of the century. Aside from all the why’s and wherefore’s about what went wrong with the merger, it also elicited the greatest number of marriage/engagement/divorce metaphors in the history of journalism.

That is quite some feat. We write of course, on the subject of the BHP Billiton/Rio Tinto story.

Aside from all the benefits that a takeover would have brought to BHP, the big point to take from it is that even mega companies are reluctant to add debt to their books at the moment. And it also gives an indication that if it is troublesome for the likes of BHP and Rio to raise money in this market, think about the smaller companies and how they must be faring.

An example of this is one of the companies in our Australian Small Cap Investigator (ASI) portfolio. Last week it released details of a new joint venture deal it had entered into. Three days later the window closed for shareholders to pick up more stock in a capital raising.

The result was that the company raised less than 40% of the capital is was hoping for. If it was twelve months ago we are sure they would have raised the full amount. Fortunately, the company in question does have a Plan B. But many small companies out there don’t. If they can’t borrow from banks and can’t raise additional capital from shareholders, it makes it very hard for smaller companies to invest in growing their business.

On the other hand, that is one of the reasons why rather than stepping back from looking at new investments for ASI, we are actually ramping up the coverage in the New Year.

The credit markets will eventually recover, but it may be slow. However, even before this becomes obvious to the market many small cap companies will have already taken advantage and should surge ahead in price.

In our view, we believe the next six months will be the best time in years to pick up undervalued small cap companies.

After re-reading the ASX circular on the new covered short selling regime it appears we made an error last week. Our assumption was that the daily report would show all ‘open’ short positions in a stock. This appears to be incorrect. Instead, in their wisdom, the ASX are only publishing the daily volume of short trades.

So, looking at today’s report for instance, a couple of points stand out. First is the daily short selling volumes are greater than we thought they would be if you compare it to the total volume traded in a stock.

BHP Billiton [ASX:BHP] had nearly three million shares traded short yesterday. Compared against the total number of outstanding BHP shares of 3.3 billion that only equates to less than 0.1%. However, when you compare the three million shorts against yesterday’s share turnover of about 18 million shares then this is nearly 17% of the daily turnover that is going short.

A more bizarre one is Fairfax Media [ASX:FXJ]. According to the short report over four million shares in Fairfax were traded short yesterday. Again, as a percentage of its total outstanding shares it is only 0.26%. Yet, as a percentage of yesterday’s traded volume of about 5.5 million shares it equates to 73%.

We just make the point out of a matter of interest. Remember that only ‘covered’ short selling is now allowed on the ASX. This means that the brokerage firm executing the trade must be satisfied that the short seller is able to deliver the stock on T+3. Also, as we understand it, the report only shows the gross amount and does not take into account short positions that may have been closed out intraday.

And we still do not have a problem either with the concept or the practice of short selling. After all, in order for a short sell to go through there must be someone else who is prepared to buy them. Hence the argument that short selling helps to add liquidity to the market.

There are many explanations for the seemingly high day-to-day shorting volumes. One is obviously those terrible hedge funds. Another is the retail investor using Contracts for Difference (CFDs). Another reason could be institutions reweighting portfolios. And another could be companies that are hedging their DRP schemes. In addition there are probably another dozen or more explanations.

The upshot of it is that the ASX will need to provide a more thorough short selling report that displays more meaningful information than what it is supplying at the moment.

ASX Renamed - Now Called the “$2 Shop”

This morning we were beaten to it by The Age newspaper. Damn the ruthless efficiency and timeliness of the printed press.

“$2 company has new meaning” reads the front page story. It tells us that 48 of the S&P/ASX200 companies are trading for less than $2. We did a similar check on the S&P/ASX100 index yesterday. Fifty-three of those companies are trading for less than $5.

Of course the actual dollar value of the share price is not always significant. The market capitalisation of the company is more relevant. But it’s certainly a far cry from the euphoria of last year. Remember when pundits were jumping up and down with excitement trying to pick which Australian share would be the first to break through the $100 barrier?

Leading the charge was Macquarie Group, CSL, Rio Tinto and Perpetual. Where are they now?

The chart below tells us the story.

From December 2006 all four of them led a charge towards the $100 level. Then October 2007 came along and spoilt the party. Since then, as you’re no doubt aware, the share prices have plummeted.

As of yesterday Rio Tinto was $75.20, Macquarie was $26.95, CSL was $36.95 and Perpetual was $35.26.

Templeton’s $1 Stocks MkII
But back to our original premise.

Company share prices are getting smaller and smaller by the day. Market caps are falling. In fact, some of the companies that used to be blue chip are now targets for inclusion in our Australian Small Cap Investigator report. More on that later.

You may have heard this story. In 1939 US investor John Templeton bought $100 worth of stock in every New York Stock Exchange listed share that was trading for less than $1. So the story goes, there were 104 companies that he invested in with 37 of them in bankruptcy.

Three years later he was in profit on 100 out of 104.

Unfortunately we don’t have the time or space to do the analysis on every share currently listed on the NYSE. So here’s what we have come up with. After taking into account inflation, 1939’s $1 is now the equivalent of $14.78.

The NYSE now has 3,619 US companies listed, which is double the amount listed on the Australian Stock Exchange (ASX). But it doesn’t include listings of overseas companies - or the thousands more that are traded on the NASDAQ.

So, how many companies are trading on the NYSE for less than USD$14.78? It would be a lot, so we won’t bother counting. But if we look at a narrower range of stocks, say the S&P500 it tells us the following story.

