowingly join the button-down, neatly clad family of four. So it goes…

The point, dear reader, is this: Efforts to tax the rich prove counterproductive. In a cruel twist of fate, Nathan Lewis, author of Gold: The Once and Future Money, points out:

“By attempting to make the wealthy foot the bill of government, in effect, the policy shifts the burden to the lower income classes. In 1980, for example, when the top income rate was 70%, the top 1% of income earners paid 19% of all the tax revenue and the lower 50% paid 7.1%. In 1988, after the Reagan tax cuts lowered the top tax rates to 28%, the top 1% paid 27.5% of all tax revenue and the lower 50% paid 5.6%.”

Analogous patterns can be seen in both the ‘20s and the ‘60s. “In 1921,” Lewis notes, “the top tax rate was 73%, and by 1926, it had fallen to 25%. In that period, the percentage of tax revenue paid by those with incomes over $100,000 (about $1.75 million today) rose from 28.1% to 50.9%. The percentage of tax revenue paid by those with income under $25,000 fell from 40.1% to 14.5%.”

Britain also shared a similar experience during the Thatcher administration.

You see, higher taxes discourage higher production. Fewer widgets mean fewer sales and fewer jobs. Fewer sales slips and W-2s equal less tax revenue. Meaning, passing the buck to the top 1% not only shrinks the overall size of the pie, but this misguided public policy also forces the middle and lower classes into paying more.

“What a country wants to make it richer,” economist John Stuart Mill wisely surmised, “is never consumption, but production.”

Unfortunately, we have it backward. We base progress on consumption. If we can’t afford more, well, then we’ll borrow more to keep the party going. But eventually, the music must stop. And the cleanup won’t be easy.

But to the magic moneymakers in Washington, that’s someone else’s problem.

As Bill Bonner points out in his latest book, Mobs, Messiahs and Markets:

“The goal here — as with all government programs — is to produce the desired benefits while pushing the costs onto someone else. That’s how politics work. You promise something…and you force someone else to pay for it. You rob one Peter voter…and spread the loot among the Pauls.”

Ahh, the beauty of politics.

Until next time,

Christopher Hancock
February 19, 2008

P.S.: Whether or not you agree with the Stimulus Plan, the real question is: How are we supposed to make money in times like this? I think you’d agree that it’s not in the U.S. That’s why I tell my Free Market Investor readers to look elsewhere.

The Stimulus Package and the Magic $170 Billion was originally featured in the Penny Sleuth.

The victim, a Johns Hopkins student, grabbed the wallet from the young intruder’s hand. He then wisely acquiesced, handing over his cash ($40.00). The suspects, 6-8 males, between 8-15 years of age, wearing dark hoods and dark pants, promptly fled westbound.

Earlier that evening, two similar juveniles approached a Hopkins employee walking westbound on the same stretch of E. Madison. Once again, a juvenile displayed a knife and demanded money. This time, however, the victim refused to comply. He continued to walk westbound. The suspects, two males, between 8-14 years of age, wearing dark hoods and dark pants, fled the scene.

One would assume these incidents were related. One would also assume the juveniles quickly surmised the benefits associated with the law of large numbers. For their efforts, they’re now $40 richer.

In what we can only assume to be an unrelated incident, three armed men wearing dark clothing and ski masks stole four paintings by Cezanne, Degas, van Gogh and Monet worth from a Zurich museum, police said today. For their efforts, they’re now $163.2 million richer. They also seem to be quite familiar with the law of large numbers.

And speaking of large numbers, we read a few snippets from Saturday’s New York Times that got us thinking. The Times reports that revolving debt — the nasty little interest-bearing IOUs for which thank Visa, MasterCard and American Express — reached a record high $943.5 billion in December. The annual growth rate of revolving debt keeps inching up as well, reaching 9.3 percent in the fourth quarter of 2007.

The Times also notes that the Federal Reserve found that roughly 4.34 percent of 100 largest bank’s credit card portfolios were delinquent. For those counting, that’s roughly $40,947,900,000.00 in delinquent debt. But what’s another $41 billion compared to the more than $135 billion in credit losses and write-downs banks worldwide have announced since the turmoil in the U.S. housing market started last year?

According to David Jolly of the New York Times, some analysts estimate that total write-downs could reach $800 billion.

Meanwhile, bubble chasers continue itching for the next big thing. “Put this banking mess aside already,” they clamor. “What’s next?”

