Wealth International, Limited

Finance Digest for Week of May 10, 2004


Canada’s universal medicare system achieves only middling success compared to other industrialized nations, despite being tied with Iceland’s as the most expensive to run, a new analysis shows. Sweden, Japan, Australia and France all permit some private involvement in their public health care systems, and all achieve lower mortality rates on a number of separate indicators, according to the report released yesterday by the Fraser Institute.

“For [Canada’s] high level of spending, we get mediocre health outcomes, some of the longest waiting times in the world, and terrible access to doctors and technology.... Our performance is just not commensurate with our level of spending. We’re not getting the value for money,” said Nadeem Esmail, a senior health policy analyst at the conservative think-tank, which sponsored the study. His co-authors were Michael Walker, the institute’s executive director, and Sabrina Yeudall, a researcher. Their study compared public health care systems in 28 nations of the Organization for Economic Co-operation and Development, all of which guarantee universal care, and most of which force patients to share in the costs. It ignored the U.S. and Mexico, which do not guarantee universal care.

In the number of preventable deaths from disease, for example, Canada ranks eighth, behind France, Sweden, Japan, Spain, Norway, Italy and Australia. All those countries allow patients to contract private medical care, Mr. Esmail said. All but Spain force patients to share in the cost. “They allow people to go out and they allow them the freedom to purchase care if the government is unwilling to provide it to them, either in an absolute sense or in the time frame or in an environment that is suitable to their needs,” Mr. Esmail said.

There are only two measures by which Canada ranks first. One is colorectal cancer mortality. The other is spending. “Shackling patients to a government monopoly with no alternative choices results in a more expensive and lower standard of care than would be available otherwise,” Mr. Esmail said. He said his results demonstrate the value of a competitive market environment for hospitals and the need for user fees on public health services. “Patients are far more responsible with their own money than they are with anyone else’s” Mr. Esmail said.

Link here.

Hillary’s Worst Nightmare

Ever since the Clinton administration’s proposal to direct America’s health care system from Washington, D.C., went down in ignominious defeat a decade ago, its chief architect, Hillary Rodham Clinton, has shied away from “comprehensive health care reform,” preferring instead to take smaller steps toward government-run health care. That is, until now.

Breaking what must have been a difficult 10-year silence, Sen. Clinton (D-N.Y.) asked on the cover of a recent issue of the New York Times Magazine, “Now Can We Talk About Health Care?” Without waiting for an answer, she called for “a new social contract for a new century premised on joint responsibility to prevent disease and provide those who need care access to it.” Unfortunately, the new social contract looks a lot like the old social contract she offered last century: perverse incentives plus tight federal controls on the practice of medicine, health benefits, insurance pricing, medical records, municipalities, hospitals, doctors, household cleaners, gym class, diet, urban sprawl, you name it. It’s déjà vu, all over again.

Since nearly every act of Congress with “health” in the title brings greater socialization, the left has been slowly and surely moving us toward its goal. So why would Clinton try to shift debate from a successful incremental strategy to the historically inhospitable terrain of “comprehensive health care reform?” It certainly is not because the case is any stronger. Except for a few 21st century garnishes, Clinton’s manifesto relies on decade-old misconceptions and drifts into cognitive dissonance. Nor has her prescription gotten any sounder. It remains “universal coverage”, despite evidence that what such health systems provide is neither universal nor coverage. To drive home the Orwellian tone, she pens, “It comes down to individual responsibility reinforced by national policy.” No, the reason behind Clinton’s shift in strategy is hidden to all but the most ardent supporters and opponents of socialized medicine.

Tucked away in the recently enacted Medicare prescription drug bill is a deceptively small provision allowing personal, tax-free health savings accounts. The consequences of this little-remarked change will be profound. Health savings accounts will lead patients to curb rising health care costs, demand greater value, and eliminate waste because it is their money at stake. However, the consequences that frighten the left are political. The left cannot impose a government-run health care system without a widespread sense of entitlement and openness to dependence, both of which are manifest in America’s health care sector. Yet health savings accounts breed the opposite values of personal responsibility and self-reliance. Clinton inadvertently acknowledges this reason for her change in strategy by veering off-message for several column-inches to denounce health savings accounts and similar reforms. To the most ardent supporters and opponents of health care consumerism, Clinton’s desire to accelerate socialization makes perfect sense.

Link here.


Free markets are so successful because individuals and businesses constantly mutate in response to changing economic conditions. Sometimes the process can lead to very surprising and interesting developments. Just as a visit to the Galapagos Islands can present one with bizarre creatures, inspection of odd corners of the economy can lead to thought-provoking discoveries. I recently noticed such a case that has positively fascinating economics. A strange regulatory environment led to stranger mutations, a set of not-for-profit companies that provide large cash gifts to citizens, and angry government officials who want to shut them down.

Policymakers have for many years sought to stimulate home ownership. For medium and high-income individuals, the primary stimulus is the mortgage interest deduction. For low-income individuals, a number of additional programs have sought to reduce the costs of home ownership. Perhaps the largest of these programs is the Federal Housing Authorities 203(b) insurance, which insures lenders for loans to qualifying individuals.