Of the 499 companies in the S&P500, a total of 142 are trading at the inflation adjusted equivalent of less than a Templeton dollar. And they aren’t all Mickey Mouse companies either. There are some big names in the mix: Western Union, Sara Lee, New York Times, Morgan Stanley, Motorola, Mattel and Intel.

To make the equivalent investment to Templeton, an investor today would need to stump up around USD$210,000.

We won’t deny it, it is a difficult time for investors and traders. Even long term investors can be shy about buying if they think the market could fall further.

Take a share like Woolworths [ASX:WOW]. The argument could be made that as Woolworths is in the non-discretionary sector it should continue to perform well even if there is an economic downturn. As they say, people still need to eat.

While that may be the case it doesn’t mean that consumers will spend the same amount. Especially if brand names start to be replaced on shopping lists by cheaper brands. Its recent rally is doubtless the result of many shareholders switching out of cyclical stocks into more defensive stocks.

But who is to say that the current share price of $28.50 is a bargain. What is to stop the price going lower? Considering we are entering into a period where stock prices may not rise significantly many investors are looking even closer at dividend yields. The yield on WOW for 2009 is not that impressive at 3.6%.

It is possible that investors will demand a higher dividend if they are to accept flatter capital growth. With the current cash rate at 5.25% and many online savings accounts offering rates near this level the shares could fall closer to the $20 mark in order to increase the yield towards 5%.

It’s one reason to be cautious about following the herd. Sure, investors should be looking at defensive positions, but only if they represent good value.

Cheers.
Kris.

Money Morning Uncertainty Index

The global economy is now slowing with several countries in Europe and Asia either in recession or at the brink of a contraction in output. But China, the world’s main driver of commodities consumption this decade, continues to grow, suggesting the severe declines witnessed for raw materials since July are way overdone.

Since hitting a peak on July 3, the benchmark Reuters/CRB Index has plunged 25%. All commodities representing this index have declined sharply, including crude oil (32%), gold (22%), copper (22%) and the grains (28%). The chart below, dating back to June, clearly shows an oversold condition based on the MACD that has progressively worsened over the last 60 days.

The “China Factor” applied to commodities demand remains one of the more formidable equations supporting raw materials. As commodities have crashed recently, the Chinese are once again hoarding industrial metals like copper, tin and steel scrap. This demand won’t disappear because of credit problems in the United States – not with USD inflation-adjusted interest rates in negative territory. The U.S. Fed Funds currently stand at 2% versus 5.6% inflation through July.

The Chinese have started to expand credit again after tightening the money-supply since 2006 in small increments. China can’t afford a recession; a major contraction in output would devastate the economy and result in tens of millions of people becoming unemployed. The People’s Bank of China also has the capacity to spend heavily to finance a continued expansion. 

As Eric put it in a recent blog post…

“If you think the Federal Reserve has muscle, think again. China is home to more than $1.7 trillion dollars in foreign-exchange reserves. They can literally bail-out the entire American banking system with one check! They’ll do everything they can to keep this expansion going strong.”

In short, commodities, which were heavily overbought heading into 2008, are now heavily oversold.

In Eric’s view, the U.S. government played a big role “talking down” commodities by attacking oil trading speculation. In an election year, it’s really no surprise the Feds are targeting oil prices. They wanted lower oil prices and they got it. But their talk won’t be able to hold down prices forever.

Yes, the global economy is slowing this fall. Europe is several months behind the United States in this credit squeeze and Japan is basically in recession again. But the emerging markets should get a dose of good news as oil and food prices have plunged by about 25% since July.

These countries, including China, will continue to expand even at the expense of weaker exports. China, India and many other emerging markets are piling billions into domestic infrastructure projects. Eric expects these and other domestic projects to keep those markets humming until the West can stabilize credit markets.

One of the upshots of the farce happening in the US is that the global economy is destined to take an even bigger shift across the Pacific towards Asia. The urbanization of Asian nations and growing wealth of individuals will compensate for lower demand out of North America. Remember, they have been saving while the West has been spending.

Australia is perfectly placed to benefit from this. Importantly, Australia actually produces things that industry wants. Correction, that industry needs. Raw materials. Commodity prices may not stay at elevated prices forever. In fact they may fall lower than where they are now.

The reality remains that Asian economies continue to grow. And their demand for raw materials is growing with it.

That’s fine for exports, but what about the Australian banking system? Thanks to the “4 Pillars” banking policy and the lack of competition, Australia is likely to miss out on the banking blow-ups that we have witnessed in the US and the UK.

Because of this the local banks have not had to get too “smart” with how they finance their loan books. For the most part they can rely on deposits to fund their lending. Our two investment banks, Macquarie and Babcock & Brown have not been so lucky.

Despite this, they do have some exposure to the complex derivatives products that have caused such trouble in the northern hemisphere, but not to the same degree.

The main risk for the Australian banking system is that it develops overconfidence. And that they start to puff out their chests congratulating themselves on escaping the worst effects of the credit bubble.

Perhaps the bravado has started already. Before the bodies of Freddie & Fannie are even cold there has been talk about setting up a government funded “Aussie Mac.”

A company called Rismark has proposed setting up a listed property derivative which would trade on the ASX. In a typical example of the private sector taking the profits and the government taking the losses, Rismark has proposed that Aussie Mac would only be a back-up in a liquidity crisis.

Just as mortgage backed securities were originally designed to help US Savings & Loans companies to hedge their risk exposure, that is exactly how the ASX property derivatives would be marketed here.

However, we have little doubt that before long the sales guys at the investment banks would be out marketing the products to as many funds and hedge funds as they can. Thanks to the past few weeks we’ve seen the consequences of nearly thirty years of the same thing in the US.