The “next big thing” our friends at the Daily Reckoning opine, “will be downsizing, cutting back, making do. Barely on the radar screen now, thrift is coming into focus more clearly day by day. So far, people are a bit embarrassed about it…a bit ashamed that they have had to cut back. But soon, it will be popular…fashionable…and finally, almost obligatory.”

Hmm… “Prices are rising in Europe as in America. Bread is up 12% in Germany over the last 12 months. Butter has gone up 45%. Milk 25%.”

Higher prices often stem from printing more dollars. “Force-feeding the rest of the world $2 billion a day (more consumption),” Warren Buffett reminded us last week, “is inconsistent with a stable dollar (more inflation).”

We share Mr. Buffet’s concern. Bernanke keeps printing. Politicians keep promising. Bridges keep crumbling. Wars keep spending. We read this week that the projected total cost of Medical care for U.S. veterans of the Iraq and Afghanistan wars will top $500,000,000,000, a figure on par with the total military spending to wage these wars to date.

And speaking of military might, Defense Secretary Robert Gates estimated in testimony before the Senate Armed Services Committee, the Pentagon will spend upwards of $685 billion next year alone. That’s $170 billion more than the $515 billion the president proposed in his first-ever $3 trillion budget.

If that weren’t enough, Gates doesn’t even expect that number to stick. “I have no confidence in that figure,” he admitted. You can expect the estimate to rise in the near future.

A hundred billion here…a hundred billion there. Who’s counting?

Apparently, no one.

But that’s not to say the S&P can’t weather the storm. The companies representing the Standard & Poor’s 500 Index now derive 49% of revenue from foreign markets, up from 30% in 2001. Meaning, those with money to burn (southeast Asian consumers) should keep earnings reports strong. Stronger repatriated currencies should only bolster this trend.

Unfortunately, we tend to think many Americans believe strong a S&P equals a strong American economy. We tend to see another American economy. We see an economy riddled with debt, more debt and even more debt. We tend to see the American consumer eerily close to tapping out. Thirty-four percent of American’s now believe they were among the “have-nots.”

It serves to reason. More than 405,000 homeowners lost their homes to foreclosure last year. With no homes or credit cards, where will the SUV nation get its cash?

Well, we’re not so sure. China perhaps. But the Chinese seem reluctant. Maybe they’re saving they’re Yuan to buy more oil. They too may have noted the Pentagon’s preparation plans for $225 oil.

In short, it seems to us that cutbacks are the only option.

With a stroke of the pen, as Roosevelt did in 1933 and Nixon did in 1971, the government can confiscate the currency and tear it to shreads.

In either case, the thief, the politician and the banker are seemingly playing the same game. They’re playing the law of large numbers. Whether they steal by the sword or steal by the pen, their craft effectively erodes the tangible wealth of the grad student walking home after a hard day’s work.

Consequently, our hero isn’t left with many options. He can always study to become a legislator or a central banker.

If that doesn’t work, may we suggest dark hoods and dark pants?

Until next time,

Christopher Hancock
February 11, 2008

P.S.: As you can tell, the U.S. stock market doesn’t look good right now. That’s why I started a new service last year that gives readers the chance to invest overseas without all the hassle that goes into it. Most people shy away from investing overseas because it can be confusing at times. But, I take care of all that. It has already produced some nice profits for my readers.

As the U.S. Dollar Tanks, Investing Overseas Never Looked So Good was originally featured in the Penny Sleuth.

It’s not uncommon for me to sit on a mall bench with a book while she peruses store to store, negotiating a discount. “You’ll be so proud,” she says on a routine stop to my home base. “Neiman Marcus has a stunning Monique Lhuillier dress for half price, and I convinced the lady to take off another 10%.”

I, of course, say to myself (and let me stress “myself”) that 50% off at Neiman Marcus is still 50% more than at most places. But my thought more often than not remains, well, just a thought.

“What’s the intrinsic value?” I ask.

My wife tilts her head, raises those eyebrows and without hesitation assures me it’s more than the price. “And furthermore,” in a tone that assures me the discussion ends here, “it’s Saturday. Leave the finance downtown.”

I chuckle.

So goes the wonderful cadence of marriage.

My obsession with intrinsic value got her thinking. The other night, she opened up her brokerage statement. A few minutes later, she says, “Why does my broker have me in Apple? I thought you said Apple was too expensive.”

“Maybe he likes iPods,” I muse. She fails to find the humor.

