Market Update 03-30-09| Leeb's Market Forecast Analysis and Tips

Short-Term Key: Negative
Long-Term Key: +54

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Inside this week's update..
***** The power of false assumptions.
***** Congress and the Fed – choosing the least damaging solution.
***** What to own until the banking crisis ends, and after.
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My old college logic professor once included in a lecture a story about Bertrand Russell, the late Nobel Prize winner and master logician. Russell, according to the story, once said, “Grant me one false assumption, and I can prove anything.”

A listener then responded by asking Russell, “Okay, assuming 1 + 1 = 1, prove to me that you and the Pope are the same.”

Russell's response: “I'm one. The Pope is one. One plus one equals one. So we are the same.”

The point my professor was making with this story is that if a logical argument relies on just one false assumption, the whole argument fails. Many people use this principle to persuade others into believing things that are wrong. It's simply a matter of putting a few false assumptions at the beginning of your argument, making what follows seem logical, and hoping no one will notice.

For example, this past weekend I was scrutinizing the assumptions that underlie President Obama's recent budget, and I was dismayed to find more than one that doesn't hold water...

OBAMA'S FALSE ASSUMPTIONS

The new budget assumes that for the next ten years inflation will never exceed the very manageable figure of 1.8%. That's a very rosy scenario. Even the blue chip consensus envisions inflation over 2%.

In addition, the budget assumes that growth will rise to an annual rate of 2% in 2010, then average 4% for the years 2011-13, before pulling back a little to 3% for the remainder of the period. Again, you would be hard-pressed to find many leading economists who would be so optimistic.

Nonetheless, it's these assumptions that allow President Obama to say he can fulfill his promises of spending money on energy, the healthcare system, education, and other areas while still reducing the current deficit by 50%.

It may sound a little cynical, but we expect that the budget team were told to come up with a budget that would meet all the President's goals. In order to make the math work out, they had to insert a few false assumptions. Realistic assumptions would have made it obvious that reaching all the goals is impossible.

The most glaring problem with the budget's assumptions is that economic growth of 4% for three years running would almost certainly lead to massive and rapid resource shortages. The supply/demand squeeze would be far greater than in 2008, and would drive commodity prices up considerably higher.

In that context, inflation would certainly rise by well over 2% a year. In fact, the only way to avoid a skyrocketing cost of living would be the sudden discovery and instant development of some miraculous new energy source, such as cold fusion, a perpetual motion machine, or magic.

At TCI, we don't believe much in miracles. There's no way to profit from such a belief. We can only look the facts squarely in the face and then try to stay on the good side of what's happening. Solving today's problems will take much more than optimism and words.

Which brings us to last week's rally...

THE FED OR CONGRESS? A ROCK OR A HARD PLACE?

The rally that followed Secretary Geithner's announcement of a so-called plan to deal with the banking crisis was not really due to widespread belief that the plan would work, contrary to popular belief. It had, we believe, more to do with Fed Chairman Bernanke's decision to buy up massive amounts of treasury paper and bad debts in order to put more money into the economy.

The problem is that Congress just doesn't have the will to spend the money needed to stabilize the banks. It doesn't even want to put more money into the TARP program. That means the balance of the work needed to get us out of the recession will have to be shouldered not by Congress but by the Federal Reserve. And with all the new money the Fed will need to create (as part of that effort), you can forget about inflation remaining under 2%. A central bank printing too much money is one of the classic causes of runaway inflation.

Take, for instance, our old friend Citigroup with its $300 billion worth of toxic (i.e. nearly worthless) assets. For the Fed to stabilize Citigroup, it would have to buy those toxic assets from Citigroup in return for $300 billion worth of T-bills, which Citi could actually sell if it needed to. That would eliminate Citi's balance sheet problem, and create $300 billion out of thin air. It's the new, electronic version of using the printing press to create money.

The difference between the Fed saving Citi and Congress saving Citi is huge.

Let's say, for instance, that Congress decided to save all the banks by spending a trillion dollars (something that Geithner implied may be necessary when he appeared on talk shows last weekend). When Congress spends, the money comes out of the budget and is financed by selling T-bonds. In other words, Congress isn't printing money; it's raising money from the public and foreign investors. It's not a desirable thing to do since it adds to the government's debt, which taxpayers will have to pay back eventually. However, it's better than letting the Fed create money out of thin air, which has the effect of debasing the currency.

Meanwhile, the real problem, to which we still have no solution, is how to turn the flickers of financial hope that have recently emerged into a recovery.

Typically, it takes four to six months of stimulus before the economy responds positively. Right on cue, these responses have appeared. Consumer spending has picked up a little. So has housing. In fact, we've seen better-than-expected economic figures over the past two months across the board.

But unless the banks have the ability to fan these positive sparks into flames of long-term growth (i.e. investment), they will die out.

As I explained in an interview last week, some consumers now have a little extra money in their pockets, thanks to lower energy prices and interest rates. So, let's assume they start spending a little more at the corner store. The store finds itself making a little more money as a result. That encourages the store owners to expand – perhaps by adding additional outlets. So the owners apply for a loan to finance their expansion.

However, if the bank turns down the application, because credit is tight, hope for an expanding economy is crushed.

Only when credit becomes available again to those who need it to invest will we see sustained economic growth. It will happen in time, but we cannot say yet how long it will take or what the total cost will be. Our strongest guess is that, no matter how the bailouts are funded, the price we pay will be very high inflation – higher than anyone expects. And that brings us to what you, as an investor, should own during this period.

REAL ASSETS FOR A REALLY TROUBLED PERIOD

As we've said many times, the coming years will probably resemble the 1970s on steroids. Just as high inflation favored certain assets back then, so those same assets will likely benefit from the inflation that's coming. Precious metals, oil, and other commodities are the obvious beneficiaries. Some stocks will also do well – those that can increase their profits despite inflation and weaker growth. We will continue to hold the best of these in our portfolio.

Oil should continue to be a strong performer, second only to gold. However, because resource prices are all interconnected, commodities in general will do very well.

We can't say for certain we have seen the market's low yet. But we can say with high certainty is that there won't be a bull market for some time. Even if a march to 1,000 on the S&P or 10,000 on the Dow (remember when those numbers seemed low?) will probably have to wait until after the banking crisis is properly solved.

Meanwhile, continue to hold gold, buy commodity stocks on dips, and keep up to date on our latest missives as we try to guide you through this difficult period.

Until next time,

Stephen Leeb, Ph.D.

Editor

The Complete Investor