Given the choice between buying resources and energy stocks at a discount or buying banking shares at a discount, we will take the resources and energy stocks every time.

We’re happy to stay clear of banking shares until at least after the next reporting season. If that means missing out on 20% upside, it’s a chance we’re prepared to take.

There’s nothing more to be said about the markets last week except that we all survived, battered, bruised, shell shocked and worse if you were shareholders in some American companies no longer with us like Lehman Bros, Merrill Lynch, AIG, Macquarie, HBOS and a host of other financial stocks.

This week events will be dominated by the shape of the rescue body announced Friday to bailout the dodgy securities.

Here in Australia we have banned all short selling, not just the naughty naked kind, in a new development revealed last night by the financial regulator, ASIC. It starts from today and continues until further notice.

It is a step up of the ban on naked shorting announced Friday.

But the big issue is the $US700 billion bailout fund which is likely to provide an opportunity for ambitious and idiotic US congress representatives to try and add pet deals of their own to the bill.

Markets around the world simply love the idea, but that affection will be hard to hold as the fund takes ages to have any lasting impact.

The Standard & Poor’s 500 dropped by more than 4.7% twice last week after Lehman Brothers’ collapse; Bank of America Corp’s takeover of Merrill Lynch and the US government’s seizure of American International Group.

But the S&P 500 ended the week by jumping 8.5% on Thursday and Friday on the US government’s plan to purge banks of bad assets, crack down on short sellers and to stand behind money market funds through support from the Federal Reserve.

Shanghai surged 9.5%, in the biggest daily gain for seven years, to 2,075.091.

Hong Kong’s Hang Sang gained 9.6% to 19,327.73, London’s FTSE 100 had its biggest daily gain in its 24-year history, jumping 8.8% and in Australia the ASX 200 was up 198 points or more than 4.2% on Friday.

It was the biggest two-day global stocks rally in 38 years. Friday’s rallies in London and the US were partially fuelled by bans on short-selling in financial stocks announced on Thursday night.

Besides the S&P 500’s gains the Dow added 929 points from Thursday’s low and markets from the UK, China, and Australia and elsewhere surged as investors appreciated the fact that the great panic had been halted for the time being.

But it is short term, even the new fund being set up to help buy the so-called toxic securities by the US Treasury.

The longer term issues will be the newly increased size of the US deficit and debt, the impact of this huge expansion of money supply on inflation, and most of all the slumping US economy and the disaster that is the US housing sector.

The S&P 500 ended up 48.57 points to 1,255.08 on Friday, the Dow surged 368.75, or 3.4%, to 11,388.44 and Nada rose 74.8, or 3.4%, to 2,273.9.

The MSCI World Index of 23 developed nations’ markets jumped 5.7% to 1,286.44 on Friday and rose 8% over Thursday and Friday. Europe’s main regional index (the Sox 600) rose a record 8.3% Friday and the MSCI Asia Pacific Index added 5.5% Friday.

The S&P 500 actually erased its fall to close up 0.3% for the week, but it is still down down 15% this year.

Market reports said a record 3 billion shares were traded on the NYSE on Friday: that was more than double the three-month daily average.

Under pressure investment banks, Goldman Sachs and Morgan Stanley saw their shares leap more than 20% on Friday as shorts scrambled to cover themselves.

Traders said that only consumer staples, the best performing group this year, fell led by Wal-Mart, the world’s largest retailer.

Its shares fell almost 3% for the biggest decline in the Dow.

That reaction has a touch of unreality because it won’t be too long before investors start worrying about the economy and banks again and go back into consumer staples.

US and European government bonds tumbled; reversing gains made earlier in the week as investor sold equities and commodities and moved into bonds as quickly as possible.

The proposal from Paulson and Bernanke (and strongly supported by president Bush over the weekend) is aimed at isolating devalued mortgage-linked assets at the root of the worst credit crisis since the Great Depression.

US Congressional leaders said they aim to pass legislation soon, but some have started wondering about loans to US car companies like General Motors and a $US50 billion stimulatory package to follow the $US120 billion tax rebate which came and went from May to July of this year.

That sort of grandstanding is going to be dangerous, and expensive.

In Australia the major banks led the surge on Friday and today the market is forecast to be up by around 130 points, if Saturday morning’s overnight futures finish is any guide.

The ASX200 index finished up 196.8 points, or 4.27%, to 4804.1, while the All Ordinaries index ended up 188.8 points, or 4.06%, to 4840.7.

The National Australia Bank soared $3.40, or 17.35%, to $23.00; the Commonwealth jumped $2.62, or 6.54%, to $42.70; the ANZ rose $2.26, or 14.63%, to $17.71; and Westpac ended up $1.54, or 7%, at $23.54.

But the focus was on Macquarie Group: after being belted up to the close Thursday, it rocketed $9.85, or 37.81%, to $35.90 after touching an intraday high of $38.55 just before noon.

Suncor Metway leapt 75c to $9.10 as the company completed the underwriting on its dividend reinvestment plan two weeks early.

In resources BHP Billiton ended up 40c at $35.40 and Rio Tinto jumped $3.10 to $101.50.

Iron ore miner Fortescue Metals Group added 50c to $5.70 despite reporting an annual bottom-line net loss of $2.8 billion and saying it would not provide a forecast for the current year because it may prejudice “the interests of the company”.

Oil and gas producer Woodside Petroleum was up $2.66 at $54.06, and Santos 53c to $18.28.

Newmont dropped 55c to $4.92 and gold fell; Newcrest eased 65c to $23.85 and Lehar dropped 3c to $2.45.