“Seriously, Apple’s price-to-earnings ratio is well above 30. That’s expensive, right?”

“You should see the price-to-book,” I quip, trying to focus on the latest episode of The Wire. She grabs the remote and pushes pause.

We walk to the bookcase. Thirty minutes later, I find my wife 10 pages deep into Christopher Browne’s latest work, The Little Book of Value Investing.

It’s been three days now. Last night, she started reading an advance copy of Chris Mayer’s latest book, Invest Like a Dealmaker.

So the first thing this morning — and I mean first thing — she asks, “How do you compare EBITDAs around various industries?” Not your typical teeth-brushing conversation, but nonetheless, I’m very proud.

She has what it takes. She focuses on what she may lose well before she considers what she may gain. She sees the business, not the stock. Let me reiterate: I’m very proud.

So this morning, I sent her a recent letter from Third Avenue Management. I highlighted the following:

“Throughout Third Avenue’s more than two decades of existence, we have experienced several bear markets, yet the macro market environment has never influenced the process by which we select investments. To repeat, Third Avenue invests for the long term.

“Third Avenue has faced securities bear markets in the past and no doubt will face others in the future. Yet for long-term fundamental investors such as Third Avenue, the general market is relatively unimportant. In the long run, the performance of Third Avenue’s portfolios will be driven by the merits of the investments themselves, not by general market considerations. As such, we continue to focus on finding securities that meet our ‘safe and cheap’ investment criteria today, allowing for potential long-term growth in the future.”

We, like the better minds at Third Avenue, have no idea which way the market is heading. In the short run, we don’t really care what Mr. Market thinks. We know he’s been wrong before.

As investors, we’re looking to buy businesses that provide a margin of safety… Companies trading near or below their intrinsic value with established earning power. Leave the charts and quarterly earnings reports to traders. They’re playing a different game.

We’re looking to buy a business, not trade it. And as with any good purchase, we never want to pay too much.

Here’s why…

Let’s say you receive a windfall bonus of $10,000. You want to invest your newfound wealth in one of two options. Option A is a government bond yielding 5% annually. Option B is market’s latest highflying growth stock promising returns of 10% or more for the next 20 years.

You naturally assume 10% is better than 5%, so you pour your $10,000 into the highflier.

As it turns out, you bought your golden stock on a 52-week high. The first year is rough…the stock loses 50% of its value over the first 12 months. But you hang on, and sure enough, the stock starts taking off. It grows at a remarkable 10% annual pace.

But even at a growth rate double that of the government bond, it would still take you 17 years to overtake that bond’s return!

Now, I’m sure that tech stocks, swank hedge funds and their excessive fees and other “insider” investments make great stories. They make you feel good when you proudly tell your neighbor that your broker just slipped you into some exclusive nanotechnology company that promises to turn the Earth on its axis, reverse the spin and solve the world’s energy problems all at the same time.

Meanwhile, my wife, the budding value investor, plans to keep a good portion of her money in a first-class company that supplies the world with cement. She notes that shares of the business trade for a very reasonable price. She also notes a recent report suggesting that modernizing urban water, electricity and transportation systems over the next 25 years, according to Booz Allen Hamilton, would require $40 trillion — “a figure roughly equal to the 2006 market capitalization of all shares held in all stock markets in the world.” She’s convinced that’s going to require one massive amount of cement. I agree.

And she’ll make her investments just as everyone should make their investments…with a margin of safety.

Until next time,

Christopher Hancock
January 25, 2008

P.S.: You have probably heard of Chris Mayer a number of times. He is one of the leading experts in value investing. His new book, Invest Like a Dealmaker, will be released on March 3, 2008. Look for more details about it in future editions of Penny Sleuth.

Learning to be a Value Investor was originally featured in the Penny Sleuth.

The proud Venetians surrendered their Austrian Crown, circulated in bright gold pieces, and their beloved Burg Theater… They traded their warm, comfortable existence for the blood-soaked trenches, breastworks and fortifications along the Western Front.

Vienna, the city that produced the Blue Danube…the city that nurtured the music of Mozart, Beethoven, Schubert, Brahmas and Strauss…now laid in ruins.

“The War to End All Wars” claimed the lives of more than 40 million unsuspecting souls.

However, Zweig found that the horrors of war also lay in the aftermath, not just senseless, meat-grinding slaughter itself.