While this program has successfully made private capital available to low-income individuals, the requirement that buyers have a downpayment of at least 3% of the purchase price of the home has created an unusual market. Not-for-profit enterprises have emerged that provide home buyers with gifts to cover their down payments. These “down payment assistance program” (DAPs) gifts are sourced directly or indirectly to sellers. While one can readily understand why a recipient might accept a gift of down payment assistance, it is less easy to understand why a seller might desire to pay it. The public policy discussion to date appears to rely upon a less-than-charitable view of the sellers’ motivations. In fact, however, two competing views of the economics of DAPs exist that have different testable predictions. Let’s have a look.

Link here.


Interest rates in the European Union have been at 2%, a 50-year low, since June 2003. At their latest meeting, the European Central Bank (ECB) again decided to leave the interest rates unchanged. The EU inflation remains at 10-year lows, despite the ECB’s efforts to stimulate borrowing. Economists, on the edge of their seats in anticipation of the first wave of inflation that the low interest rates are supposed to bring, are getting impatient and frustrated. Indeed, what is going on?

The ECB’s stated objective has been to keep inflation under 2% per year. However, Forbes wrote recently that, “after exceeding the 2% price stability target between January 1999 and October 2003... a first estimate of euro zone inflation data showed that inflation slid to an annual rate of 1.6%.” In the U.S., a similar trend has been developing. Fed Chairman Alan Greenspan recently told Congress: “Aggregate liquidity does not appear excessive. The monetary aggregate... actually contracted during the fourth quarter [of 2004]. All told, our accommodative monetary policy stance to date does not seem to have generated excessive volumes of liquidity or credit.” In other words, despite the rock-bottom interest rates, the inflation risk in the U.S. also remains “reasonably contained”, as Greenspan put it in his April testimony.

To sum up, despite similarly loose monetary policies and historically low interest rates, inflation remains surprisingly tame on both sides of the Atlantic, defying one of the basic principles of economics. The mainstream press has not talked about this phenomenon in over 50 years, but here it is: deflation. Our publications have been advising readers that deflation, not inflation, will be “the next big thing.”

Link here.


The Fed “controls” virtually nothing when it comes to rates, yields, and bonds. The so-called overnight (or discount) rate is the sole exception, and that is only for very short-term lending in a liquidity prices. The market sets the trend in rates. The 10-year Treasury note has closed lower for the past eight weeks in a row, to the lowest price level in nearly two years.

Does this matter to interest rates? Look up the trend in mortgage lending rates since late March (on bankrate.com, e.g.). The rate on a 30-year mortgage has jumped nearly a point since then. The question is not, What will the Fed do?, but WHEN will the Fed follow a trend that is already in place?

Link here.


[Note: Elliott Wave pundit Robert Prechtor aspires to “help subscribers understand how the prevailing negative mood would reveal itself in finance, the economy, politics and other social trends” (source), and has noted many times that the heros of a bull market often find themselves as defendants in the subsequent bear market. This is the latest example.]

Ken Lay, Martha Stewart, and now Frank P. Quattrone must have been the culprits who caused the recession of 2001 and are also responsible for the relatively poor performance of the economy since then. We can think of no other reason as to why the U.S. Government has embarked upon numerous criminal investigations of business firms and their executives. That certainly is not what federal prosecutors are saying, nor is the sycophantic press (like the New York Times) laying full blame upon these hapless people, two of whom are headed for prison after being convicted in federal court of “obstruction of justice”. Yet, it is clear that the government needs scapegoats for the poor economy, and since the feds are not blaming themselves, it must be these criminal business executives.

Quattrone is going to prison on an “obstruction of justice” conviction that in the real world of law and justice does not pass the smell test. Quattrone, writes the New York Times, “who helped ignite the initial offering boom in technology stocks, was to the 1990’s what Mr. (Michael) Milken and his junk-bond financing was to the 1980’s. Both devised new ways of generating cash that helped fuel a wave of innovation and a stock bubble.” The Times, not surprisingly, gets it only half right. Quattrone and Milken were financial innovators on Wall Street, but they did not create the stock bubbles that burst. No, as many writers on this page already have pointed out, that honor belongs to Alan Greenspan and the Federal Reserve. Greenspan, we should note, will be able to sleep in his own bed, not one of prison issue, as Quattrone will soon face. The markets responded to the perverse incentives of Greenspan’s new funny money in very predictable ways, or at least in ways predicted by the Austrian Business Cycle Theory. The trouble was when the government decided to investigate Quattrone instead of itself.

According to the government, when Quattrone heard that an investigation was underway, he told investment bankers who worked with him at Credit Suisse in Boston to “clean up those files”, which the feds declared amounted to a “cover up”. The question that leaps out at the curious observer, however, is this: What was “covered up”? Even after its investigation, the government concluded that Quattrone and his associates had committed no crimes. But in modern times, Congress has given prosecutors an inordinate number of “weapons” to use against anyone who is targeted, and there is no doubt Quattrone was a juicy target whose trial and conviction would bring many political benefits to the U.S. attorneys involved. The phrase “clean up the files” can mean anything. However, what the government wants us to know is that all business records, and about anything else that is in our possession, ultimately is the property of the state. This is an ominous message; it means that there can be no financial privacy whatsoever.

