Finance Digest for Week of February 16, 2004

“TURTLE TRADER”: AN INTERESTING SITE FOR SERIOUS TRADERS

The sellers of the Turtle Tading System warn: “Good Trend Following systems (including the Turtle trading system) average five or six trades per market per year. What do you need to get started? 1.) An active mind, willingness to learn and passion to win. 2.) No knowledge of what an Italian bond is worth or what companies comprise the S&P or FTSE index. The key is the price on the chart. 3.) Discipline and common sense to do the right thing per all rules. 4.) About an hour each day at the end of the day to check trades. 5.) A PC and telephone line (or internet connection).

“Trading is a zero-sum game. For every winner, there is a loser. What is the difference between winners and losers? Smarts and strategy. For every loser in the NASDAQ implosion there was a winner. Does this mean that there are traders with neither strategy nor smarts actively losing, effectively shifting their funds to the winners, armed with strategy and smarts? Yes, absolutely.”

Testimonial from the home page: “[TurtleTrader] offers no comfort to those who are looking for a quick buck or the Holy Grail, and the proprietors don’t seem to suffer fools gladly. The message is open, honest, straightforward and makes no hyped-up promises. It sticks to the facts; it is one of the best system trading sites for... traders I have seen.”

CHINA WATCH: WELCOME TO A FREE MARKET WITHOUT SOCIALISM

Swaps, options, derivatives ... no more state backing for new banks, and no more freewheeling credit to fund the development of basic industries to create jobs for the masses ... If there were, improbably, any lingering hopes among diehard communists about where the emphasis might come to fall in the managed evolution of a “socialist market economy with Chinese characteristics”, the National Financial Conference in Beijing has surely laid the last of them to rest.

When silk markets make way for futures’ markets; when the pensions of retiring workers must come to depend not on the state, but on the investment performance of insurance companies; and when money saved by those workers is not used to finance economic development at home but may be lent abroad, there is surely not much of socialism left in that “socialist market economy”. And what may remain is disappearing fast. That the goal is to progressively remove the Communist Party and the last vestiges of socialism from the financial system (while retaining complete party control of the political system), can surely no longer be in any doubt.

China takes steps toward overhaul of its financial system.

Economic officials in China concluded three days of talks that brought together mostly government officials in charge of banks, insurers and the stock market and signaled a faster tempo of action in these areas, China watchers said. The measures that officials endorsed included accelerating bank reorganization; slowing the growth of money supply and lending; easing restrictions on the outflow of money; and later, possibly altering China’s exchange rate controls, according to official Chinese news reports. It may be months before the specifics of the plans are determined, but several economists interviewed said this week’s announcements seemed to signal the beginning of a new, deeper round of financial changes.

Hong Kong business chiefs warn about the perils of democracy.

Tsang Hin-chi, chairman of the Chinese General Chamber of Commerce, said the organizers of protests held last July against a government-sponsored anti-subversion bill were “definitely anti-patriotic”. Pro-democracy leaders were not true democrats, he said. Pro-democracy groups have stepped up calls for political reforms to allow universal suffrage. They would like in particular to see direct election of the chief executive and entire Legislative Council, the city’s main governing body.

Until recently, Beijing has refrained from comment on the debate -- a sign analysts interpreted as evidence of China’s president and premier’s greater openness to reform. But last week, in a statement published in the official media after a visit to Beijing by a Hong Kong government taskforce on political reform, it warned that Hong Kong’s leadership should be governed by a spirit of patriotism.

Gordon Wu, chairman of Hopewell Holdings and one of Hong Kong’s wealthiest tycoons, said that under universal suffrage, politicians would try to win votes by encouraging the government to introduce welfare reforms that would signal “the beginning of the welfare state in Hong Kong”. Speaking at a symposium, Mr Wu warned that if politicians who support welfare reforms were elected, “capitalists will move their business to other countries”. Hong Kong business leaders, most of whom have substantial investments in mainland China, have traditionally opposed democratic reforms.

GREENSPAM

Greenspan’s semiannual testimony before Congress is much anticipated by market watchers, much discussed in the media, and much dissected by analysts for any nugget of the future that might be discerned. The reality is his testimony is all about deception. Greenspeak, his torturous twisting of words with endless assumptions, conjectures and qualifications, is not meant to inform, but to misinform and to give the impression that all is well, at least at the Fed. For your own sake, think of his testimony as Greenspam. Delete it from your mind like Spam e-mail messages.

I actually have a Greenspam translator device, which eliminates all the extraneous information and provides a short summary of what Greenspan really meant to say. Here are the results from the last two days of testimony: “We really do not know what is going on in the economy, but all we really care about is getting George Bush reelected. I screwed his father out of a second term and I’m not going to make that mistake again. We are not sure what we are going to do after the election, but because interest rates cannot go much lower, they are probably going higher. We do know that we are going to royally screw a lot of Americans in the process, but that cannot be helped. It is what we do here at the Fed.” As Gary North warns, when Greenspan is dealing the cards, pay no attention to what he is saying... keep your eyes on his hands.