War debt replaced gold. Consequently, the government quickly turned on the printing press. Every village and every town began to print it’s own worthless fiat money. Inflation soared. Famine ensued. Tiny bits of copper and nickel had more value than Austrian paper.

The people, who no less than five years earlier obtained one of the highest cultural and productive societies the world had ever seen, were suddenly reduced to primitive barter. They demanded substance for substance… In the time-span of one presidential term, one of the most progressive societies on Earth had been reduced to a cave-dweller’s squalor.

Retrospectively, Zweig writes that before the war: “Marvelous was this tonic wave of power which beat against our hearts from all the shores of Europe. But there was danger too in the very thing that brought joy, although we did not perceive it. The storm of pride and confidence which rushed over Europe was followed by clouds; perhaps the rise had come too quickly, the States and cities had become powerful too hastily. The sense of power always leads men as well as States to use or to abuse it. France was puffed up with wealth; it wanted yet more, wanted a colony even though there was no superfluous population for the old ones; it almost went to war over Morocco. Italy wanted Cyrenaica, Austria annexed Bosnia, Serbia and Bulgaria pushed toward Turkey, and Germany, still excluded for the time being, raised its paw for an angry blow.”

The World of Today

The world of yesterday seems strikingly familiar to the world of today…

The storm of pride and confidence which rushed over the American landscape was followed by clouds; perhaps America’s 20th century rise to power came too quickly, the central government teamed with the central bank had become too powerful too hastily. The sense of power always leads men as well as States to use or to abuse it.

America was puffed up with wealth; it wanted yet more, wanted exclusive access to foreign oil and cheap labor; it spent more on defense than the next seventeen countries combined. President Bush pushed for missile defense systems in Eastern Europe. Russia, for fear of being outmatched, laid claim to the North Pole and all its Christmas goodies which, just happen to include 10 billion tons of gas and oil deposits…not to mention the significant sources of diamonds, gold, tin, manganese, nickel, lead and platinum peacefully resting on top of the world. To punctuate their resolve, they threatened to turn off the lights in Europe.

China, for their part, passively eases their desire to absorb American IOUs. Japan dips their toes in waters remilitarization. Venezuela throws its proverbial hat in the ring by ousting foreign oil while Iran consistently defies the international community by mischievously playing with yellowcake.

Oil and food prices surge… M3, the fullest measure of U.S. money supply, continues growing at a 12% annual clip. Entitlement programs goad us deeper and deeper in the red. Politicians promise more. Meanwhile, the Iraq war tab keeps churning along at a rather brisk $400 billion dollar a month pace; or, if you prefer, $100,000 per minute. Throw in the Afghanistan on the running meter and we add another $18,000 every 60 seconds.

The average American worker brings home $39,795 per year — or $19.13 per hour. So excluding overtime, John Q. Public must now clock three years to pay for sixty seconds. So dismiss the fact that his interest-only house payment is set to expire. Forget the fact his credit card bills bear a $15 thousand dollar balance. It’s only interest. Washington plays this way…why can’t he?

It gets better. The world now wrestles with a multi-trillion dollar international credit crunch. Markets around the globe shiver.

Where do we go from there?

The World of Tomorrow

It’s 2008. We’ve been at war for nearly five years. There’s no end in site. No way to determine the true long-term costs.

Meanwhile, our debts continue to grow. But we keep printing. The U.S. money supply continues to surge three to four times faster than the GDP itself.

Mr. Bernanke sets to assuage investors into believing inflation is under control. Excluding food and energy, he says, the cost of living isn’t going up too much.

Well, as it turned out, the Labor Department reports that inflation at the wholesale level rose to 26-year highs in 2007. While the producer price index managed a tiny 0.1% fall in December, the government reported this morning that total 2007 producer inflation rose to 6.3%, a level not achieved since 1981.

Thankfully, it’s an election year. And as we’ve opined before, that’s where Hillary, Mitt, Barack and Mike come in.

Politicians who push populist economic agendas take the stage. They yearn for more government intervention atop more cheap credit. What could be better?

So which well wisher promises the most? We’re not sure. But it seems to us that he or she will write more government checks backed with dollars…and that’s the heart of the problem.

Every imaginable rescue mission for the overly indebted American consumer, not to mention the overly indebted American government, leads to increasing quantities of dollars and credit, which can only mean one thing:

Inflation will only get worse.

“Inflation,” according to Congressman Ron Paul, “is immoral.”