The lesson of the Quattrone case is not that one should “cooperate” with the government (whatever that means), but rather that modern federal criminal law has become the Theater of the Absurd. Law has lost its meaning in the federal system, and the popularity of the Quattrone verdict demonstrates that the political classes and all of the “masses” of people who have voiced approval of the conviction want to keep it that way. In the end, we do not have rule of law; instead, we have rule of very ambitious people who have been given the power to make the law whatever they want it to be.

More on this story here.


Every Presidential election year has its economic themes. In 1992, James Carville famously coined the expression, “It’s the economy, stupid!” I would like to propose a theme for the 2004 election: “It’s the spending, stupid!” The federal budget has gone from a surplus of $127 billion in 2001 (and a surplus of $236 billion in 2000) to this year’s Congressional Budget Office projection of a $477 billion deficit -- a flip of $713 billion in just four years.

Congress is now debating next year’s budget, which is expected to show a huge increase in both spending and the deficit. Plus Congress is working on a highway bill that adds more than $256 billion. Politicians of both political parties are trying to buy our votes with our own tax dollars. But don’t blame this year’s tax cuts for the deficit. The tax cuts -- everything from the top tax rate to the dividend tax cut to the ending of the marriage penalty and increasing the child credit -- lowered tax receipts by only $164 billion this year. The rest of that $477 billion deficit is being created by new spending.

And don’t blame the Iraq war and post-9/11 anti-terrorist measures for all that extra spending. A new study by Brian Riedl of The Heritage Foundation shows that defense spending and all 9/11-related spending amounts to less than half of the increase in government spending last year. The rest comes from a wide variety of programs passed by Congress. Examples of outrageous spending are not hard to find. ...

Link here.


Gold, silver, commodities, and commodity and precious metal stocks have had a steep fall over the past month or so. For example, Silver has fallen from about $8.50 to about $6.05 -- a fall of about 40% -- while gold has corrected by about 9% from $426 to about $390. Precious metal stocks have also taken it on the chin as illustrated by the decline of about 35% in the HUI index. Such a steep fall has many people worried sick causing a lot of angst at not having sold in spite of the timely warnings of so many knowledgeable people writing on gold and silver. The million dollar question is whether the holdings should indeed be sold/traded or held as an investment for the long term (if such a concept still exists today)?

A couple of morals drawn from a prior experience in the infotech stocks boom in India between 1997 and 2000:

  1. Large corrections in primary trends (bull or bear) are common in all markets in all asset classes. We must stay the course as long as the fundamental reasons have not changed. A change in the fundamentals alone warrants a liquidation of positions.
  2. I avoid trading and churning since I have interests in my professional life other than just buying and selling as an end in itself. Additionally, I am not so smart to keep calling the turns correctly, and I am worried that I might trade myself out of my positions prematurely.
  3. A blue chip company is less volatile, far more gentle on my stomach lining, and better for my sleep. The speculatives should be picked up later in the cycle. I invest so that my speculative investment is written off (subsidized from earlier profits) avoiding the unnecessary heartburn.
  4. The earlier corrections in a primary bull trend are designed to shake out the non-believers, traders, and the weak bulls. Conviction in the reasons for the existence of the primary trend helps us keep our mental balance and our positions.
  5. Lastly I avoid monitoring my net worth on an hourly or daily basis. Weekly (if you are compulsive) or monthly is a better frequency. I spend my time instead on tracking the market fundamentals always searching for that change in fundamental conditions which would then prompt me to begin liquidating or adding to my positions.

Incidentally NM Rothschild has exited the gold business of which they were active participants for the past 85 years! Rothschild’s withdrawal from gold is part of a complete retreat from the commodity trading business. This is as great a signal as any to contrarians and increases my conviction in the primary bull trend of the precious metals markets.

Link here. Gold market quotes available here.


The owner of the business that is my bankruptcy project for the day comes across as a decent enough guy, but not a detail-oriented, green eye-shade kind of businessman. For several years, he under-bid remodeling jobs, often to get his foot in the door and with the idea that he would make it up on that infamous “Change Order Number One”. Or maybe this guy bid the jobs correctly, from the perspective of a more perfect world, but he failed to keep a handle on his labor costs and production schedules. This owner stalled very well -- an optimist to the very end, he believed that he could if he could just “get a handle on it”, things would work out.

This project is not ENRON or Worldcom, but it is one of those 1.6 million bankruptcies that have hit the Federal Bankruptcy Courts every year of late. As to this particular bankrupt party, we are talking about the order of several hundreds of thousands of dollars of unsecured debt, almost all of it incurred for purchase of tangible assets or transient services. The assets and services are gone, used up, consumed, expended. The debt incurred to purchase the assets and services will, accordingly, just vanish into the ether. But moving back up the economic chain, that discharged debt will come out of the hides of vendors and jobbers and service-providers, as well as a couple of banks and insurance companies. One business failure infects and harms many other businesses.