PESSIMISTS MAKE MORE MONEY

Pessimists tend to make more money gambling or investing in the stock market. This is not really that surprising, because the real story is that everyone loses money -- it is just that the pessimists tend to limit their losses, while the optimists believe that they are about to turn things around.

DEBT VS. INCOME: AT THE POINT OF NO RETURN

At the beginning of 2003, the level of debt that American’s owed as an absolute amount, and as a ratio of income, was already approaching levels never seen before. Debt can be handled in a number of ways: 1) earn enough money to pay it off; 2) default; 3) borrow even more; or, 4) pray for inflation so you can earn more dollars (but really pay back less). Where are we now?

Last year, personal income increased about 2%. Individual debt increased about 10%. Mortgage debt rose about $800 Billion, and total individual debt rose over $925 Billion, while wages and salaries rose only $190 Billion. In December, the savings rate dropped to a new low of 1.5%; and the savings rate is actually materially overstated. Personal Income, according to the Bureau of Economic Analysis, includes a few hundred billion dollars in “imputed income” for owning your own home and receiving value for other “non-cash services”. What is perfectly clear from simple arithmetic is that without a sudden increase in the number of jobs and the wages they pay, individual debt cannot be serviced by personal income. Worse yet, not only are people not saving, but their financial reserves are not in real cash.

The market value of homes in 2003 rose about $1 Trillion and stock market values rose about $1.5 Trillion. The rising asset prices look like they balance rising debt on household balance sheets. Tragically, the increase in asset prices will vanish the day that interest rates rise, but the debts will still remain. Indeed, not only will the debt remain, but the cost of servicing it will go up dramatically. As interest rates rise, wages and salaries must increase or massive debt defaults will follow. Income and job growth are so low that we have certainly passed “The Point of No Return”. There cannot be an easy resolution to the debt bubble and resolution will only come when a crisis forces change. By 2005, the ultimate outcome to resolve the debt problem looks like it will be a combination of inflation, rising interest rates and debt default.

INDIA WARNS U.S. OVER OUTSOURCING CURBS

India told United States Trade Representative Robert Zoellick that a US Senate bill which seeks to curb the export of US jobs could hamper Indian support for world trade talks. Indian Commerce Minister Arun Jaitley said the bill to limit the outsourcing, or shifting overseas, of US government work was leading to disaffection with free trade discussions.

The loss of jobs overseas has become a hot topic in the United States, and Indians fear other measures that could hit the rapidly growing software industry and a related sector that runs call centers and performs back-office work remotely using high-speed telecom links. This has led to a wave of protest in several developed nations as trade unions fear massive jobs losses to developing countries such as India and China. But Zoellick said if India wanted to have an outsourcing business and wanted to sell goods to the United States, it would also need to open up its markets to US exporters.

SENATE BUDGET COMMITTEE FOCUSES ON LEASING TAX BREAKS

Chairman of the Senate Budget Committee Don Nickles has pledged to close down tax loopholes that allow corporations significant tax breaks, as lawmakers attempt to patch up the growing black hole in the government’s fiscal finances. Nickles placed a lot of emphasis on corporations who lease public infrastructure to municipalities, allowing the companies to take advantage of large depreciation allowances, something the Senator labelled a “shell game”.

US Corporations have entered into leasing arrangements with foreign as well as domestic government authorities. The Treasury Department estimates that the value of these leasing arrangements is in the region of $750 billion, and calculates that $33 billion could be recouped in tax revenues if the practice was shut down. However, these figures have been hotly disputed by the Equipment Leasing Association, a non-profit association that represents companies involved equipment leasing to the business community, government and media. The Equipment Leasing and Finance Foundation’s 2003 State of the Industry Report estimates the size of the entire leasing industry to be $218 billion in 2004.

MIDEAST MIRACLE?

When it comes to the middle east, the eyes of the world focus mainly on Iraq and on the Israeli-Palestinian conflict. Yet in coming months Egypt will be initiating reforms that should dramatically transform its economy into a wealth-creating, wealth-distributing dynamo that will lead millions of Egyptians into avibrant, increasingly democratic middle class. The country is set to become an economic miracle rivaling Ireland or Hong Kong. In doing so, Egypt will deal a devastating blow to global terrorism.

The catalyst is something that is prosaic yet absolutely essential for a sustained, innovation-oriented economic takeoff: property rights. We in America and the rest of the West take our inclusive, easy-to-access property systems for granted. You own land, for instance, and everyone recognizes it. You can readily mortgage it. Want to start a business? The legal requirements are easy. Want to sell bonds or shares or use other capital-raising instruments? The legal structures to do so are open to anyone who can meet standard requirements. Commercial contracts? They are widespread, and the courts are there to enforce them and to adjudicate disputes.

Incredibly, most of the world has no such property rights or common rule-of-law system. Japan did not until after World War II, when, under General Douglas MacArthur’s occupation, it shucked off its medieval social structure and put in place institutions and laws with principles long familiar to Americans. This dramatic change played a critical, oft-overlooked role in Japan’s rapid postwar modernization and economic expansion. After several years of preparation, Egypt is about to commence a Japanese-like makeover of its society, one that will profoundly and positively impact the rest of the Middle East and the developing world.

