The Dow rose 89 points yesterday. Oil rose to $118…and has almost reached $119 this morning. The reason given for oil’s rise is a storm in the Caribbean, named Gustav, which threatens to shut down oil rigs in the Gulf of Mexico.

Gold rose $3.50 – to $831. We may have just had – and may still have – a great opportunity to buy into gold. The yellow metal seems to have bottomed out. Time will tell, of course…

“You never know what will happen or when, but things always happen the same way…”

We were trying to explain the mysteries of market cycles to a neighbor at last night’s dinner. We might just as well have been trying to describe the Holy Ghost or tell him precisely where to find a photon. Our interlocutor was a practical man – a developer who had begun a huge project, building hundreds of new apartments on France’s Mediterranean coast. He wanted practical answers.

“Is there enough demand for those new apartments?” we asked mischievously.

“Well, there used to be…until recently…”

Throughout much of the world the story is the same. Lenders are more reluctant to lend than they were a year ago. Buyers – who can’t get ready credit – are less able to buy. Demand, and prices go down.

From the LA TIMES comes a report that prices in the Golden State have fallen 40% since the bear market in housing began. A year ago, the typical house cost $587,000, says the Times report. Now, you can buy it for $350,000.

A blogger on the Times’ website said that he had found a house marked down 77% – and still no buyer. We looked at the photo of the house. No wonder it had found no buyer. It is a shack, not a real house. Unfortunately, many of the houses on sale in California are shacks. At least, now they’re selling for less money.

“We’re going to have to cut prices,” said our developer friend, “or just put the project on ice until this situation turns around.”

Then came the obvious question: “When do you think things will return to normal?”

Our answer slipped out as easily as a silk handkerchief: “Things ARE normal now,” we replied.

As we explained yesterday, the eagerness of lenders to lend and the value of their collateral tend to rise or fall together. When mortgage lenders compete to give out money so people can buy houses, you have to expect prices for housing to go up. Eventually, houses become so expensive that even though people can still afford to buy them, they can’t afford to pay for them. This is when the lenders begin to have second thoughts. And once the lenders get scared, prices fall. All perfectly normal.

So far, everything is working just as it should. Boom follows bust, which follows boom. Over and over again, the same mistakes are made – but by new people.

But people don’t like to admit they’ve made a mistake. So, when markets begin to turn against them, they imagine that the turn is just a fluke. They expect things to return to ‘normal’ quickly, not realizing that it is normal for them to make mistakes and lose their money.

When housing first began to go down, at first people didn’t believe it. They’d learned that “property always goes up,” or that “you can’t go wrong with real estate.” Naturally, they took the first signs of a downturn as a buying opportunity. Later, they realized that it was a selling opportunity – the last chance to get out before the roof collapsed.

Likewise, when banks, hedge funds and mortgage lenders began to send out alarums, the problems were thought to be temporary and modest. “Containable,” is how Hank Paulson described the first little cracks in the sub-prime debt market. But the cracks widened. And now, some of the biggest financial edifices in the country – Bear Stearns, Lehman Bros., Fannie Mae and Freddie Mac – have either already fallen down or are leaning dangerously.

One in four junk bonds is in distress, says CFO.com. And the credit crisis is far from over. It has continued for more than a year, but with the value of the collateral still dropping, there are probably hundreds of billions in losses that have not yet been discovered, acknowledged and written off.

But maybe the collateral will stop falling in price…? And maybe, then, lenders will be more willing to extend credit…? And maybe the good times will roll again…?

“US home sales show signs of recovery as price declines ease,” is a headline in yesterday’s International Herald Tribune. The gist of the good news is that house prices fell less in June than they did in May (though the 12 months through June showed the biggest drop in housing in US history) and in July, sales of new and used houses actually went up!

At least 3 or 4 times over the past year, stock markets have rallied on news that “it’s over.” Eventually, of course, it will be over…but probably not before people have stopped looking for the end.

*** When will housing stop falling in price? Remember, housing is a consumer item, not an investment. It needs to be affordable. That is, the average fellow has to be able to buy the average house – and pay for it. Otherwise, prices must come down. How much must housing come down now so that the average person can buy a house? We saw estimates of about 30%-40%. And generally, there’s a little over-shooting. Nationwide, prices are down about 18% from their peak. We’d expect about as much more.

*** But while things are happening in a perfectly normal way in the housing market, in the broader world economy we are in the realm of the extraordinary. Never before have so many people in so many places had so much money. The Chinese are earning billions. The Arabs too. And Russians…

“This story coming out of Ossetia is very revealing,” said a fellow diner last night. “The region is much more complex than I realized. These people have been at each others’ throats for centuries. You know, they have about 50 different languages – and none of them related to any of the others. It is only when there is a strong imperial power in place that they settle down and behave themselves. The Tsar pacified the region in the 19th century. Then, the different cultures lived side by side. There were Catholic churches next to Orthodox churches next to mosques. And people mostly got along. And then, Stalin took over. He tried to erase a lot of the ethnic divisions…making them all communists…and forcing them all to learn Russian. But the Russians – either from the time of the Tsars or the time of the Soviets always had trouble along the southern periphery of the empire. They could never very easily bring the Muslims under control. That’s what the Crimean war was all about…and then, in Afghanistan, the Muslims kicked them out.

“But what I think is most interesting about this story is the way Russia is asserting itself. I don’t know what was going through the Georgian president’s head. You don’t attack Russia with just 17 tanks. He must have thought he had support from the U.S. and Europe. But what could the U.S. or Europe do? We know that the Russians can cut off natural gas to Europe anytime they want. They have the energy; we don’t. If they cut off the gas, it will be a long, cold winter for us. And the United States? Putin knows that the U.S. is bogged down in Iraq. And he knows too that the U.S. doesn’t have any money. In geopolitics, the country with the energy and the money wins. And right now, that’s Russia.”

Yes, dear reader, Russia looks like a winner. And China. And India. And all the countries that seem to be on the way up. Who knows which will succeed…or when? But it looks to us as though these countries are catching up – first in economic terms…later in military terms – to the United States.

What does this mean for investors? It probably means that, over the long run, shares in growing, developing countries are a better bet than those in the United States. And it probably means that the dollar is a bad way to store wealth – since it is tied to an economy in (relative) decline.

It probably also means that limited resources – gold, copper, land, water – will become (relatively) more expensive, because there are more and more people who want them and have the purchasing power to buy them.

And this situation with Russia most definitely put a spotlight on how dependence on foreign oil can be a country over a barrel…and the race is still on in the United States to find a viable alternative to the black goo. Our intrepid correspondent, Energy & Scarcity’s Byron King tells us of an untapped energy source that lies underground just north of San Francisco.

“It is a ’slow volcano’,” explains Byron, “brewing under the Earth’s surface, unable to erupt, but spews heat. It actually pumps out 750 megawatts of electricity…enough to power 750,000 homes, or a city the size of San Francisco.”

A recent piece of California legislation states that by December 2010, at least 7.6 million Californians are slated to get all of their electricity from renewable sources like “slow volcano” power.

“And I’ve found a small company – a share costs less than a newspaper – that is the only ‘pure play’ on California’s government-forced explosion in renewable energy.”

You can take advantage of Byron’s ’slow volcano’ research, and all of the rest of his Energy & Scarcity Investor recommendations for 4 months. If you aren’t satisfied at the end of this time period, you will receive a full refund – no questions asked. Click here to learn more…but hurry – this offer is only good until midnight tonight!

Regards,

Bill Bonner
The Daily Reckoning