The concept of credit implies a belief in, and reliance on, the future success and productivity of the borrower. The borrower has to have a run of good work and good fortune sufficient to repay the debt plus interest. Creditors need to keep in mind that not all borrowers will be successful. And creditors ought to keep in mind that borrowers of unsecured credit, well-intentioned though these borrowers may be at the outset, have even less incentive to be successful. Individuals, businesses, and governments, in the U.S. and in many other places throughout the world, have too much debt on their books. There is too much debt only because there is too much credit. From my humble perspective, as someone who deals with the discharge of debt, I cannot envision how most of the world’s debts will ever be repaid.

Link here.


On January 1, 2005 a largely forgotten provision of a 1998 tax law will finally kick in, allowing certain affluent retirees a chance to convert their traditional IRA accounts into Roth IRAs. That is one reason now is a fine time to consider a conversion. Another is that with the federal budget deficit mounting, tax rates probably are not going any lower and could soon head higher, making Roth conversions even more attractive now.

A traditional individual retirement account is funded with pretax dollars. Investments grow tax deferred, and withdrawals are taxed at ordinary income rates, with a current top federal rate of 35%. A Roth is funded with aftertax dollars, but any withdrawals made after five years and past age 59 1/2 are tax free. While you must begin withdrawing funds from a traditional IRA the year after you turn 70 1/2, you and your spouse can leave a Roth untouched and growing tax free as long as you live.

Now for conversions: You declare all or part of a traditional IRA as taxable income now, pay federal and state tax on that amount and then convert the money into a Roth. Roth conversions are allowed only for taxpayers with “modified adjusted gross income” of $100,000 or less -- before the income recognized from a conversion is counted.

Why would anyone elect to pay a tax now that could be deferred? Because your family could come out ahead, particularly if you pay all or most of the taxes due on the conversion with funds from outside your IRA and if you intend to leave the Roth to your kids or not tap it for many years. Remember to factor in state taxes, too.

Link here.


Hedge funds will suck in $100 billion this year from an ever-broader swath of investors. Pretty good for a business rife with exorbitant fees, phony numbers and outright thievery. It is amateur hour in the hedge fund business. This sideshow of sometimes bizarre (and always costly) investing is on a tear like never before. It is attracting some of the shrewdest and sharpest minds on Wall Street -- and also shills, shysters, charlatans and neophytes too crooked or too stupid to make any money for you. In 1990 only 600 or so U.S. hedge funds were in business. When we last surveyed the genre (August 6, 2001) there was $500 billion on the table. Now $800 billion is invested, says Hedge Fund Research, a hedge fund tracker, divided among 6,300 funds -- 900 of them less than a year old. Besides growth, there is a lot of coming and going in this business. More than 10% of hedge funds tracked by HedgeFund.net became defunct in the past year.

This year eager investors are expected to pump in $100 billion more. The scary part: Hedge funds were once targeted at high rollers who could put up $1 million without a wince, but now they are reaching out to the rest of us. What is driving this red-hot industry: fees that would be outlandish or even illegal if extracted from a plain old mutual fund. For customers the illusion is that the high fees go hand in hand with high returns. Do they? Yes, some funds have racked up stunning results. Others have gone bust. The winners you hear about. The others just disappear from the performance databases. So far the government crackdown, such as it is, has been mainly on the thieves, the operators who run off with your money. Vendors who are merely incompetent or greedy have free rein.

Link here.


Natural gas flares are blazing across swaths of Africa, Russia, Asia and the Middle East, burning off 10 billion cubic feet a day -- the equivalent of 1.7 million barrels of oil. There is more gas where that came from. Reserves of “stranded” natural gas -- the stuff that is abandoned because there is no economical way to transport it -- come to maybe 2,500 trillion cubic feet. If captured and converted, the gas would make (after conversion losses) 250 billion barrels of synthetics, from clean-burning diesel to jet fuel. That is like finding another Saudi Arabia.

For a century the world has been looking for economical ways to convert undesirable fossils like coal and methane (natural gas’s main ingredient) into desirable ones like diesel. Success may finally be at hand.

Link here.


Inflation is back. How much? What can investors do about it? Rooting around economic statistics, Roger M. Kubarych has built a case that the beast is returning. Fortunately he also has the outlines of a defensive portfolio. Kubarych is not so pessimistic as to predict a double-digit rerun of the 1970s horror show. He reads in the numbers a milder, though still vexing, inflation trend, reaching 3% to 4% annually in 2005. Beyond then, he cannot tell. The way for investors to combat the mounting inflation, he says, is through an amalgam of strategies ranging from betting against 10-year Treasurys to natural-resources stock plays.

If Kubarych’s inflation jeremiads sound something like those of Henry Kaufman, known in his heyday as Dr. Doom, there is a reason. He is Kaufman’s protégé. Kaufman, who won renown as chief economist at Salomon Brothers, wielded market-moving influence during the nasty inflation of the late 1970s and early 1980s.