MORE EVIDENCE THAT THE INTERNET BUBBLE IS COMING BACK

During the boom years, you could not open a business/techie magazine without reading an article about some teenager running a company that was valued at millions of dollars for no clear reason. Now, here is a new article talking about the 19-year-old CEO of a UK ISP.

COLORED DIAMONDS A GIRL’S REALLY, REALLY BEST FRIEND

So how to tell a real player from a plebe? See who’s sporting the jujube-size colored diamonds. Jennifer Lopez nabbed a 6-carat pink solitaire engagement ring that reportedly cost more than $150,000 a carat, some eight times what a plain old flawless diamond would cost. Hailing primarily from Australia, pinks are so rare that a year’s worth of mining for them would only fill a champagne flute.

Only 1 in roughly 10,000 stones has a hue, sometimes caused by trapped elements. Nitrogen accounts for the canary yellow boulders that frequently bedeck P. Diddy. Purple diamonds owe their color to imperfections in the crystal structure.

The increased popularity in colored diamonds can be illustrated by the surge of requests for grading of these gemstones at the Gemological Institute of America, the world’s foremost authority in gemology. GIA has experienced a 102% increase in demand for colored diamond services since 1999.

Famous Colored Diamonds

Many of the world’s most famous and expensive diamonds are natural color gems. Probably the most celebrated of them all is the Hope Diamond, a fancy blue diamond of 45.52 carats. It is displayed at the Smithsonian Institute in Washington D.C. Then there is the Dresden Green, a 40.70 carat apple-green diamond named after the German city where it is displayed. One of the most outstanding yellow diamonds is the Tiffany, a 128.51 carat cushion-cut canary yellow gem.

Red and pink diamonds are extremely rare. There are only about six known red diamonds in the world. The Argyle Diamond mine in Australia is the world’s foremost source of intensely pink diamonds, but only a handful are recovered each year. The largest Champagne colored diamond is the Golden Giant which weighs 407.43 carats. At the other end of the color scale in this family is the Earth Star, a pear-shape cognac diamond of 111.59 carats.

The many facets of man-made diamonds.

Before the 1930s, the gems of choice for engagement rings included opals, rubies, and sapphires. But in the 1940s, De Beers -- the South African mining firm that controls the majority of the worl’qs diamond supply -- introduced “A Diamond Is Forever”. The success of this campaign turned diamond into the symbol of eternal love and dramatically increased demand for the gems.

Today, two start-up companies are staking their futures on the lure of more affordable, laboratory-grown diamond gemstones. But because of diamond’s remarkable optical, thermal, chemical, and electronic properties, synthetic diamond promises to offer a lot more than just beautiful jewelry.

Naturally occurring fancy-colored diamonds -- yellows, blues, pinks, and reds -- are very rare and thus very valuable. A Gemesis-created yellow fancy-colored diamond -- visibly indistinguishable from a natural one, even to a trained gemologist -- can be purchased for about $4,000 per carat. That is about 30% less than the price of a natural diamond of similar color and quality, according to Robert Chodelka, Gemesis’s vice president for technology. Just like naturally occurring yellow diamonds, the yellow lab-grown stones get their color from trace amounts of nitrogen impurities: Replacing fewer than five out of each 100,000 carbon atoms in the diamond crystal lattice with nitrogen atoms gives a yellow diamond.

Previously companies such as GE and De Beers marketed their synthetic stones as heat sinks for electronics or used them solely for research purposes. Gemesis, on the other hand, is growing diamonds for jewelry. And because Gemesis’s yellow lab-grown diamonds are visually indistinguishable from their mined counterparts, some in the gem industry have expressed concern that the lab-grown diamonds could be passed off as naturals.

But Gemesis’s business plan only begins with gems. Diamond has an extraordinary range of materials properties: It is the hardest and stiffest material known; is an excellent electrical insulator; has the highest thermal conductivity of any material yet barely expands when heated; is transparent to UV, visible, and infrared light; and is chemically inert to nearly all acids and bases.

THE HISTORY OF THE CREDIT CARD

Where would Americans be without their credit cards? As hard as it is to imagine, there was a day not all that long ago when general use credit cards simply did not exist. Before 1950, to be exact. It was in that year that Frank X. McNamara put his napkin down at a dinner in New York City, only to find to his mortal chagrin that he had no money to pay for his meal. Perhaps it was while an embarrassed McNamara sat waiting for his wife to arrive with cash to rescue him that he dreamed up what eventually became Diners Club... and the world stepped onto the slippery slope of easy money.

Today, of the $2 trillion in total U.S. consumer debt, the share due to credit cards is about $700 billion, or about $2,400 per every man, woman and child in America. According to CardWeb.com, the average American now carries a total of 7.6 cards, which further breaks down to 2.7 bank credit cards, 3.8 retail credit cards and 1.1 debit cards. 24% of all personal consumption is conveniently made via some combination of bank credit cards, retail cards and debit cards. In the getting-scary category, Visa happily reports that 43% of property rental companies now accept Visa credit and debit cards for rental payments.

