How to Spot a Bubble – With the Government's Help

Plus, discover the man who's using bacon as money...

BACON. That's been the secret all along, writes Dan Denning for the Daily Reckoning Australia.

If only we'd known! We would have told you sooner. More on the power of bacon below...

First, here's a simple answer to a question that has troubled economists and central bankers for ages: how do you spot a bubble? It's easy. Look for the government's latest tax!

Manipulating the price of credit is how central banks cause asset bubbles. But popularly elected governments only become aware of a bubble when prices are high, mainly owing to the imbecility of most politicians. High asset prices attract government tax collectors the way car accidents attract ambulance chasing lawyers.

So it was in 2010, when Kevin Rudd, Wayne Swann, and Julia Gillard unleashed the Resource Super Profits Tax on the Australian economy. The tax was announced on a Sunday night and the market trended lower for about a month. But as stocks like BHP Billiton made new highs over the next twelve months, Wayne Swan must have dreamt of extra billions for his budget.

In August of 2011 BHP reported the largest corporate profit in Australian history of $22.5 billion. Revenues were up 35% year-over-year thanks to the booming steel industry in China. The company said at the time, 'Another strong year of growth in Chinese crude steel production ensured steelmaking material prices were the major contributing factor to the $US17.2 billion price-related increase in underlying earnings.'

We now know that was probably the top...for everything. China's 4 trillion Yuan 2009 stimulus translated into BHP's $22.5 billion profit blowout. And that was the peak of the iron ore bubble. Since then BHP's stock price, Chinese steel production, iron ore prices, and coking all prices have fallen. The Federal Government's covetous glance at the mining industry's profits was the signal that the profits had reached a cyclical peak.

This reminds us of Ronald Regan's famous quote: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it. If iron ore and coal prices keep falling at this pace, and China's 'moderation' becomes a hard landing, it won't be long before the government subsidizes the mining industry the way it subsidizes the car industry.

We're not there yet. But we may be headed that way. Chinese imports fell 2.6% from a year earlier in August, according to data released yesterday. Japanese exports fell by 7.4% as well. The two data points are related.

China imports raw materials (from Australia) to manufacture goods for export. Like Japan, China's economy is powered by exporting goods to the rest of the world. The rest of the world—at least the United States and Europe—are in the middle of a debt crisis they can't come to grips with. The business of globalization is not good.

You wouldn't have guessed any of this based on yesterday's price action in the market. But then, markets seem to be front running the idea of more money printing by the US Federal Reserve and the European Central Bank. In our view, this is setting up for a big fall if the size of the eventual money printing disappoints.

Meanwhile, the fall-out from the bursting of the iron ore bubble continues. BHP and Xstrata announced a combination of 900 job cuts from their coal operations in Queensland. This comes at just the time the Liberal government in Queensland seeks to raise royalties on coal producers. Government incompetence is bi-partisan.

It doesn't cheer us to bring you any of this analysis. But our job isn't to make you feel good. Our job is to tell you what we think is really going on. Since we don't depend on advertisers of purveyors of financial products for our revenues, we have the independence to call it like we see it.

You may be surprised to know that we see a lot of this as positive for investors. Investors like it when they can buy assets on the cheap. Normal market cycles see stock prices move from undervalued to overvalued. The intervention by the Fed and other central banks has made all assets overvalued, which makes it really tough to spot a bargain.

A good cyclical crash in the resource sector actually works to the advantage of the diligent investor. Provided you don't get wiped out on the way down, you're left to pick up the pieces on the cheap at the bottom. That's where we reckon we're headed...but not before a much bigger fall first.

Maybe your safest bet is to begin stockpiling bacon and other pork by-products. In a hungry world, bacon is as good as gold. An American man is setting out on a cross-country trip to see if he can make it from coast to coast with no Federal Reserve notes or credit cards to pay for things. His only currency will be a tonne and a half of sweet, delicious, butcher thick cut bacon.

Josh Sankey calls his trip the Great American Bacon Barter. And as you might have guessed, the whole stunt is a publicity exercise for Kraft Foods to promote its new bacon. If you want to follow the bacon barter tour, be advised that it could make you hungry. 

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