Link here.


Among the lessons learned from the collapse of the Asian markets and the Russian default in the summer of 1998 was that all the smart people tend to come up with the same bright idea at the same time. We are in such a moment now. Hedge funds, proprietary trading desks, Appalachian coal producers, Indonesian copper miners and Argentine farmers are all long China.

One of the most interesting aspects of investing is observing the Law of Unintended Consequences at work and then identifying the opportunities this law creates. Interfering with the natural function of markets through pegging short-term rates at emergency levels, the Federal Reserve has created economic distortions. To keep the consumer consumption machine humming, it has been artificially subsidizing Ford and General Motors, Fannie Mae and Freddie Mac. The unintended consequence is the great speculative boom in once-neglected commodities.

By keeping short-term rates way too low for way too long, the Fed has pushed speculative capital into the commodities markets. This interference drove prices way, way up, a lot higher than they ought to be. Trouble is, they will not stay up forever. Rates are bound to go up and commodity prices down. And soon. We already have seen weakness in precious metals. It all will end badly for people who are long commodities. I do not buy the reflation argument (see article immediately above).

Higher rates in the U.S., the world’s largest economy, mean that capital will move elsewhere from expensively priced commodities. Higher rates in China will tamp down that nation’s torrid growth and thus its vast demand for commodities. We are experiencing a bubble in asset prices, assets from beans to bonds, metals to mansions. Where do you hide? Thanks to the Fed-caused distortions, everything is too expensive, hence ripe for a painful correction. Well, often the most difficult investment is the right investment, and today Treasury bills at 1% look right. But sell those coal, steel and mining stocks -- and closed-end China funds. Get paid (even if just a little) and wait for better opportunities.

Link here.


I am not wavering from my earlier (Feb. 16) forecast that U.S. stocks would be up 20% in 2004, even though the market has delivered a return of only 2% in the first four months. My reasoning had to do with the fact that most experts were predicting anything but returns near that 20% -- and that markets always veer off from the consensus forecast. Now here is another reason for a bullish view: Interest rates should also be more benign than what is expected in the consensus view.

Just as I do for stock markets, I build bell curves of professional interest-rate forecasts. This year’s forecasters universally called for rising rates, on both long- and short-term bonds. I say the crowd is wrong, and rates will be flat to down from where they are now. The crowd-is-wrong theory says that the 10-year Treasury note’s yield will end the year anywhere but in the 4.5%-to-6% range, where the experts’ darts are clustered. I do not see how the 10-year rate can wind up north of 6%.

Despite speculators’ huge bets on a falling dollar this year, the greenback has risen 2.7% against global currencies and almost all major ones, except sterling. The benign effect of Asian money supply expansion is low interest rates and high stock prices in the U.S. and Europe. Here are four ways to participate. They all relate to the auto sector, itself a prime beneficiary of low rates, which make its products more affordable to people buying cars on credit.

Link here.


For most American economists, sufficiently easy money is of infallible efficacy. The few instances in history when record-low interest rates persistently failed to work, like recently in Japan and during the 1930s in the United States, are summarily discarded with the argument that central banks failed to act fast enough. During the whole postwar period, it has, in fact, been typical that depressed economies promptly took off once central banks eased. Yet for us, this was never proof of the efficacy of monetary policy. Since all postwar recessions had their cause in monetary tightening, it was only natural that economies promptly jump-started when central banks loosened their brakes.

But the situation today is radically different. For the first time in the whole postwar period, the U.S. economy slumped against the backdrop of rampant money and credit growth. But if tight money or credit did not break the boom in 2000, it is hard to see how easy money can be the cure. What, then, brought the U.S. economy down in 2000? In short, several years of unprecedented credit excess. In both the U.S. boom-bust from 1927 to the 1930s and Japan’s boom-bust since 1987, extraordinary asset bubbles played a key role in escalating credit excess. The third, and probably worst, case of a “bubble economy” is the United States for the past several years.

Credit excess thwarts economic growth even in the absence of monetary tightening, through effects ambiguously known in Austrian theory under different labels: structural maladjustments, distortions, and imbalances and dislocations. The all-important question now, of course, is whether ultra-loose monetary policy and the associated development of asset prices have laid the foundation for a normal, self-sustaining economic recovery. Good luck, Dr. Greenspan.

Link here (scroll down to piece by Kurt Richebächer).


On the nature of money, capital, scarcity, growth and capital preservation. A wide-ranging discussion on investment issues with Sean Corrigan, the “Austrian-school” strategist of Sage Capital.

Q: [P]eople have been forecasting disasters forever. There are a number of people out there who make tidy profits preaching doom and gloom, but it never happens. Life just goes on. Now Buffett pipes in with such melodrama. It makes one stand up and take notice, no?