“It’s immoral in the sense because it steals, it steals value. If you double the money supply and your prices go up twice as much, it’s an invisible hidden tax. But the real immorality here is that some people pay higher prices than others. So if you’re in a middle class or especially in low middle income, your prices might be going up 15% a year…and somebody on Wall Street might be working leverage buyouts and making billions of dollars and they don’t have to worry about the rising costs of living.”

“This to me is an immoral act that is prohibited by the constitution and the outcome is always tragic.”

Dear Mr. Paul, we concur.

Your editors believe all prosperity begins and ends with a sound money system. History has proven this fact time and time again.

Too bad Congress can’t subpoena Stefan Zweig.

Well, at least they got Roger Clemens…

Keep spending (it will only be worth less tomorrow),

Christopher Hancock
January 17, 2008

P.S.: I’ve been touting this anti-inflation issue for a while now. But, instead of just talk, I decided to act. A while back, I started a newsletter called Free Market Investor. In it, I recommend safe investments from around the world to my loyal readers. And so far, it has worked beautifully. Currently, my readers are up double digits on 70% of my recommendations. And you know, in this market, that’s rare.

War, Debt, and Inflation from the Past to the Future was originally featured in the Penny Sleuth.

America’s industrial revolution required the basic commodities and raw materials essential to a nation’s growth. So it’s no surprise that the original Dow Jones Industrial Average consisted entirely of companies that produced goods like cotton, sugar, tobacco, gas, lead, coal and iron…

These are the resources developing countries like China can’t live without. The “China story” is nothing new. It’s been played time and time again. Southeast Asia’s insatiable appetite for a limited supply of natural resources will continue to rise right alongside its staggering annual growth rates.

In 2005 alone, Beijing approved the development of 168 new power plants. These facilities alone have the capacity to provide enough electricity to power all of Italy. More importantly, the same basic commodity the Chinese have been burning for roughly 6,000 years — coal — will fuel the vast majority.

In many ways, the world hasn’t changed. Peel away the layers of technology, the Internet, the PC, the television…all the way down the line. What are you left with?

You have nations and their economies, war and commerce. These are the constants in the evolution of modern civilization.

In our digital age, in which every human desire is a simple click and several nanoseconds away from instant gratification, something as elemental as commerce — trade between nations — seems terribly outdated and inefficient.

But until we reach a stage of technological innovation in which the major staples of trade — things like corn, rice, soybeans and oil — in other words, basic commodities — can be disassembled one molecule at a time and instantaneously beamed to another location, our current means for commerce will remain the most efficient.

So it’s no surprise that the majority of the Dow 30 are still “smokestack” corporations. Even with all the hype surrounding the Googles, eBays and Amazons, our country still rests on the shoulders of the seasoned giants like General Electric, Procter & Gamble and JP Morgan.

Right now, the world is struggling with the adjustments of globalization. Specifically, energy security has prompted many nations to issue threats, assess strategic positions and begin to retrench to protectionist tendencies.

Energy security will be the No. 1 topic for years to come. Congress stood up in arms when a Chinese oil company attempted to purchase America’s Unocal. And it’s standing up once again as Dubai Ports World (owned by the United Arab Emirates) positions itself to buy an American port.

The Russian-Ukrainian natural gas dispute appears to be just a taste of what’s to come. Russia (Siberia, in particular) is full of natural gas, and competition for access to those deposits is getting fierce between Europe and the energy-hungry nations of the Far East.

Now more than ever, countries are dependent on global markets to supply essential resources. In turn, I believe nations will begin to reassert state protection of the resources that will remain vital to their domestic needs.

China’s insistence, in particular, on protecting its domestic oil market will remain one of Beijing’s very top priorities.

Oil is much more than the commodity that fuels our cars. Petroleum-based products undoubtedly serve as the most important commodity driving domestic economies. Domestic stability rests on its relative availability. Consequently, Beijing will certainly protect the vested interests of the two large energy companies, PetroChina (PTR: NYSE) and Sinopec (SHI: NYSE).

I believe these companies will provide consistent long-term returns with minimal risk. While companies like these may not offer the kinds of returns known to penny stocks, in the uncertain world we live in, they might be your best bet.

Until next time,

Christopher Hancock
January 11, 2008

P.S.: Here at Penny Sleuth, we spend a lot of time on the smallest of U.S. companies. But in a world of uncertainty, we sometimes have to look elsewhere. That’s where I come in.

Invest in China’s Version of the 1896 Dow was originally featured in the Penny Sleuth.