The Australian dollar finished higher in New York at 83.40, US cents after the US dollar lost ground as nervy investors sold the currency.

Earlier, the Aussie had finished around 81.15 on Friday, up about 1.3 US from Thursday’s close of 79.88. That’s up 3.5c in two days, or almost 5%.

And naked short selling will be banned on the Australian Stock Exchange from today.

But in a dramatic decision the regulator, the Australian Securities and Investments Commission has banned ALL short selling for a month from today, not just the naked variety.

 ASIC said the widened ban would act as a circuit breaker to restore investor confidence.

Short selling, where traders seek to profit by selling borrowed shares of companies to then buy them back, in the anticipation their prices will drop, has been partly blamed for the sharp falls of stocks such as Macquarie Group in recent days.

Naked short selling, involves selling without first borrowing the stock, or even ensuring the shares can be borrowed.

The Australian Securities Exchange (ASX) said on Friday it would remove all securities from its list of stocks approved for naked short selling from Monday.

The ASX said the “The removal will remain in force until further notice.”

“It will be reviewed when the government’s foreshadowed legislative amendments to the reporting of covered short selling activity take effect.”

But last night the ASX ban was supplanted by the wider ban from ASIC.

ASIC chairman, Tony D’Aloisio, said “To limit the prohibition to financial stocks, as has been done in the UK, could subject our other stocks to unwarranted attack given the unknown amount of global money which may be looking for short sell plays.” 

So, what does the banning of short-selling mean to the market?

It’s a good question. In our view, short-selling is no more to “blame” for markets falling than long buying is to blame for markets rising. In other words, it does have an impact on the downside but only as far as it adds to the number of sellers. It is not the sole reason for a share price falling.

We keep hearing commentators and analysts tell us that the likes of ABC Learning and Babcock & Brown are fundamentally strong companies. We are told that they hold great assets and that the market is failing to recognize it.

a couple of months ago that it was a misleading argument. Sure, these companies may have good assets, but that is only one side of the balance sheet. Don’t forget about the debt on the other side. If we only concerned ourselves with the assets then share prices would never go down.

Cause and Effect
It is easy to confuse cause and effect. Short sellers aren’t the cause of a share price falling. The cause is due to something that the company has or hasn’t done. The effect of the company doing (or not doing something) leads to investors selling those shares. In some cases this will involve investors short selling.

In reality, the ban on short-selling is likely to have almost zero impact. There may be short term price action to the upside as those who currently have short positions buy back the stock to close out. Secondly, those investors that use short selling to hedge a long position may choose to close out their long positions, which could put pressure to the downside.

But for those professional investors wanting to trade ’short’ they need look no further than the Options market. Options traders will be able to implement reasonably simple strategies that will give them almost exactly the same exposure as if they had used the share market to short sell.

In financial terms they call it a “synthetic short.” By simply buying an ‘at the money’ Put Option and writing an ‘at the money’ Call Option the trader can replicate a short trade. It is not exactly the same, but if an investor really wants to short particular stocks it is an easy way to do it.

The bigger question is what will happen to the markets next. We all have an interest in share prices rising, but are we really interested market manipulation?

ASIC and the ASX have rules against investors falsely manipulating the market. Yet its actions to restrict short-selling are doing exactly this in the short term. The banking stocks again look likely to be the main beneficiaries of this policy when they eventually start trading this morning.

What Happens When the Party is Over
The party on the stock market will doubtless continue today after Friday’s celebrations. But as is usually the case with a big party, there are plenty of hangovers.

Governments and regulators have thrown everything at the markets over the past week to try and ‘fix’ things. It may work. But if it doesn’t they haven’t left themselves with many other options.

Not surprisingly the ASX/S&P200 looks as though it is going to get off to another strong start this morning.

We dare say you have all had the opportunity to digest plenty of information over the weekend. Newspapers and websites have been screaming about financial Armageddon. Two weeks ago very few people would have heard of Henry “Hank” Paulson. Today he is almost a household name.

A quick summary of what has happened over the last few days in chronological order.

Markets have slumped. The US government has proposed buying up bad debts from US banks. The US, UK, France, Germany, Switzerland, Canada and now Australia have implemented various bans to prevent or limit short-selling. Markets have soared.

For those of us that still have mortgages it is a happy day. For every $100,000 of mortgage outstanding we will be richer to the tune of 68 cents every day. As yet we are undecided about what to do with our windfall, but something frivolous could be on the cards.

For weeks the Reserve Bank of Australia (RBA) has indicated exactly what it was going to do. It couldn’t have telegraphed it any more if it had tried. Therefore the decision to chop interest rates by 0.25% was of little surprise to anyone, with the exception of those that were crowing for a 0.50% cut. But have no fear, because markets have already convinced themselves that a further 0.75% of rate cuts over the course of the next twelve months is almost a formality.

We don’t know for certain whether it is necessary or not. Nobody does. And even after everything has run its course nobody can say for certain whether its actions were effective or not. It’s a bit of a Y2K syndrome. Did all the billions of dollars spent on upgrading computers prior to 2000 really have any beneficial effect apart from lining the pockets of IT geeks?

What we can question is whether it is sensible for the RBA to be cutting rates while inflation remains above 5%. The RBA is in effect attempting to predict the top of the market, believing that inflation will rise a bit higher before easing back over the next 18 months or so.

Australian Mortgage Market Not as Bad as US/UK
Some commentators and analysts have also tried to use the credit problems in the US and the UK as a reason for cutting rates, arguing that it is necessary in order to prevent a freezing up of credit, a slump in the housing market, and an increase in home repossessions.

