by Addison Wiggin & Ian Mathias

Government financial bailout now most expensive endeavor in U.S. history… tops even WWII

So why is no one worried about inflation? Chris Mayer on the “reflation” of 2009

Market volatile as ever… Surprising places where the “smart money” is seeking profits

Bill Bonner on a very rare occurrence in stocks and bonds

Plus, “If you’re so smart, what’s your solution?” a reader asks… The 5 responds, below





Wow. The U.S. government has now thrown more money at this “credit crisis” than it did fighting the entire Second World War.

By CNBC’s estimation, the cost for World War II — adjusted for inflation — was $3.6 trillion. At $4.2 trillion, the credit crisis of 2008 clocks in as the most expensive endeavor in American history.

That’s a lot of moola getting pumped into the system. In ordinary times, the meters would be screaming, “Inflation!”



But we assure you, there are few warm bodies in Washington who care about inflation. The “consensus” agrees with Ben Bernanke and Hank Paulson that government should spend whatever it takes to reinflate the economy.

On the surface, the latest producer price index (PPI), a measure of prices at the producer level, indicates the “consensus” might be right not to worry about inflation. The PPI fell by a record 2.8% last month. According to the Labor Dept. this morning, gasoline prices for wholesalers fell by 12.8% — their biggest drop in 22 years. Food prices fell for the first time in eight months, down 0.2%.

Thus, producer inflation rose 5.2% over the last 12 months — steep, but not as bad as the Street anticipated. Sigh.

However, if you strip out energy and food costs, which economists are wont to do, given their volatility, “core” PPI rose 0.4% — more than anticipated. The “core” inflation rate has now risen 4.4% in the last year — its fastest rate since the Berlin Wall fell.

The Fed isn’t out of the woods, by any means.



“I think we’re set up for some huge reflation in 2009,” asserts our managing editor Chris Mayer. With the latest Grant’s Interest Rate Observer in hand, Chris passed on a few inflationary notes we’ve become all too familiar with:

The Fed’s balance sheet has grown by 133% in the past 12 months. Traditionally, growth over 10% was seen as too aggressive

The Fed’s balance sheet crossed $1 trillion for the first time in September. It then broke through $2 trillion Nov. 5. And according to Federal Reserve Bank of Dallas estimates, it could top $3 trillion by 2009

Federal Reserve bank credit is up 1,560% from this time last year.

“Our Federal Reserve seems hellbent on making Argentina look like Switzerland in terms of monetary restraint. Why is this ballooning balance sheet inflationary? The Federal Reserve increases its assets by buying stuff — financial assets of banks and others. The Federal Reserve pays for these assets by creating money that did not exist before. That’s it. Simple as pie.

“Of course, our government is not acting alone. Central banks across the globe are doing the same thing, if with somewhat lesser vigor, at the moment.

“In any event, it means paper money will buy less. We may see nominal prices — for oil and gold and metals — continue to fall in the short term, but long term, look for huge reflation in 2009.”



In the market… another day, another roller-coaster ride for U.S. equities.

Traders started the week in a bad mood, due mostly to business as usual on Wall Street, but especially after Japan officially declared recession. Stocks drifted up late morning, but quickly reversed on news of massive Citigroup job cuts, more signs of distress from automakers and lousy industrial output data.

All of the S&P’s 10 sector groups fell, but financials, consumer discretionary and materials led the way.



In such turbulent markets, what are the “smartest guys in the room” doing?

John Paulson, arguably the smartest investor of 2007, is buying securities backed by residential mortgages. Paulson, who personally earned $3 billion last year after betting against subprime, started buying up these toxic assets last week after the Treasury announced it was no longer interested in using TARP money to buy asset-backed securities. Paulson manages over $36 billion.



In a similar fold, Marty Whitman, one of the modern heroes of value investing, is ramping up his contrarian purchasing. The manager of the famous Third Avenue Value Fund scooped up truckloads of MBIA, Ambac and GMAC shares and notes.

“Distress securities seem to be trading at ultra attractive prices,” he told his shareholders this week. “Discounts have widened appreciably for the common stocks of very well-capitalized companies where the common stocks trade at meaningful discounts from readily ascertainable net asset values (‘NAVs’); and where the prospects appear good that over the next five years, such NAVs will increase by not less than 10% per annum compounded.

“I have the unique perspective of being a distressed investor for many decades, and safe and cheap [investing] on a long-term basis seems to be about as attractive as it was in the 1970s.”



Another smart fellow, Warren Buffett, is buying Big Oil. Berkshire Hathaway told the SEC this week it had quietly acquired 66 million shares of ConocoPhillips, making BRK its biggest shareholder. Buffett also commanded Berkshire to pick up a big stake in Eaton, an aero and auto parts manufacturer, and more shares of NRG Energy, a power producer.

On the other side of the ledger, Buffett reduced holdings in Bank of America by nearly half, and sold just a little bit of his beloved Wells Fargo.

All told, we see Buffett is taking the “buy stocks” advice he gave in The New York Times last month… BRK purchased almost $4 billion in equities during the third quarter, while selling “only” $300 million.



Also, it might not be a bad time to pick up shares of Warren Buffett himself. Berkshire Hathaway A shares have fallen below $100,000 for the first time in two years. If you’ve got $95,000 you’re just dying to invest, we could certainly think of worse places to put your greenbacks.

Despite falling 32% this year, BRK is still outperforming the S&P 500 by nearly 10%.



