January 2006

A while back, we went toe-to-toe here with Jim Otis on the topic of deflation. Jim holds forth at the Optimist, a Web site that, as the name implies, tries to see the sunny side of things. But we think it's a bit of a stretch to find something cheery to say at all times about the direction of the economy. In our view, the U.S. economy is mortally sick, fatally compromised by an addiction to easy credit and consumption, and burdened with so much debt that repayment will be impossible other than via a massive, deflationary wave of bankruptcies or through hyperinflation of the money supply. We have long maintained that it is by way of the first mechanism that we eventually will wipe the slate clean. The alternative, hyperinflation, appears most unlikely for reasons that I have argued here many times. And even if it were to be tried, the only conceivable outcome would be a deflationary bust, since hyperinflation is by definition unsustainable. In Jim's rosy world, we will have neither hyperinflation or deflation, but stagflation ' a muddle-along outcome that avoids a wrenching cleansing of debt. In the essay below, published several days ago, he concocts a very interesting scenario under which this could occur. Read it and judge for yourself. My response follows his essay. A Surprise Interest Rate Increase? The following rumor about the next change in interest rates has no basis in fact, but is only the result of the Optimist's imagination. Please do not make any trading decisions based on this questionable rumor! OK. Now that I've dutifully warned all to ignore everything I am going to say in this commentary, I can feel free to start a rumor about the next change in interest rates. My total lack of any factual

A short squeeze in the final hour of Wednesday's session telegraphed yesterday morning's bolt from the gate, leaving us with little to do but pick our teeth. We had a 0.15 bid in for some Citigroup Feb 47.50 calls (CBW) on the opening, but it proved too stingy. Because these calls had traded freely for 0.15 the day before, I made the mistake of thinking there'd be plenty of them for sale at that price when the stock began to trade Thursday morning. No such luck. The calls opened for 0.20 and never looked back, trading as high as 0.60 intraday. That kind of movement could make you wonder why so many advisory services like to load up their subscribers with calls and puts that cost $200-$300 or more apiece. I've been trading options on and off the floor for more than thirty years and can't remember more than a few instances when $3 options that I owned tripled in price. Yet, here was an easy 400-percenter in Citi , a call option you could have bought in copious quantities for bupkus the day before. And how much would you have risked!? The final sale on Wednesday was at 46.25, meaning the Feb 47.50 calls, quoted at 0.15-0.20, were $1.25 out-of-the-money. If Citi had gapped down $1 the next day, how much might you have lost? Answer: probably no more than 0.05. That's because the Feb 47.50 calls would have been quoted 0.05-0.10, or perhaps even 0.05-0.15. A rip-off? Sure. But why should the market makers want to offer them any cheaper than that with nearly a month remaining for Citi to do something crazy. The calls might have a theoretical value of, oh, 0.06 cents with the underlying stock trading near $45. But who would want to short-sell them

Given the $7.4 billion price tag, it's hard to blame Steve Jobs for selling out to Disney even if it means that his Pixar Animation Studios, one of the most successful companies in the history of show business, is about to be turned into Disneyfied rubbish. You can always count on The Magical Kingdom's bean counters to smother creativity and success when the talent behind it is up for a raise. Take Miramax, for instance. After Disney bought the independent producer from Bob and Harvey Weinstein in 1993, the brothers continued to run the company with the kind of panache that must have made Michael Eisner's skin crawl. (Click to enlarge) Miramax was a class act, and the company produced and distributed for Disney a string of box-office hits and Oscar-winners that would have done Walt proud: Sling Blade, The English Patient, Good Will Hunting, Shakespeare in Love, Chocolat, Gangs of New York, Chicago, Cold Mountain, Finding Neverland. There were also some wickedly offbeat 'small' films in the mix that gave Disney bragging rights on the festival circuit: Birthday Girl, Chasing Amy, Garden State, A Walk on the Moon, Rabbit- Proof Fence, House of Sand and Fog. In the end, though, the Weinsteins were just too brash for Eisner, the epitome of the corporate stiff. The final straw for the brothers was Disney's refusal to distribute Fahrenheit 9/11, Michael Moore's paradigm-shifting piece of agitprop. It went on to become the highest-grossing documentary of all time, vindicating the Weinstein's commercial instincts if not their ability to champion truth. And now Steve Jobs is Disney's largest individual shareholder. Like he needed another feather in his cap. Perhaps if he can parlay the $3 billion he'll bank from the Pixar deal a few more times, he'll have enough cash to become a major