Again this seems a little disingenuous. As we mentioned on Monday, Australia hasn’t been immune from the tightening of credit markets as evidenced by our list of woe. However, some things are different.

Australian financial institutions have had to rely much less on the securitized mortgage market to raise funds to offer mortgages. This means that there is less of a ‘sausage factory’ feel to it like what you have especially in the US. There, the Savings & Loans in particular are able to offer mortgages and then quickly parcel them up and sell them onto to Freddie Mac or Fannie Mae. This means that having sold off that mortgage they can bring in the next one, and so on.

In that instance, providing Freddie Mac and Fannie Mae continue to buy the mortgages the S&L is going to keep pushing the mortgages through… until there is no more money left, which is what happened in the US recently.

Wizard Keeps Rate Rise Under Its Hat
The whacky crazy guys at Wizard Home Loans thought they could pull the wool over everyone’s eyes. At the weekend they trumpeted their intention to reduce home loan interest rates regardless of the action taken by the RBA.

However, what they weren’t so keen to announce was that it would be raising interest rates on credit card debt by 2.75%. This, the company announced would help Wizard to keep fees down.

The signal it sends is that clearly Wizard (or owner GE) is seeing some problems in the unsecured credit facilities that it is providing and therefore it needs to ramp up the margins.

It’s time to shift your focus to the most unloved, abused securities.

Here’s why: As the global economy slips into an economic recession over the next several months, those unwanted securities will yield the fattest profits for your portfolio.

The last time the global economy suffered the tribulations of a major economic recession was back in 1990. We can thank the last U.S. real estate “bubble” (a.k.a. Savings & Loans Crisis), and the demise of the European Exchange Rate Mechanism (ERM) for that contraction of output. You may remember the European Exchange Rate Mechanism (ERM) as the euro’s predecessor - the European Currency Unit (ECU).

Asia, however, saw the biggest decline in economic output since WW II starting in 1997 when Thailand triggered the Asian economic crisis. That watershed event led to the massive destruction of credit, currencies, and stock-market values. As a result, regional economies plunged into the abyss until they finally bottomed in late 1998.

The last U.S. recession in 2001 was mild by historical standards. That’s because housing values continued to appreciate during that span while financial assets were decimated. Basically, money had somewhere to flow unlike this year. Until recently, commodities have been the only “game” in town for investors. And now, even commodities are pulling back.

The Worst Worldwide Recession in 20 Years

The economic slowdown now threatening the United States and other industrialized economies will probably lead to the worst recession in almost 20 years.

The world economy will continue to struggle with the heavy burdens of rising food and energy inflation. On top of that, industrialized nations are facing deflation in housing and bank credit. And all the while, consumption will continue to erode because consumers will save more and spend less to address balance-sheet erosion.

For the first time in the post-WWII era consumers are facing a bizarre mix of lethal food and energy price inflation and deflation (or declining prices) in real estate and financial assets (stocks and bonds).

Never in the post-war period have consumers and investors alike faced such a challenging environment. We’ve simply never had to deal with two powerful economic forces converging with lightening speed.

Deflation, not inflation, does far more destruction to consumers and the global economy. That’s because debt burdens become increasingly difficult if not impossible to finance.

That’s the lesson of the 1997-1998 Asian economic crisis, the Russian ruble collapse in 1998 and now, the credit and real estate deflation attacking the United States and Western Europe since August 2007.

Inflate or Die

In a typical deflation environment, credit “bubbles” deflate. This process or monetary phenomenon can take several years to control until finally the forces of inflation eventually win. At that point, global central banks usually try to print their way out of economic distress.

The only way to beat deflation or an environment of rapidly declining prices is to expand bank credit like there’s no tomorrow. That’s what Asian central banks did in 1998 and the United States started in 2001.

The last U.S. deflation, back in the 1930s, was eventually cured by the Second World War. The war led to renewed economic production as the United States converted from a sleepy, peaceful country to a wartime economic juggernaut.

But today, the sub-prime crisis has morphed into a diabolical monster as it spreads from one facet of credit to the next. In the process, debt deflation or credit destruction is now underway.

The entire gamut of credit deflation reads like a bad movie script - and it’s still unfolding.

Bank credit continues to tighten in the United States and Europe, particularly in the United Kingdom, Ireland and Spain. As a result, default rates are now rising for companies and consumers.

Credit card delinquencies are surging and even top-notch investment-grade companies are being denied credit. Corporate bond spreads trade at multi-year highs, banks’ capital ratios have plunged amid a blizzard of unprecedented losses, and mortgage markets are hemorrhaging.

The Debt Deflation Strategy

According to data from Morgan Stanley, only U.S. Treasury bonds posted gains during the last deflation or Great Depression of the 1930s. Gold, however, might have gained in value had FDR not confiscated ownership in 1933.

In my view, gold along with the U.S. dollar would post significant gains versus most assets, including foreign currencies in a debt deflation.

Silver, however, might not appreciate as strongly as gold in a severe recession.

Silver remains mostly an industrial metal and I doubt it would appreciate in the same context as gold during price deflation. That’s because industrial demand for silver would collapse in a hard recession, unlike gold - viewed universally as a surrogate currency and a long-term store of value against fiat currencies.

Other commodities, including oil, are unlikely to rise in value if the current economic situation deteriorates further. There’s no historical case to be made for holding raw materials in a debt deflation. Not even China will save commodities from a major decline.