“There’s still more downside potential for most stocks,” cautions our new options adviser, Wayne Burritt. “As you can see from this daily chart of the S&P 500 — a good stand-in for the broader U.S. stock market — U.S. stocks continue to slide. In fact, a break below 849 — the red dotted line on the chart — is now very likely. And that means key near-term support is pretty much out the window.

“Below that, my technical signals tell me the S&P 500 won’t likely find support until 769, or 7,197 on the Dow. Those are the October 2002 lows that sparked the latest bull run that ended last October.

“In other words, the market is on course to give back everything it gained in the latest, five-year long bull run. And it will likely do so in a fraction of the time.”



“Stocks are down so much,” notes Bill Bonner, “that dividend yields are beginning to look respectable again — averaging about 3.8%. For the first time in 50 years, you can get more yield from a stock than from a 10-year U.S. Treasury bond. You remember, stocks were supposed to pay lower dividends because stockholders are supposed to earn capital gains, as well as dividends. The combination of capital gains and dividends gives investors a total return greater than bonds; this is the ‘risk premium’ that you get to compensate you for periods when stocks go down. What happened to the risk premium? Here it is!

“When is the risk premium at its lowest? At the very moment when investors believe it is highest. That is, at the end of the ’90s, investors came to believe that they couldn’t go wrong with stocks. They were so sure that stocks were the way to go that they willingly bought stocks that paid little or nothing in dividends. They thought the price of the stock would go up; so they didn’t need dividends.

“But stocks have gone nowhere since the mid-’90s. Now investors want dividends.”



In markets today, traders are keeping an eye on Capitol Hill. The House Oversight Committee is concluding its week of economic harassment by grilling the bigwigs: Hank Paulson, Ben Bernanke and FDIC chief Sheila Blair are all testifying today. Any hints into the details of the TARP or the confidence and capabilities of this panel could shake up the stock market. We’ll include a “best of” in tomorrow’s 5.



And across the hall, the Senate Democrats proposed legislation yesterday that would lend $25 billion to the Big Three automakers. If passed, the bill would simply take a chunk out of the TARP’s $700 war chest and send it off to Detroit.

Opposition among the Republicans and in the White House is significant, and this one looks like it will end up a stalemate. Still, Majority Leader Harry Reid is pushing for debates and test votes this week, so we’ll keep an eye on it.



In the oil patch, light sweet crude fell to a 22-month low of $54 a barrel today. Like last week, traders are selling oil in anticipation of Wednesday’s Energy Dept. inventory report. Like the previous seven weeks, the government is expected to report more excess supply and weaker demand for oil and gas.

The only real buying pressure we’ve seen has come courtesy of… ummm… pirates?

Yarrr! We come for ye crude!

Well, not exactly. The modern pirate is an angry Somali armed with RPG’s and motorboats. Somali rebels pulled off an impressive heist Monday, jacking a Saudi supertanker hauling about $100 million in oil. We’re not sure what they plan to do with it, as the ship is kind of… huge:

The hijacking added about $1 to oil’s price in New York yesterday, but traders have since shrugged it off and sold crude back down to $54. If you plan on sailing off the coast of Africa with valuable cargo, you’ve been warned.



But as oil prices fall, so does your price at the pump. The national average is quickly closing in on just $2 a gallon. Considering the rate of decline lately, and today’s national average of $2.06 a gallon, the average American will be paying less than $2 a gallon by this time next week.

Gasoline is at its lowest retail cost since March of 2005, over $1 cheaper than this time last year.



Gold continues to consolidate into a tighter and tighter range. It’s been stuck between $730-750 all week, and currently sells for $738 an ounce.



“It is very easy to be critical,” writes another, “of Obama’s wanting to spend money to invest in energy development and infrastructure to try to kick-start the economy. Investors have been putting money into pushing paper around. They are not interested in taking the risk, but will be glad to take over the investment when they can privatize profits.

“Have you looked at your portfolios lately? How well are your suggestions for investments doing? If you stopped all government spending today, there would be a complete economic tsunami tomorrow. What is your solution to turn this ship around?”

The 5: The problem with running deficits as a matter of course, as the U.S. has done for the better part of the last 40 years, is when there’s a real crisis, the government is short on resources. Where is the $4.2 trillion we led off today’s 5 with going to come from, for example?

The government, under Barack Obama’s leadership, should tighten its belt; balance the budget; and set up tax incentives to encourage saving and investment in productive assets locally, be it alternative energies, infrastructure or otherwise. Hmmn… seems like we just said that yesterday. Oh yeah, we did.

Instead, what the “consensus” wants it to do with all this borrowing and spending is reinflate the fictitious paper and consumer economy. Trouble is if they’re successful, they’ll have to keep it alive on government support. Then you can kiss the dollar goodbye.

Regards,

Addison Wiggin

The 5 Min. Forecast

P.S. Seems like a good time to have a documentary on the subject out in theatres for “regular” people to get a bead on what’s happening to their country. Apparently, the Motion Picture Academy agrees… I.O.U.S.A. was shortlisted for the Oscar yesterday. That means, among all 94 documentaries that qualify for an Oscar nod in 2008, the Academy has whittled down the 15 it’s willing to consider for the final nominations on Jan. 22. Five films will be chosen on that date.

P.P.S. If you haven’t heard, Pat Cox is making a very big announcement tomorrow. He’ll reveal what he believes will be the next breakthrough transformational investment class. Just as railroads, automobiles and computers were to previous generations, Pat says he knows what will lead us into the next age of investing. If you want to be the first to read his special report, sign up here.