How did the formerly virtuous, frugal, fiercely independent, neither-a-lender-nor-borrower-be American corrode into an overburdened debtor? Like human nature itself, the answer is complex and multi-faceted. There are, however, a couple of clear culprits, starting with risk-based credit models that have facilitated easy credit to every strata of the American demographic. These models, and the underlying business practices, developed in no small part because of Wall Street’s harpish demands for consistent earnings growth and quarterly improvements in loan book size and profitability -- demands that have triggered profound, structural changes in the lending markets. In order to increase their loan books and keep Wall Street happy, banks and other financial institutions were forced to reduce creditworthiness standards to the point where competitively priced consumer credit is now available to almost all elements of the population.

A look at recent debt-service to disposable income ratios, bankruptcies, and credit card company late fee revenues indicate that consumers are reaching the point of pain. Over 70% of the economy is driven by consumer spending. Should consumers decide to cut back, the U.S. economy will not necessarily hit a brick wall... but it will clearly be in for a slowdown in GDP growth.

FISCAL IMBALANCE STEMS FROM SPENDING GROWTH, NOT TAX CUTS

Some critics charge that the Bush tax cuts have dramatically reduced government revenues, causing big long-term deficits that will hurt the economy by driving up interest rates. This is a misguided argument, not only because of a very weak relationship between deficits and interest rates, but also because historical budget data show that tax revenues in future years will be at their historical average -- even if the tax cuts are made permanent.

From 1951 to 2000 federal tax revenues averaged 18.1% of GDP, while tax revenues for 2012-2014 will average 18.1% of GDP, according to Congressional Budget Office (CBO) data. And this assumes that the tax cuts are made permanent. Tax revenues are currently below that level, but this is a short-term phenomenon resulting from the recent recession and the temporary stock market-driven collapse of tax revenues from capital gains.

Deficits, however, are not the issue. The real problem is government spending, and rising deficits are merely a symptom of that problem. This is true in the short run and the long run. In the short run, federal spending has jumped dramatically, climbing from 18.4% of GDP in 2000 (the lowest burden of government since 1966) to more than 20% of GDP in 2004. But this short-term expansion in the burden of the federal government is minor when compared to what will happen after the baby-boom generation begins to retire. Without reform, huge unfunded promises for Social Security and Medicare will cause an enormous increase in federal spending -- and lawmakers just made the problem worse by creating a new entitlement for prescription drugs.

It is also worth noting that national defense expenditures are not the source of the problem. Defense spending today consumes 4 percent of GDP, compared to an average of 6 percent during much of the post-World War II period. Even during the Carter Administration defense spending never fell below 4.7% of GDP. Conclusion: Today’s deficit debate is largely a charade. Proponents of big government shed crocodile tears about the deficit because they want higher taxes.

Medicare reform backfires on Bush.

President Bush signed a prescription-drug act two months ago that is actually hurting his popularity instead of boosting support from the elderly as intended. Mr. Bush finds himself under fire from two directions on the health care issue. Democrats say the Medicare plan does not do enough to defray prescription expenses for retirees, and Republican critics call the drug benefit an unprincipled bid to buy votes in November. Critics accuse the Bush administration of lying about the bill’s cost to taxpayers.

CHINA’S ECONOMIC ROLLERCOASTER

China has created the third wave of Asian growth. When it collapses, as it must, will it bring down the world economy? This will depend on how successful foreign enterprises are at managing risk. The problem is that no one knows just what the risk is.

China has generated one of the greatest booms in history. We do not make more of it because this it is almost what we expect from Asia. Japan created one of the biggest booms when its prolonged growth made it an economic titan. Then the Asian tigers followed. For nearly two decades, economic growth between 8 and 10 percent per annum was the norm in Asia while the rest of the world grew at 3 percent.

The problem is the state of China’s finances. Recent abrupt government bailouts highlight the fragility of China’s financial system. It is awash with debt. Total national debt, including foreign loans, stands at 176% of GDP according to estimates from Morgan Stanley. While China’s growth rockets, it can afford a lot of debt. But the poor quality of the debt is the worry. A bigger worry is no one knows just how much there is. Recent analysis draw parallels with conditions in China today and the situation in Asia on the eve of the currency crisis. The challenges facing the Chinese leadership would defeat most politicians in most countries. They are good, but they would have to be miracle workers to prevent a crash.

BIG SUGAR GETS ITS WAY, AGAIN

To paraphrase Winston Churchill and apply it to the U.S. sugar industry: “Never have so few taken so much from so many.” Washington uses preferential loan agreements and trade barriers to keep the price Americans pay for sugar artificially high. Currently, U.S. buyers must pay three-and-a-half times the world market price for sugar. Sugar’s absence from the recent U.S.-Australia Free Trade Agreement is disappointing on three counts. First, it stands out as a symbol of a perceived American hypocrisy on trade. Second, in order to get a pass on sugar, U.S. negotiators were forced to overlook Australian protectionism on wheat, broadcasting and audio-visual services, and other areas. Third, the exclusion of sugar from free-trade disciplines sets a terrible precedent that encourages other import-competing producers to demand similar favors.