High quality Treasury bonds and non-financial A and AA-rated corporate bonds are also ideal hedges against credit destruction. As interest rates collapse amid an outright deflation or severe recession, long-term debt prices should rise markedly. Avoid junk bonds and any other category of bonds that aren’t of the highest quality.

The U.S. dollar is also poised to rise vis-à-vis most currencies as the recession unfolds. That’s because foreign economies lag behind the U.S. credit squeeze by about 12 months and will increasingly find debt deflation at their doorstep.

Foreign central banks will begin cutting interest rates in 2009 to offset rapidly deteriorating output. That makes the dollar more attractive on a relative basis because the Fed has already aggressively reduced lending rates to boost growth. That’s certainly not the case in Europe and Asia.

Get Out of Dodge While You Can

I would also consider opening a foreign bank account to hold some gold and U.S. dollars as a safe-haven strategy.

It is not unfathomable that some sort of foreign exchange control may arise over the next few years. If that happens, it will restrict your overseas transfers and stop individuals from opening a foreign account. The British government imposed such controls in the early 1970s during an economic crisis. It can happen again.

I have little faith, apart from the above short list of strategies, that other assets will protect investors. Debt deflation is the absolute worst nightmare for investors, central banks and the general populace.

The key is to protect what you have. At some point, as the crisis eventually subsides, great bargains will beckon in distressed debt, bankruptcy reorganization securities, common stocks and real estate.

For now, I’d brace for some difficult years ahead and start planning for a hard economic landing. In a worst case scenario, it’s better to be safe than sorry.

The market is down 20. That comes on the back of a 27 point rise on Wall St and a 6 point rise in Futures this morning. Pretty quiet day today. Hard to find a feature other than the fact RIO hasn’t done much on the back of what looked like great results (see below). Resources flat and financials down a touch. We are awaiting Woodside’s results.

Pretty quiet night on Wall Street – Dow closed up 27 - Up 50 at best. Down 46 at worst. Financials up a touch on an FDIC report saying 98% of companies were well capitalized. Homebuilders down on poor housing data, oil up and energy and resources up. Lehmans speculated to be planning to set up a company funded by third party investors to take on some of its mortgage assets to dispel the fears around its debt and one analysts said Fannie Mae and Freddie Mac had enough capital to last the year – the duo up 8.3% and 20.67%. Energy stocks up 1.8% - up for the first time in 3-days on higher oil prices and Anadarko Petroleum announcing a confident buy-back of $5bn in shares. In economic news, July new home sales were up 2.4%, economists had expected 525,000, and August consumer confidence was up 9.6%, beating analysts’ expectations. The NASDAQ closed down 0.15%.

Wall St has a long weekend this weekend for the Labor Day holiday.

• The SFE Futures suggested a 6 point gain in the market.
• Both BHP and RIO up in ADR form overnight, 1.93% and 0.66%. BHP goes ex-dividend 46.9c on Monday.
• Metals all down – Nickel down 4.06%, Zinc down 2.37% and Copper 1.29%. Aluminium down 0.88%.
• Oil price up $1.46 to $116.31 as Hurricane Gustav threatened the oil infrastructure in the Gulf of Mexico.
• Gold up $2.50 to $824.20
• Bonds up with the 10 year yield down to 3.78% from 3.79%

Rio Tinto announced their 1H result late yesterday – They were written up on the website yesterday. The price performance in the US was less than exciting…up 0.66% in the US in ADR form and down 0.5% in the UK. Made US$5.474m against forecasts of $5.133m. Up 55%. EBITDA up 73%. Cash flow up 54%. Capex up 91%. Jury still out on the success of the Alcan acquisition (Aluminium price have been falling since the acquisition) but they say “Rio Tinto Alcan integration is making good progress and remains on track to deliver $1.1 billion of after tax synergies from the end of 2009”. Dividend up 31%. They talked about a positive outlook, strength in commodity demand, low inventory levels and constrained supply. They continue to tell us the BHP offer is too low. RIO down 0.25% today.

Results out today…

• WPL – Woodside– Results just out. NPAT up 67% to $1.016bn – at first sight its ahead of analyst forecasts of $955m. Expect stronger production in H2. Will meet production targets. Revenue up 45%. Of course they are reporting for six months in which the oil price went up from $60.85 to $139.96 so the results should be good. Since the end of the Financial year the oil price has fallen 17%. WPL up 1.15%.
• WDC – Westfield Group – IN LINE - Net profit down 55% to $1.29bn mainly due to property revaluations - Analysts’ on average expected between $983.8m-$1.004bn. Operating income up 14.7% in constant currency terms to $928m, brokers predicted operating profit of $940m on average. WDC down 20% so far this year, outperforming the REIT sector by 12%. WDC down 1.7%.
• TCL – Transurban – BELOW EXPECTATIONS - Underlying earnings up 19%. Posts a FY net loss of$142.8m. EBITDA up 19% to $489.6m, up from $419.9m last year – analysts’ expected EBITDA of $543m ranging from $492.2m to $573.2. Revenue up 30% to $1.02bn. TCL down 0.7%.
• TPI – Transpacific Industries – UNDER - Report a FY net profit of $175.3m, up 70% after a distribution to step up preference security holders. Analysts’ on average expected $179.5m. GSJB Were expected $174.8m. Declare a final dividend of 10.1c. TPI down 3.3%.
• MMG - Macquarie Media Group– FY net profit up to $273.8m from $37.8m on the back of acquisitions and asset sales. Declared a final distribution of 22.5c, down from 24.5c last year. MMG up 0.5%.
• CEU – Connect East – Announce a FY net loss of $13.6m. Intends to declare a distribution for the period from 1 April to 30 September of 5.25c. Says the EastLink average daily trips in the first month came in at 135,555. While marginally ahead of the 133,722 trips during the first week, it was still well below the company’s forecasts of around 186,000 daily trips during the first month of operations. CEU down 4.6%.
• AIX - Australia Infrastructure Fund – FY net profit up 23% to $206.5m. Final distribution of 8.5c. Expects a satisfactory performance in 2009. AIX down 3.6%.
• MCW - Macquarie Countrywide Trust– Net profit down 79.7% to $100.4m from $493.3m. FY total income down 76% to $150.7m. Declare a final distribution of 7.2c, down from 7.8c. MCW unchanged.
• Gloucester Coal (GCL) – IN LINE – FY net profit up 30% to $23.4m and expects further profit growth this year. Big increase in contract coking coal prices in the 2H helped lift profits. Declared a final dividend of 16c. GCL down 1.3%.
• AUW - Australian Wealth Management – said its net profit was up 13% to $65.2m and said it was well placed for further acquisitions. AUW down 6.9%.