A: We should be careful of making the Sage of Omaha -- an investment genius -- into the Oracle of Omaha -- the possessor of an economic crystal ball: he himself would traditionally never have claimed any such a special insight. That said, when eminent investors such as Buffett, Sir John Templeton, Jim Rogers, and Pimco’s Bill Gross, as well as sober and well-regarded market analysts such as Richard Russell, express opinions ranging from caution to outright alarm at the state of play, we, too, should at least consider what it is that they see that the central bankers and their mainstream worshippers fail to recognize.

Link here.

Deflation unlikely, says Sean Corrigan.

Even in the face of mounting evidence that the Fed and its peers have uncorked the bottle which has largely contained the genie of higher prices for goods and services (as opposed to those for assets and property) for so long, there are respectable market commentators, among them the estimable Richard Russell, who still seem concerned about the prospects for deflation. Recently -- and very much in the same vein -- I was asked whether I agreed with the thoughts expressed by Robert Prechter when he wrote “The great irony is that paper money printing cannot result in inflation until the deflation is over and at the point it is not needed.”

My correspondent went on to inquire what I though of Prechter’s further argument, as he paraphrased it, that: “A corollary of deflation will be a soaring dollar, as demand for cash increases when debtors come to sell anything they can, at fire-sale prices, while its supply decreases as lenders restrict their activity.” Given the current state of affairs, it may be of some interest to others to read the reply I gave the gentleman concerned.

I would contend that while it is possible that the complexities of the intertwining of today’s overlarge financial architecture could contain all sorts of triggers and trip wires, or that unforeseen disasters and unintended consequences would abound, it is hard to see how the authorities around the world -- acting in concert, but led by the Fed -- would fail to find a vessel into which to pour all the new money needed to keep the system afloat thereafter. Certainly, some prices would thereby decline; some firms would go under; some banks would close their doors: but we can assuredly predict that the new money created as a countermeasure would end up boosting prices elsewhere and probably, on the aggregate, by more.

To see an instance of this, just look at the equities to housing switch, or at the marked private to public sector drift of the past three to four years, as the partial repair of the damage wrought upon corporate balance sheets in the late-1990s has been effected at the cost of the ruin of their governmental and household equivalents.

Of course, amid any such upheavals, we would undeniably be materially poorer -- capital would turn out to have been misallocated, the wrong skills acquired; business plans and personal ambition, both, would be thrown into disarray. But -- monetarily -- it is incomparably more likely that we will find our decreased prosperity takes the form of too much, rather than too little, money chasing what goods and services are out there for sale. Wheelbarrows and war finance are the main dangers to capital which lie ahead, not specie shortage and soup kitchens. Not at first, at any rate.

Link here.


Wednesday brought a cluster of real estate news: 1.) Home loan refinancings have “plummeted”; 2.) The average interest rate on 30-year mortgages just reached an eight-month high; 3.) Mortgage lending rates have climbed for eight consecutive weeks; 4.) Adjustable rate mortgages (ARMS) as a share of applications reached its highest level in 10 years; 5.) An exchange-traded fund that mimics REIT indexes (real estate investment trust) has lost nearly one-fifth of its value since April 1. The common thread is this: The real estate “boom” appears to be imploding. At the start of the year, real estate analysts were claiming “This ‘bubble’ won’t pop!”, and the number of newly-licensed realtors swelled to an all-time record.

The scariest of the facts above may be the ARMs data. People are frantically locking themselves into a payment structure that becomes more costly if interest rates go higher... but there is no “if” about it. The trend higher is unfolding already.

Link here.


A barrel of oil and the price at the pump are the highest in years. The U.S. trade deficit reached a largest-ever $45 billion. With less than six months until the next election, a sitting president’s approval rating fell below 50%. The U.S. is fighting a far-flung “war against terrorism,” and the loss of blood and treasure has no end in sight. Interest rates are climbing fast. The stock market is down on the year so far.

The percentage of homeownership among U.S. households is at an all-time high. Many economic indicators appear to be improving. Labor costs are low, productivity is high. The Federal Reserve has declared “that output is continuing to expand at a solid rate and hiring appears to have picked up.” The stock market remains higher than it was one year ago.

Consider the contrasts in the two paragraphs above. Both are factual; both describe the financial and social environment during recent weeks and months. Does it mock common sense that BOTH paragraphs are true? Not at all. In fact, it is what you should expect during the changing of a decades-long trend. A trend change always includes a time of “mixed signals”, when old emotions blend and overlap with the new. If it is a near-term trend, the new mood soon becomes clear.

But in a long-term trend change -- very long, in this case -- the confusion can last for years. The old optimism revives easily; thorny new facts may not look so bleak. But then other facts appear and the landscape looks thornier still. More and more people feel the sting, and follow their emotions toward any sign of hope. Japan’s Nikkei index, for example, saw rallies of 48%, 34%, 56%, and 62% during the 1990s, during a bear market that lasted thirteen years. A lot of hopes rose ... but soon enough those emotions crumbled to ever lower levels.

Look again at the FACTS in the top paragraph, and consider the trend they represent. Think back to the start of the year. Did the “Rosie scenario” crowd see any of it coming?

Link here.