More than 10 times as many Americans face possible job cuts and slower growth because of the U.S. sugar program than are helped by it. The program is devastating the U.S. candy industry, for example. Workers in export sectors are victims of “big sugar”, too. Future FTA negotiations with Thailand, Colombia, Peru, and other proposed sugar-producing partners are now far less likely to succeed.

Most worrisome is the fact that the sugar program has become an impediment to the war on terror. Sugar is a key export for many fragile democracies, including those in our own hemisphere. Many reform-minded leaders have staked their political futures on the promise of free trade with the United States. They are greatly weakened by an administration that expects trading partners to accept politically difficult concessions and wrenching economic dislocation while clinging stubbornly to a closed sugar market.

NEARLY HALF OF EXECUTIVES ADMIT THAT THEY DO NOT DESERVE ANY CUSTOMER LOYALTY

It turns out that most companies have forgotten the fact that it really is their customers who pay their salaries, and they do very little to cultivate any kind of dialogue between themselves and their customers. The only really surprising stat is that nearly half of all executives admit that they do not deserve any loyalty from their customers. If an executive realizes this, why aren’t they doing anything to change it? Too much of a short-term view.

U.S. ECONOMY RUNNING ON EMPTY ... IN PICTURES

In his testimony before the Congressional Committee on Financial Services the Chairman of the Federal Reserve Board, Alan Greenspan, said that he could see good chances for a sustainable expansion of the U.S. economy. Greenspan has informed us that his low interest rate policy since January 2001 is finally starting to produce good results. But is it factually correct that the financial condition of consumers and businesses has improved to such an extent that economic expansion is likely to be sustainable? Let’s take a look.

THE PERFECT “SLEEP AT NIGHT” INVESTMENT STRATEGY

If you are wondering whether your investment portfolio is going to retain its value in these uncertain times or whether your retirement savings are safe, there is an almost fail-safe way to assure that you do not get hurt -- whatever may come. In the late 1970s, I devised a concept that has been proven to accomplish this goal. It is called a Permanent Portfolio, because once you set it up, you do not have to continually reevaluate it, alter it, or even think about it. And it does not matter whether the future brings prosperity, inflation, recession, or even a depression; you will know you are safe no matter what.

Over the decades, the portfolio has achieved an average annual gain of 9.2% and has had only four losing years. For individuals concerned above all else with capital preservation, this is a truly “sleep at night” investment strategy.

The goal of the Permanent Portfolio is simple: to deal effectively with uncertainty, with a minimum of effort. In the 35 years I have been following the markets, I have found no one who can reliably predict future gold prices, stock valuations, the direction of the economy, or anything else that has to do with human action. The bottom line is that you have to accept uncertainty and handle investments as though you have no idea what is coming next -- even when you think you do.

The general premise of this approach is that anything that happens -- war, peace, civil unrest, instability, good times, bad times, etc. -- will translate itself into one of four economic environments: prosperity, inflation, recession, or deflation. Stocks and bonds both profit during prosperity; gold does well during inflation; bonds do well in deflation. And although nothing does well in a recession, cash helps to cushion the fall in other investments. A portfolio consisting of equal parts of each of those four types of investments is not volatile and has a relatively consistent rate of return.

GOOD INVESTORS HEAD TO THE BEACH

In May 1969 Warren Buffett decided to close up his investment partnership. The previous year Buffett’s partnership gained 59% as assets ballooned to $104 million. After a year like that, a modern-day mutual fund manager would take out a full-page ad in the Wall Street Journal. He would brag about his one-year, five-year, and ten-year track records, trying to garner more capital... and more fees. Not Buffett. He let it be known that such a performance “should be treated as a freak [event],” akin to a 100-year flood.

That is the difference between value investors and everybody else. Everybody else loves it when stocks go up. They buy more and suddenly feel like financial geniuses. Value investors just collect their profits and wait for stocks to get cheap again. That is exactly what the great value investors of our time are doing right now. Their recent shareholder letters are very clear. They are not the complaints of lazy, uninformed losers, but rather are carefully made observations of the best and brightest portfolio managers ... some of the most successful investors of the last four decades. They have got all the research staff they could ever want at their disposal.

In these pages a few weeks ago I noted that only ten stocks in the S&P 500 were trading for less than ten times earnings. There were four such issues in the S&P Midcap 400, and 17 in the S&P Smallcap 600. On January 29, Barron’s reported the identical observation. In the current issue of Barron’s, there is an article noting how few stocks are trading at discounts to book value. A week later I identified only nine U.S.-traded stocks over $100 million in market cap, that were cheap based on earnings, book value and sales. After 11 months of a rallying market, bargains are scarce.

“DR. DOOM” DISSES THE ECONOMIC RECOVERY

The present “strong” recovery phase in the U.S. economy will not last for long, as it is totally artificial. There are simply too many imbalances in the system -- as reflected by a record low national saving rate, record household debts, and record trade and current account deficits -- for this recovery to lead to sustainable strong growth that would justify the present stock valuations.