In other news…

• Babcock and Brown Infrastructure looking for investment partners to buy stakes in three of its core assets. BBI down 10.75%.
• Babcock & Brown Communities (BBC) has requested a Trading Halt as it finalizes its response to the previously announced strategic review. Its board expects various agreements to be conducted with Babcock & Brown (BNB). 
• Record Realty (RRT) has provided an update on record Realty Property Transaction loans. Down 2.5%.
• According to Australian Broadcasting Corp.’s 7.30 TV program last night, we can expect some bad news from ABC Learning (ABS) – which remains suspended for a third day ahead of its FY result. The show detailed questionable accounting practices.
• Lots of broker stuff on Woolworths this morning – Merrill Lynch say BUY with a 3500c target price, Citi HOLD, Credit Suisse cut their recommendation to NEUTRAL from Outperform and Macquarie Equities upped their recommendation to Outperform. WOW up 1.42%.
• The response from Brokers on Foster’s Group post results is also mixed – Macquarie expect it to Underperform, Credit Suisse says it will Outperform and JP Morgan have labeled it as Neutral. Fosters up 3.1%.

Asian stocks, including Australia fell last week, sending the region’s benchmark index to its lowest in more than two years. But Friday’s quick reversal of Thursday’s commodity price spike, led by oil, should steady markets in the region today, and Australia’s bounce on Friday off the back of the higher resource stocks, could be sustained if resource stocks are resilient.. Oil prices fell more than 5% on Friday in the biggest one-day slide since 2004 as dealers completely reversed the previous day’s madcap chasing of oil and commodities. A weakening British pound helped push the US dollar higher. Wall Street kicked higher Friday on the slump in oil and suggestions Lehman Bros might be rescued by a Korean Government-owned bank coming to its aid with a generous deal to buy 50%. It’s only a maybe, but some on Wall Street treated it has a fact and sent Lehman shares higher. What should worry investors more is Warren Buffett ruling out any interest from his Berkshire Hathaway company in helping rescue Fannie Mae and Freddie Mac shareholders. He says his company was a shareholder eight years ago but sold when he realised the two companies were producing quarterly profit results to suit Wall Street and not reality. The Standard and Poor’s 500 added 14.48 points, or 1.1% Friday to 1,292.20, the Dow jumped 197.85, or 1.7%, to 11,628.06 and Nasdaq was up 1.4%, or 34 points to 2414.71. For the week to Friday, the Dow fell 0.3%, the Standard & Poor’s 500 Index lost half a per cent and the Nasdaq lost 1.5%. Traders said the market was the thinnest since last Christmas. Only 888 million shares were traded Friday on the New York Stock Exchange, the lowest volume since December 26. JPMorgan Chase & Co. strategists said investors should buy more financial stocks and US companies that rely on discretionary spending by consumers and sell energy and raw- material producers. But big institutional investors have been doing that since May. That’s why financial stocks haven’t followed Fannie Mae and Freddie Mac lower. But Morgan failed to tell clients the downside of buying these shares, except for a rotation of investment objectives.  US banks and retailers face a year of misery with the banks having no money to lend and consumers no money to buy anything but essentials. In Asia the MSCI Asia Pacific Index lost 0.8%t to 121.97 to take its losses so far in 2008 to 23%. It was the 4th weekly fall in a row as Asian markets seem to be ignoring the up trend in the US. Japan’s Nikkei Index fell 0.7% Friday, China’s CSI 300 Index lost 1.5% but Australia’s S&P/ASX 200 Index added 1.2% on the resource-driven rebound that will be tested today, despite the futures market showing a 70-plus point rise for the opening today. Friday’s rise cut the week’s losses to 1%, the 12th weekly fall in 14 weeks. The ASX200 rose 56.2 points, or 1.2% to 4931.4 while the broader All Ordinaries gained 60.6 points, or 1.22%, to 5010.2. BHP Billiton lifted $1.20, or 3.08%, to $40.15, Rio Tinto gained $2.10, or 1.77%, to $121.00 and OZ Minerals surged 19.5 cents, or 11.57%, to $1.88. Babcock & Brown closed up 26 cents, or 11.71%, at $2.48, compared to $4.51 on Monday. Among the banks, Commonwealth Bank was up 78 cents to $41.38, NAB was steady at $23.55 and Westpac added 34 cents to $22.00. The ANZ was up 8 cents to $15.67 after delivering a report explaining its controversial involvement with collapsed securities lender Opes Prime. Insurance Australia Group reported a $261 million annual loss, but says its performance should improve this year. Its shares rose 6 cents to $3.75. And Caltex Australia reported a fall in first-half earnings due to refinery shutdowns affecting production, and a narrowing of refiner margins.