Stocks rallied for all the wrong reasons yesterday, including an announcement from Ford that it will shut 14 plants and cut 34,000 North American jobs over the next six years. GM appeared to have benefited as well from investors' loopy notions about the tonic effects of creative destruction. 'Getting small' used to be the running gag of comedian Steve Martin, but now it evidently has become the driving force behind American industry, or at least what's left of it. Let's hope Dearborn's and Detroit's newfound zeal for shrinkage doesn't take root in the malls, because if it does, things could get mighty bleak around the holiday season. Picture a Dollar Store or a Subway where Bergdorf's used to be and you get the idea. You can't blame the automakers for trying, though. Rather than, so to speak, putting a new Bergdorf's in downtown Flint, they are finally getting serious about building cars that Americans might conceivably buy without huge discounts and incentives. Selling the car instead of the deal is a tactic Detroit will have to relearn following years of profligate, low-interest giveaways. Can they deliver the goods? Perhaps. They might even get some help from their European competitors if Mercedes and BMW continue to push the envelope on horsepower. With gas prices lurching once again toward $3.00, it's hard to believe all of the hubris emanating from Daimler Benz and BMW over their latest 500 hp stallions. Turns out, American automakers are not the only ones who have been bent on suicide. Meanwhile, it doesn't take much imagination to morph China's new $10,000 subcompact into a $30,000 cruiser will all the amenities of a Bentley. *** The Deflation Mailbag We dip into the mailbag today for more insights and provocations concerning deflation. First up is Eric Andrews, who believes

Friday's punitive stock-market decline wiped out the New Year's rally and then some, challenging the arrant complacency that has ruled Wall Street of late with a steady drumbeat of unsettling news. Much of it emanated from Iran, which threatened to choke off the world's supply of crude oil by reducing OPEC's output. Energy prices soared, in line with our prediction here a while back that spot crude would challenge last August's highs near $72. The February contract need only have surpassed $68.44 to all but guarantee this, but in the event, it reached $68.80, closing at $68.45. Teheran also announced that it has begun pulling money out of European banks ahead of possible U.N. sanctions over its nuclear program. (Another unanticipated setback for the multitudes who have been betting against the dollar?) These two body blows sent U.S. investors reeling. Although earlier in the week bulls had ratcheted up obliviousness to the threshold of hubris, shaking off punk earnings news for Q4 and incipient panic in Tokyo markets, Friday's geopolitical tidings overwhelmed buyers with sheer tonnage. We were among those who bought into the session's steepening decline, but our position allowed us to do so profitably and with no anxiety. We'd held a bushel basket of Feb 40 QQQ puts at the outset, and they nearly tripled in price over the course of the day. If we had sold them at their highs the profit would have been $1,600. Instead, we shorted Feb 39 puts for the same price we'd paid for the Feb 40s, effectively legging into a $1 vertical put spread for no cost. We stand to make as much as $6,400 if stocks fall moderately between now and February 17, with almost zero chance of loss. Not bad odds ' and a great way to enhance our

We resume our discussion of deflation today with some interesting letters from readers. If you'd like to respond, please cite the specific passage and the author. First up is Marv Anderson, who says that the question of whether inflation or deflation will do us in is not black-or-white. Marv writes as follows: Although I am inclined to favor inflation, your arguments supporting deflation are very compelling. But why is this being framed as an either/or, black and white issue? Reality is seldom that simple, and this situation is far more complicated than most. It is clear to any but the most ignorant observer that there are very powerful inflationary forces at work, and also clear that there are equally powerful deflationary forces. There is no need to identify them, as this has done hundreds of times in dozens of forums. I liken the world economy to a car in which the driver is simultaneously pressing the accelerator (inflation) and the brake (deflation) as hard as he can. The engine is under enormous strain, and the brakes are being stressed to the max. Something has to give, and the question is: Will it be the engine or the brakes, or will they both collapse simultaneously? In any of these three scenarios, the car suffers massive damage, and the driver is in deep s__t. It seems silly to try and anticipate whether inflation or deflation will win, because in any case we all lose. How can anyone question that we are in a period of inflation? Even the staunchest deflationist recognize that currencies are being debased at a record pace, which is clearly monetary inflation. How can anyone question that there will be an eventual deflation? Even the hyper-inflation fans realize that a currency collapse is inevitable, which is clearly monetary deflation.