Peter Bernstein writes: “The imbalances are now enormous, far more glaring than at any point in the past. Furthermore, the linkage of the parts are so tightly knit into the whole that reducing any one imbalance to zero, or even compressing them all to a more manageable level, appears to be impossible without a major upheaval. A hitch here or a tuck there has little chance of success. When it hits, and whichever sector takes the first blows, the restoration of balance will be a compelling force roaring through the entire economy -- globally in all likelihood. The breeze will not be gentle. Hurricane may be the more appropriate metaphor.”

I am not sure exactly how the present imbalances will play themselves out, since, as Mark Twain remarked, “A thing long expected takes the form of the unexpected when at last it comes.” But I am certain that the breeze accompanying the restoration of balance will not be gentle.

NOBODY WOULD FINANCE MORE THAN 100% OF A DEPRECIATING ASSET ... RIGHT?

In recent years Iwe have read about folks who take out a mortgage that exceeds the purchase price of the home they intend to buy ... and then pocket the difference. The lender and borrower would argue that this type of mortgage debt is sound, since the asset in question is supposed to increase in value. The home’s price should “catch up” with the dollar amount of the mortgage. Of course, “supposed to” and “should” are the key words in the argument. It hinges on betting correctly about the future.

What about taking on a debt that exceeds the purchase price of an asset, when that asset is certain to LOSE value from the moment the borrower takes control? What would you call that? “Stupid” fits as well as any synonym. Well, USA Today this week broke the news: “In 1997, banks financed an average 89% of a new vehicle’s cost. Last year, it was 101%, says the Consumer Bankers Association, as consumers sought loans that cover a new car and thousands more than they owed on the old one.” The article also said “40% of all trade-ins” come from people who “owe more on their cars than they are worth.” No pocketing the difference here. They need new debt to pay off old debt on a depreciated asset in order to finance another depreciating asset.

REAL ESTATE RICHES, RUINS OR REWARDS

I think it is safe to say that real estate “refi madness” has been the true wealth effect that has helped keep the US economy afloat, amidst large numbers of blue and white-collar job layoffs over the past 2-3 years. I will take a look at the factors that drove prices up, and the factors that will probably drive prices down over the next few years.

Home ownership is not just a financial issue, but a very emotional one as well. It is a status symbol, part of the American Dream, and people have been almost conditioned through advertising not to “throw their money away on rent,” when they could be building up equity over time with their home or condo. People in their 20s and 30s are looked upon as if there is something wrong with them if they have not bought a house by the time they are 30. It is part of the disease called “affluenza”, or “keeping up with the Joneses.” The only problem is that the Joneses are broke. Even though they look great on the surface, this abundance of flash has led to a lack of cash. Trying to keep up these appearances and lifestyle is the fastest way to financial self-destruction, and Americans are doing a great job of that in the 21st century.

If the real estate market does take a tumble down, and pulls the stock market with it, how does a prudent American consumer or investor prepare? First of all, do not buy a bigger, newer house if you do not have to. Even if you are a tenant and tired of paying rent to someone else, be patient. In Denver, the rental market has taken a beating. You can find some very good deals -- and negotiate some great ones. I see a LOT more downsize risk than I do upside potential in the real estate market.

As Warren Buffett says: Be brave when others are fearful, and be fearful when others are brave. Right now, most Americans are pretty courageous in the stock and real estate markets. Or as the wise sage in one of the Indiana Jones movies said: “Choose... but choose wisely.”

ARE WE OUT OF GAS YET? THE CONTINUING “OIL CRISIS” CRISIS

Once again, the gauge on our national economy is dropping dangerously to the red. So swears a spate of books and articles in the past few years, reviving 1970s-era fears of impending oil catastrophe. In his 2001 book Hubbert’s Peak: The Impending World Oil Shortage, Princeton University Professor Kenneth Deffeyes found “that world oil production will peak in this decade -- and there is [nothing] we can do to stop it. While long-term solutions exist in the form of conservation and alternative energy sources, they probably cannot -- and almost certainly will not --- be enacted in time to evade a short-term catastrophe.”

There is a choirmaster to this chorus of oily doom: the late geophysicist M. King Hubbert. In 1956 Hubbert predicted, correctly, that U.S. oil production would peak in the early 1970s. Like Hubbert, current doomsayers reach their grim conclusions of impending octane depletion by using estimates of the world’s recoverable reserves of oil and comparing them with estimates of rates of future use. From this they derive predictions of when the demand for oil will outstrip the supply, and most suggest that dry pumps will greet us before the end of this decade. Once the peak is reached, oil doomsters foresee skyrocketing prices leading to economic ruin and social and environmental collapse.

But we have heard it all before. “These kinds of doom and gloom energy predictions become popular every 10 years or so,” says Michael Lynch, president of Strategic Energy and Economic Research, a Massachusetts consulting firm. Lynch’s new study The New Pessimism about Petroleum Resources, pokes holes in forecasts of imminent oil doom. It is true that oil discoveries peaked in 1982, but Lynch argues that is because of politics, not geology.

The fact is, we do not really know how much oil is left. “Available supply” is not merely a geological fact. It depends on technology and economics as well. But we do have some good guesses out there. Annual global oil production these days is 24.5 billion barrels. At the current rate of production, oil supplies would last at least 90 years. Taking into consideration various scenarios for future energy use and based on those USGS estimates, the Energy Information Administration sees oil production peaking anywhere from 2030 to 2075. Hardly an imminent crisis.