I doubt that Alan Greenspan sleeps very well these days. Despite ultra-low short-term interest rates (negative when adjusted for inflation), highly expansionary monetary policies, a huge debt expansion, a declining savings rate, and a large and seemingly growing budget deficit, the economy and the stock market have only made very modest progress over the last 18 months. In addition, the stock market has hardly risen over the last three months, despite near-record equity mutual inflows of $75 billion since the beginning of the year. In Europe, the recovery in stock prices has also failed to erase the substantial losses that occurred after 2000. Although the German stock market is up by more than 60% since the lows in March 2003, it is still down by 55% from its March 2000 high.

In the United States, consumption has continued to grow, driven by asset inflation in the real estate market, but how sustainable is this debt-driven asset inflation, which keeps consumption up? Bridgewater Associates recently published a report entitled “Housing Price Blowoff?” and commented, “The recent surge in prices is above and beyond anything we have seen in history, both in a level and rate of change sense.” Housing prices relative to household incomes are at their highest level ever.

Mr. Greenspan has managed not only to create a series of bubbles in the United States, but also on a worldwide scale. The only problem is that more and more debt is required to sustain the housing asset inflation and keep the economy from imploding. From the 1950s to the late 1970s, $1 of additional debt generated between $0.50 and $0.70 of additional nominal GDP. However, more recently, $1 of additional debt has only managed to increase nominal GDP by around $0.20. In other words, in order to maintain its altitude, the pilot of the U.S. economic airplane needs to continuously increase the RPM of the engine. But aside from excessive profits for the financial sector and asset inflation, the increase in RPMs does not translate into the economic airplane making much headway, but will wear and tear down the aircraft’s engine before it reaches its final destination and lead to a crash landing (over-leveraged households without any pent-up demand).

In the meantime, the external imbalances (trade and current account deficit) have grown worse, and inflation, driven by rising energy, commodity prices and health care prices, is almost certainly much higher than what the government publishes. On the one hand, Mr. Greenspan must keep the housing asset bubble intact by keeping interest rates artificially low, which encourages even more leverage through strong credit growth; on the other hand, inflation is picking up and may at some point force the Fed to tighten, unless it wants to take the risk of being faced with soaring prices at a later stage.

In fact, we are in a rather peculiar and paradoxical situation, which can only lead to extreme financial vulnerability, because the best chance for the credit and housing asset inflation-driven economy to continue to do well is for the real economy to perform so miserably that no meaningful inflationary pressures come up. In sum, I remain convinced that the U.S. economy is heading into a brick wall. This brick wall may come in the form of rising interest rates, as a result of diminished affordability, or because of a sudden change in liquidity preference among end users and speculators. I must admit that I do not know how far away the brick wall is.

Link here (scroll down to piece by Marc Faber).


I place economy among the first and most important of republican virtues, and public debt as the greatest of dangers to be feared. -- Thomas Jefferson

The U.S.’s financial obligation is so big that it is hard to fathom. One way to look at it is to consider the fact that America’s annual deficit almost matches Canada’s annual GDP. We have reached a point where federal debt stands at a level equal to 4 times America’s GDP, equivalent to each American owing roughly $25,000. The nation’s ability to pay back what it has borrowed is next to impossible. It is probably safe to say that no empire has faced such a startling predicament since Rome.

America’s debt bubble has grown so big that there is only one way out -- inflating the dollar and reducing the real cost of its payments. In order to do this, the Fed will not be able to raise interest rates. The last time the Fed raised rates (1999 to 2000), it brought about a collapse in the stock market and a subsequent recession. Today the economy is far more dependent on asset inflation in real estate, stocks, bonds and mortgages. The long and short of it is that credit will continue to be expanded in this country until no more borrowers can be found. Then, when borrowing dries up, the government will become the borrower-of-last-resort, with the Fed monetizing all the government’s excess borrowing or budget deficits. This monetary inflation virtually guarantees a bull market in gold, silver and commodities.

Link here (scroll down to piece by John Myers).


The trade deficit swelled to an all-time high of $46 billion in March as a stronger U.S. economy stoked Americans’ appetite for foreign-made cars, TVs and other goods. Although imports grew faster than exports, sales of U.S. goods and services to other countries also climbed in March, to their highest level on record. This was encouraging news for U.S. manufacturers and exporters. America’s politically sensitive deficit with China widened to $10.4 billion in March. But U.S. exports to the country totaled a record $3.4 billion.

Link here.

The trade deficit and imports.

No aspect of international trade is talked about more and understood less than America’s perennial trade deficit. Critics of free trade, and most Americans for that matter, believe the trade deficit is prima facie evidence that American companies are failing to compete in global markets or that U.S. exporters face “unfair” trade barriers abroad, or both.

America’s trade deficit is not a cause for alarm. It results from a net inflow of foreign capital into the United States, capital drawn by America’s vibrant and growing economy. Without this capital inflow, domestic interest rates would be higher, investment lower, and long-term growth rates slower. Imports raise the living standards of U.S. workers and provide low-cost inputs and capital equipment for American industry. Imports help to create better jobs by allowing Americans to shift resources to sectors where we can be even more productive.