Recent give-and-take here on the subject of deflation, including a would-be debate with uber-inflationist Gary North, generated quite a bit of reader mail. To stimulate, provoke and enlighten you, I will be presenting some of the more interesting letters in the coming days and weeks. Readers who wish to add their thoughts should do so via e-mail, citing the author to whom they are responding by name. I will interject my own arguments only when addressing a point that I have not dealt with earlier, either explictly or implictly. Phil Dorsey sees a Jack Benny choice: You may recall that I favor the inflationary scenario but I do not scoff at deflationists. The massive debt in my view leaves us headed ultimately for an "inflate or die" scenario or maybe an "inflate and then die" scenario. Sort of like the old Jack Benny radio skit, "Your money or your life." Responds Jack: "I'm thinking, I'm thinking." I think it is the Fed's call and it will choose inflation over total collapse into a deflationary depression but I think we do well to be prepared for either fire or ice. Here's my critique though. I think [your co-deflationist] Jas Jain is confusing depression with deflation. He cites examples of stagflation to refute the inflationary view, but we must remember that stagflation is inflation and precisely the kind we are most likely to see in the near future if it is fire and not ice that the future holds. My biggest problem, however, is not the deflation argument, but the strong-dollar argument. Your position has been that massive debt creates the equivalent of a huge short position on the dollar. I would agree that if dollars were borrowed to buy foreign currencies that would be very much akin to a huge short

Yahoo and Intel were getting shaken down in after-hours trading on Tuesday, presumably by the kind of arse bandits who would be out stealing little old ladies' handbags if trading stocks were not so lucrative. Intel's earnings came in a whopping three cents below expectations and Yahoo's numbers were actually pretty good, so we should hardly have been surprised to see widows, orphans and pensioners stampeding last evening to ditch their shares in two of America's best companies. Will these two stocks, along with the broad averages, recoup their losses shortly after this morning's opening? Does it rain in Indianapolis? What better time to broach the theory that the Dow Industrials are bound for new all-time highs? I mentioned this possibility on a paid-subscriber page the other day, but it's time to go public with it. My hunch about this is purely intuitive, resting as it does on hearsay. First, nearly every competent technician I know sees the market topping here. Second, global liquidity seems far too high right now to allow speculation, even the wantonly reckless kind, to dry up. Here's a corroborating note from our friend Erich Simon that fleshes out the case in a stream-of-consciousness rant worthy of Hunter Thompson. Judge for yourself: Going 'Stepford' 'There's a renaissance of liquidity so apparent it's frightening,' he writes. 'Look at the Hang Seng, Nikkei, Dax, Dow, commodities, platinum, low mortgage rates despite all the 'tightening' -- everywhere I turn, like we've all gone Stepford. Oil, the rand, Mexico -- it's all around now. What happened to the debt implosion? The grinding rub of reality? Never mind the BIG adjustment (current account or otherwise) -- not even an honorable mention. The SEC and [debt bear] Doug Noland have quieted down, IPOs and acquisitions are back in the news, Google is

Now those crazy Iranians supposedly are feeding uranium hexafluoride into a centrifuge enrichment cascade, a key step toward producing a nuclear bomb. The good news is that, unlike the Iraqis, they are making it extremely difficult for the civilized world to ignore their nakedly hostile intentions. The prospect of having to face down a nuclear threat from these lunatics puts one in mind of The Firebugs, a satirical 1950s play by Max Frisch in which a man realizes that the two boarders in his attic are the same guys who have already burned down much of the town. Sepp and Willi are not very subtle as they cheerily go about their business, moving oil drums, fuses and such into the attic. The play of course ends with one of them asking the landlord, Biedermann, for a match. 'Surely,' Russia will reply to Iran when the time comes. Actually, Russian has been so very eager to conduct nuclear business with Iran that we shouldn't be surprised to learn at some point that the world's reigning troublemaker already possesses a useful quantity of weapons-grade plutonium. We can only guess about China's involvement, but it is not comforting to see the Chinese pulling out all the stops to defend their diplomatically deranged, petro-rich new friend. China has argued unconvincingly against U.N. sanctions and sees Iran's removal of security seals from several nuclear facilities as having been within the law. Kim Il-Jong would no doubt agree. (Click on image if something should possess you to see it enlarged) Channeling Hitler Although in all of his recent public pronouncements Iran's president appears to be channeling Hitler, it is fortunate for the world that Ahmadinejad does not have at his disposal even a tiny fraction of the Fuhrer's pre-war firepower. But that doesn't mean Iran is