Ultimately, instead of a catastrophe, Lynch expects a relatively smooth transition to new energy sources. And history bears out his optimism. Oil crisis mongers make the mistake of thinking that “markets are so myopic that they cannot foresee future supply trends; that markets won’t realize when a resource is running out.”

U.S. NATIONAL DEBT TOPS $7 TRILLION FOR FIRST TIME

The U.S. government’s national debt -- the accumulation of past budget shortfalls -- totaled more than $7 trillion for the first time as of Tuesday, according to a Treasury Department report. While passing the $7 trillion mark itself has little practical significance, not unlike a car’s odometer rolling over, it may signal some tough political times for President Bush’s administration on fiscal policy.

The government debt ceiling stands only a few hundred billion dollars ahead at $7.384 trillion, and Treasury would need Congress’s blessing to borrow beyond that. Treasury officials say they expect the limit to be hit sometime between June and October. And in this election year, Democrats may also use the $7 trillion figure to assail Bush’s tax policy and the federal deficits on his watch. Bush blames the deficits on a sluggish economy and needed spending on security and defense. Rep. Baron Hill of Indiana, part of a centrist group of Democrats said, “It is simply immoral to run a national debt exceeding $7 trillion, every penny of which our children and grandchildren will be responsible for paying back.”

KERRY’S PLAN TO STOP JOBS MOVING OFFSHORE WILL BE UNWORKABLE SAY ECONOMISTS

Tax policies designed to stop the flow of US jobs offshore, proposed by front-running Democrat presidential candidate John Kerry, are flawed and may even prove counterproductive, economists have argued. Under the plan a new tax credit will be created that will give firms a two-year refund on an employee’s payroll taxes. In addition, US-based manufacturing firms will pay less corporate tax.

However, economists believe that the massive differentials in wage costs that exist between the United States and overseas labor markets such as China and India will not come close to being bridged by Kerry’s proposed tax reforms. Analysts also fear Kerry’s tax plan will have a distorting effect on the nation’s labor market, leading to firms turning over staff quicker in order to take advantage of the two-year tax credit, and in this way will have a negative, rather than a positive effect on US jobs.

NEW U.S. DIVIDEND TAX RATE COMPLICATES TAX FILING

Since the dividend tax on many shares was cut to 15% last year, it has been reported that many brokers and mutual fund companies are experiencing difficulties calculating exactly how much tax their clients owe, and it is feared that many will either underpay or overpay this year’s taxes. Generally, dividends on most US common stocks are eligible for the 15% rate, while investors in the lowest tax bracket qualify for the 5% dividend tax rate. However, there are a number of other classes of stock where the 15% rate does not apply, including preferred securities (technically debt as opposed to equity), shares in REITS and foreign stocks that are not listed on a US-based exchange.

JAPAN A RENEWED FORCE IN ASIA

A new economic force is rising in Asia. Growing at an annual pace of 7% in the last quarter of 2003, it left both the old guard of Europe and the big shot, America, for dust. With its exports surging at a 17.9% annualized rate in the three months from October to December, its monetary authorities are struggling to keep its currency down. Meanwhile, its firms are scrambling to add capacity to meet the demands of customers at home and abroad: investment in fixed capital grew by 22% in the final quarter of 2003 (again, at an annualised rate).

This new force is not China, the aggressive upstart, but Japan, the forgotten giant of Asia. Its GDP figures for the fourth quarter, released on Wednesday February 18th, were its best for over 13 years. GDP growth of 7% may not be sustainable. The figure may also be flattered by continued deflation: Japan produced 7% more output, but the money value of that output grew by a more modest 2.6%. Still, after a comatose decade or more, Japan’s metabolism may finally be picking up.

WHO IS THE REAL WINNER IN THE AT&T WIRELESS BIDDING WAR?

Cingular has bought AT&T Wireless for some $41 billion after an intense bidding war with Vodafone. But the price paid may make it a pyrrhic victory -- and the speed of technological change may make it an irrelevant one. Wi-Fi, a wireless networking technology, is not a complete substitute for mobile phones, as it only works in a limited area, but it threatens at least part of the mobile operators’ revenue base. Cingular is convinced that it can make the deal work. Vodafone may soon be relieved it did not have the chance.

HAVE INVESTMENT BANKS REALLY LEARNED NOTHING FROM HISTORY?

The size of investment banks’ bets is rising rapidly the world over. This is because potential returns have fallen as fast as markets have risen, so banks have had to bet more in order to continue generating huge profits. The present situation “is not dissimilar” to the one that preceded the collapse of Long Term Capital Management, says Michael Thompson, a strategist at a consultancy that specializes in the very risk-management models that banks use. Like LTCM, banks are building up huge positions in the expectation that markets will remain stable. They are, says Mr. Thompson, “walking themselves to the edge of the cliff”. All past financial crises have shown that the risk-management models woefully underestimate the savage effects of big shocks, when everybody is trying to wriggle out of their positions at the same time.

