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Castles In The Air

Dan Denning
The Daily Reckoning
Sep 24, 2005

The Daily Reckoning PRESENTS: Two separate news events late in August tell you all you need to know about the course of the low-intensity economic battle between the United States and China: China is winning. Dan Denning explains...

First, the Chinese have not given up their determined pursuit of scarce energy assets. Chinese National Petroleum Corp. - China's biggest oil producer - succeeded in its $4.2 billion bid to buy Petro Kazakhstan. Petro Kazakhstan is a Canadian company, but most of its 150,000 barrels of production per day come from Kazakhstan, which is considerably closer to China than Canada.

This is simply Round 2 of China securing energy reserves closer to its borders. The CNOOC bid for Unocal was first, and failed. But the Chinese strategy hasn't changed. The second, successful, bid is more evidence that the bull market in resources is being driven as much by national strategy as it is by economic scarcity.

And in winning the bid, the Chinese beat out their Indian rivals on the subcontinent. It's bad news for India, because China has an additional $700 billion in currency reserves with which to conduct its global campaign for resource security.

While the Chinese patiently execute their strategy for economic competition with the United States, I'd be remiss if I didn't note the joint military exercises conducted by China and Russia in August, dubbed "Peace Mission 2005." Over 11,000 Russian and Chinese forces coordinated a mock invasion of a restive country. The exercises took place on eastern China's Shandong Peninsula, which is well north of Taiwan.

But make no mistake about the several messages being sent by both China and Russia. First and foremost is always Taiwan. A recent report published in the China Daily newspaper quoted a government report concerning the social instability sparked by a growing gap between rich, urban coastal dwellers and poor, rural farmers, who have not benefited from China's sudden prosperity. "China's growing income gap is likely to trigger instability after 2010 if the government finds no effective solutions to end the disparity," the article concluded.

This is the kind of instability that puts pressure on a government. Faced with domestic pressure, most governments create a straw-man foreign enemy - in this case, Taiwan. One way of viewing the exercises with Russia is as a reminder that the communists in Beijing are willing to turn any domestic instability into an excuse to attack Taiwan.

However, I'm sure the Chinese would prefer not to attack Taiwan militarily, at least not yet. And the Chinese would prefer to put diplomatic and economic pressure on the United States, not spark a military conflict. Enter the Shanghai Cooperation Organization, a group that includes Iran, India, Russia, Pakistan, Kazakhstan, Kyrgyzstan, Tajikistan and Uzbekistan.

These countries were invited to watch the exercises. And in the future, this is just one of the ostensibly diplomatic groups China will employ to exert subtle pressure on the United States. China recognizes it is in a long-term, nonmilitary conflict with the United States for scarce economic resources. China has gone about securing resources through careful alliances and agreements. Of course, China also does a great deal of business with U.S. consumers. But in the long term, China sees the United States, and perhaps rightly so, as its chief global economic rival. All of the actions of the Chinese government indicate this is the case, and that the government will do all it can to win this low-intensity economic war.

While China takes the reality of peak oil production seriously, the second important news item from August shows that Americans are still behaving as if it were possible to get rich buying houses from one another. However, the news on the housing front was mixed.

On the downside, sales of existing homes fell off the record pace in June by 2.6%. That said, 2005 sales of existing homes are still on track to eclipse 7 million. Yet the median price of an existing home is now over $218,000, and it went up in July. Could it be that rising prices are starting to price out certain new buyers from the existing home market? It could be.

Even the upside isn't so up. July new home sales jumped 6.5%, to a 1.41 million pace for the year. That was the good news. The bad news is that the median price for new homes fell 4% for the month. A study by National City Corp. showed housing prices in at least 53 American cities were "extremely overvalued." But let me just give you some insight from here on the ground in Superior, Colo.

I'm staying with my older brother and his wife before I leave for Australia in November. They live at the end of a cul-de-sac in a relatively new neighborhood that's grown up near the enormous FlatIron Crossing shopping center outside Denver. It's nearly a perfect example of the consumption economy at work. People buy expensive houses with low interest rates, cash out some equity, and head to the mall.

The only problem is house prices aren't inevitably going up. A flier from a local real estate agent showed the list and final sale prices for a dozen new homes in the areas. Only two of the 12 homes sold for the original list price. The "Cabernet" and "Chardonnay" models seemed to fare the worst. One "Chardonnay" model, a four-bedroom, four-bathroom, 3,100-square-foot monster, originally listed at $525,000. Its final sale price was $397,500.

If you're doing the math at home, that's a hefty 24% discount to the list price. Still, nearly $400,000 for a home isn't exactly cheap. Yet this is further evidence that the frothy mentality that has sent home prices to the boiling point may finally be cooling off.

Will it just cool off, or will it pop, with all the gory consequences to the stock market and the economy I've predicted? Well, the economy is a lot more dependant on the housing sector - for employment and retail sales - than many people realize. That doesn't even include what might happen to regional banks that own a hefty slice of mortgage debt should home prices fall radically. Yet as I showed, all that has to happen is for home prices to grow less fast for retail sales to grind to a halt.

This is what happens when you gear an entire economy to wealth accumulation through rising stock and house prices. Of course, those are assets everyone should own in order to get or preserve wealth. But only when you can buy them at a good price.

In a low-interest rate-driven economy, rampant speculation, not patient wealth building, becomes the name of the game. As easy as the money came with low rates, I fear it will go away just as easily with high rates. All of which means that owning the right stocks - companies with durable competitive advantages and pricing power and good management - is more important than ever.

Regards,

Dan Denning,
for The Daily Reckoning

Editor's Note: Dan Denning, editor of Strategic Investments, is one of America's most respected "big picture" analysts working today.

In his new book The Bull Hunter, Dan lays out all the details of how to profit in ways most investors never imagined just five years ago. What's more, he'll show you why it's never been more dangerous to put all your investment eggs in the basket of the U.S. economy. It's a timely warning, along with an exceptional opportunity.

You can buy The Bull Hunter at Amazon.