Caltex shares finished 20 cents higher at $11.95.

Energy stocks were higher Friday and that will reverse today after that sharp fall in oil prices. Woodside finished $1.85 higher, or 3.35%, to $57.00, Santos 72 cents to $18.90 and Oil Search 12 cents to $5.69.

Woolworths dipped 84 cents, or 3.11%, to $26.14 ahead of its results this week while Coles’ owner Wesfarmers slipped 95 cents, or 2.89%, to $31.95 as investors continued to give it the thumbs down for the poor Coles numbers in its report on Thursday.

European shares had the best day for a fortnight Friday rose the most in two weeks as investors speculated takeovers may increase and the plunge in oil prices sent car companies and airlines higher.

Europe’s Dow Jones Stoxx 600 Index added 1.9% to 283.82, the biggest rise since August 5 and cut the week’s loss to 1.5%.

Despite the optimism of Friday it was the worst week for shares in the region for a month as reports signaled faster-than-forecast inflation in the US and Germany and a shuddering halt to growth in Britain where second quarter growth stalled, according to figures out Friday.

But the optimists in Britain looked at the lower oil price, some corporate activity in insurance, saw the possible Lehman Bros deal and said yippee!

The FTSE 100 jumped 135 points or 2.5% to be up 0.9% over the week.

Oil fell sharply. Turning Thursday’s big rebound in commodity prices into a one-day wonder that only confirmed the weakness in sector.

At one stage crude prices dropped more than $US6 a barrel, dropping the most in percentage terms since December 2004, as the US dollar also rebounded from Thursday’s weakness.

The main driver of Friday’s fall was BP restoring shipments on a Caspian Sea pipeline through Turkey, and a belated realisation that a tropical storm was delivering rain, but not high winds to oil producing and distributing regions of the US Gulf of Mexico coast and Florida.

New York oil futures dropped $US6.59 over Friday to close at $US114.59 - the biggest one-day drop since 2004. That took its fall back over the 20% from the peak of $US147 a barrel reached in mid-July. Oil hit a low of $US112.87 on Monday. 

The dollar climbed 0.9% Friday to $US1.4772 per euro in New York from $1.4899 on Thursday, when it fell 1%.

In London October Brent crude oil dropped $US6.24, or 5.2% a barrel to close at $US113.92 a barrel.

Comex December gold fell $US9.50, or 1.1%, to $US829.50 an ounce in New York.

That cut the week’s gains to 4.7%, which came after an 18% fall over the previous five weeks.

But it recovered in after hours trading to finish off $US5.90 an ounce at $US833.80.

Comex December silver futures dropped 28.8 US cents, or 2.1%, to $US13.555 on Friday. That cut the fall this year to 5%.

LME zinc jumped 9% to $US1,825 a tonne last week, while nickel rose 11.5% per cent at $US20,850 a tonne, also helped by short covering.

Implosion of Babcock & Brown
It has been quite an interesting week. Record profits for BHP Billiton. Big profits for Commonwealth Bank of Australia. Talk of interest rate cuts in September. Increase in profits for Qantas.

But the story that has interested us for a lot of this week has been the implosion of Babcock & Brown. It is part of a story which we have been musing on ever since our days with The Daily Reckoning. Back then we expressed some concerns about the sustainability of infrastructure funds and the business model that they operated under.

Of course, Babcock & Brown is or was one big fund, a hedge fund, not a “small investment bank” at all. It has all the characteristics of a hedge fund, which in hindsight made it the first hedge fund to be listed on a stock exchange.

It borrowed money from investors (in this case shareholders), just like a hedge fund. It borrowed a stack of cash from banks, just like a hedge fund. It sought to take over or take control of large assets; it was not afraid of leveraging its position; it was prepared to pay a premium for an asset providing it believed it could still make a profit; it sought to resell assets back to the public; and most important of all, it paid executives massive performance bonuses based on profits… all just like a hedge fund.

What surprises us is that they managed to get away with a flawed business model for so long.

The amusing end to this charade is that based on the investor presentation on Thursday, B&B truly seem to believe that they have reorganized the company so much that it is a completely different beast. Not so. Part of the supposed reorganization trumpeted on Thursday was the change to the board. You don’t even need to look at it closely to see that it was just musical chairs. Six of the eight members of the ‘new’ board served on the previous board. Then if you add in the new CEO Michael Larkin who was previously CFO then you have seven board members with an indelible link to the current woes of the company.

One of the management changes was to create a new role called Chief Investment Officer. The person to take up this position is B&B’s current Head of Global Infrastructure; surely the very man who has ably assisted B&B to get to the position it is in now.

The company looks more and more like a secret men’s club the longer you look at it.

There is so much more that we could make comment on, but there just isn’t the space to do so. Therefore, the final comment we will make is on the salaries for senior executives at B&B, just in case you are not yet convinced that the company was and probably still will be, a hedge fund.

In 2007, Babcock & Brown made a net profit of $639 million. Pretty impressive. However, it would have been a lot higher if total executive remuneration hadn’t stripped $160 million or approximately 20% away from this.

Compare that to engineering company Worley Parsons who this week reported a net annual profit of $343 million and paid its senior executives just $15 million or 4% of net profits in total.

We would be surprised if this wasn’t the end of the story. The next phase will be to see if any investors take legal action against B&B or brokers or planners over the marketing of infrastructure funds as safe and reliable, growth and income investments when in fact they were all highly leveraged hedge funds.