So-called value-at-risk (VAR) models determine the amount of capital that banks must set aside against their trading positions, and purport to show how many millions of dollars a bank might lose should markets turn against it. If its VAR is rising, a bank is, in effect, taking more trading risk -- and VARs have been climbing for just about all of the banks that dabble seriously in financial markets. The VAR at Goldman Sachs, which is known on Wall Street as a hedge fund with an investment-banking business on the side, has more than doubled. One of the bank’s senior traders was told recently that he must take still more risk.

Banks have been increasing their trading exposures in other ways, too. The most notable is via direct investments in hedge funds, often those set up by traders who used to work for the banks themselves. In total, banks have invested many billions of dollars in such funds. All of which is splendidly profitable, as long as markets behave themselves. But the strategy puts banks and hedge funds alike at huge risk if markets suffer a severe shock -- a far more common occurrence than banks allow for.

By regulatory fiat, when banks’ positions sour they must either stump up more capital or reduce their exposures. Invariably, when markets are panicking, they do the latter -- all at the same time. It has happened many times before with more or less calamitous consequences. It could well happen again. There are any number of potential flashpoints: a rout in the dollar [recall that the 1987 crash was precipicated by the dollar’s then-weakness], or a spike in the oil price, or a big emerging market getting into trouble again. If it does happen, the chain reaction could be particularly devastating this time. Banks and hedge funds have increased their exposures most to those markets that they are least able to get out of.

INVESTING IN INDIA, OR CHINA, OR ASIA IN GENERAL

I am not opposed to investing in India, China or Asia in general. I am opposed to investing without a darn good guide who knows what is happening on the ground. There are too many “me too” investments that pop up from these countries with nothing more than a trumped-up story of gold in them thar' hills. So, please, invest away, but do so with eyes wide open and ears to the ground.

I cannot wait to go back to India and China to see what is really going on. Both countries have truly magnificent scenery and history. The people on the whole are terrific, but that is not why I invest. If I listened to the financial press today, I would be fully invested in the next economic miracle. But, I think I owe myself the real scoop before I get on the bandwagon. Both countries, and the region in general, could be spectacular stories. But, I have been there and done that several times with emerging markets in Asia, South America, Russia, Turkey -- you name it. The recurring theme is this: Buy when blood is running in the streets, not when the chicken in every pot is ready for consumption. That chicken could be you.

PREPARING FOR AN INCREASINGLY WICKED INFLATION

Inflation proper -- an expansion of the supply of money and credit -- has been going on for quite a while. It was the fuel for the late nineties boom. But a different sort of inflation is now beginning to emerge, a growing menace to indebted consumers. In the dollar’s decline we have started to see price inflation -- a general and widespread increase in prices, or stated differently, a general and widespread decline in the purchasing power of money -- but it is only the beginning.

Bill Gross of PIMCO, the Warren Buffett of the bond world, has long been an astute observer of the bond market, and financial markets generally. His December 2003 Investment Outlook contained a nice summation of an investment thesis for 2004. In short, Gross is in the inflation camp. Gross seems to take Fed officials at their word when they talk about “printing presses”. There are few things government cudgels do with much skill, but one of them is certainly destroying the value of their own currencies.

In Gross’s view, the “reflationary” effort is only in its infancy and is not likely to immediately jump up and bite investors. Nonetheless, the stance for investors today should be one of preparing for increasingly wicked inflation. Gross presents the following asset categories, which he ranks by his own personal preference: commodities and tangible assets, foreign currencies, real estate, TIPS, and global bonds and equities denominated in non-dollar currencies. Gross calls these “reflatables”. If you are shopping for places to put your money, this list would be a good place to start ... at the general level. Finding concrete ideas and opportunities that meet a rigorous test for a margin of safety is more difficult -- it always is.

Warren Buffett, for one, is selling the dollar. In his article for Fortune (“Why I’m not buying the U.S. dollar”) Buffett writes, “Through the spring of 2002, I had lived nearly 72 years without purchasing a foreign currency. Since then Berkshire has made significant investments in -- and today holds -- several currencies.” When the Oracle of Omaha does something he has never done before, that is worth noting. Buffett is not alone -- Soros, Templeton, Jim Rogers and other investment luminaries are betting on a dollar decline. That is not a crowd one is going to make a lot of money betting against.

INDIAN STATE WOOS MEDICAL TOURISTS

Together with the its business sector and private health-care providers the Indian state of Maharashtra recently launched the Medical Tourism Council (MTC) of Maharashtra. Its aim: to make India a prime destination for medical tourists. Bombay, members of the council argue, has private hospitals on a par with the best in the world. Many of the surgeons at hospitals such as the Hinduja are leaders in their field, working with the best equipment available. But they can provide their expertise at a fraction of the price that comparable surgery would cost in Europe or the United States.

The brochure produced by the MTC has a table listing the comparable costs of procedure. It says, for example, that the average price of private heart surgery in the West is $50,000. In Bombay it can be done for $10,000. The same ratio applies to joint replacement, neurosurgery and cancer treatment. The council plans to provide fixed-price treatment packages to foreign patients, integrating all their transport, medical and living costs into one price.