Link here.


When most energy analysts were calling for the price of oil to decline at the start of the year, Phil Flynn, vice president of Alaron Trading, was predicting it would climb to $40 a barrel. If that seemed like a wacky estimate at the time, it is all too real today. This week, Nymex crude oil futures closed above $40 for the first time in 13 years. So what is Flynn saying now? Even though oil prices have risen 25% this year, Flynn believes they could be heading higher still, possibly to $45 a barrel before they begin to moderate.

“I think that $45 area is going to do the job and lighten up the demand a little bit,” he said. “[But] I don’t see a crash in oil prices. Forty dollars is going to be the new norm.” If true, that bodes well for energy stocks, which are already expected to post record earnings in the second quarter. It bodes less well, however, for consumer spending.

Link here.


We are seeing days like we have not seen since the 2001-2002 period. And I have news for you -- it actually was not this bad even in 2001-2002. The breadth of selling has been immense in the past few weeks. I often take a look at the New York Stock Exchange Tick indicator; at any given moment, it shows you the number of stocks for which the last trade was an uptick minus the number of stocks for which the last trade was a downtick. For instance, if the Tick is +500, that means 500 more stocks upticked than downticked.

On any given day, the Tick will usually fluctuate between +500 and -500. Very rarely is the Tick greater than +1,000 or less than -1,000. The Tick’s lowest point in the past five years was hit on April 14, 2000, when the Nasdaq crashed and ended the boom. That day, the Tick reached -1,679.

The next lowest point for the Tick was -1,495, which it reached on two separate occasions. The first instance happened, as could be expected, in the week after the terrorist attacks, on Sept. 20, 2001. The second occasion was last Friday. In the past month alone, the Tick dipped below -1,300 on five different days -- and that has never occurred before. Mass selling unlike any we have seen in the past decade has been happening. The fact that there has not been an actual “crash” has hidden the fact that portfolio devastation has been brutal.

So what is the problem? A wall of worry is being rebuilt after it was largely smashed down in 2003. In April 2003, after three down years and a rebuilding economy, there were many reasons to buy. But that was a year ago. A multitude of concerns are being built into this market. When this wall is built, like all good walls, it will be scaled. But brick by brick, we are all patiently awaiting its finish, which will conclude when the aforementioned concerns and possibilities are all finally discounted by the market. It could be over, or there could be more to come. And then, regardless of the economy, global politics or the election, this market will go straight up.

Link here.


What if every place Warren Buffet turned for shelter were to quickly become an investment minefield? We can reasonably infer that this is not a hazard Buffett is likely to have dodged, given his well-publicized aversion of late for U.S. stocks and the dollar. Let’s give him the benefit of the doubt on the performance of his stock portfolio, since the Dow Industrials are trading only slightly lower than they were when the year began. But with regard to the dollar, after having shifted a reported third of his cash into foreign currencies, Buffett would appear to have been in the wrong place at the wrong time, at least since mid-February. That is when the greenback commenced its strongest rally in nearly a year -- a rally that continues to this day and which last Friday was spitting fire.

A few months ago I would have said that anyone diversifying out of dollars could not possibly go wrong. Now I am not so sure. My reasoning is based on lessons learned during the twelve years I spent on the options trading floor, and my speculative conclusion has less to do with economics than with the sometimes extreme irrationality of securities markets. Longtime subscribers will know that I have been sounding a deflation theme for years. At the outset, I was inclined to think that a deflation-bound economy -- particularly a global one -- would create the most challenging investment environment imaginable. And so it has. I have always believed that deflation would bring, not money-making opportunities, but rather a prolonged period of economic adversity during which even the savviest investors would be challenged to hold onto 30%-40% of their original net worth.

I was laying it on a little thick, perhaps, just to make the point. But not now; for if the likes of Warren Buffett can get hijacked doing what is very arguably the right thing, then what chance do the rest of us have of protecting our nest eggs, never mind making a bundle? This is mainly because there is no easy way to leverage a deflationary bust -- there is no way to short the residential real estate market with ten-for-one dollars.

It is absolutely crucial to understand that deflation will not be dot-com mania in reverse. There will be no penny shares whose value increases ten-thousand fold, nor will there be pictures of “Deflation’s Newest Billionaires” on magazine covers. At best, as asset values fall, the most astute investors will be the ones who can resist buying the formerly $6 million Aspen ski chalet for $4 million. They will have the imagination to see that the same house could conceivably go begging for $400,000 before deflation has run its course.

For many of us, the big question is whether gold will prove to be the perfect hedge against a deflationary bust that has been taking shape for more than ten years. I had thought it would until recently. After all, I reasoned, the U.S. dollar is already intrinsically worthless, and it is therefore only a matter of time before everyone figures this out and stampedes into tangible assets, especially bullion. But Buffett – and millions of other investors, most particularly precious-metals bulls -- could be very much mistaken in assuming that a weak or even worthless dollar cannot soar, at least for a while, for reasons wholly unrelated to its fundamental value. I have seen this occur on the trading floor too many times to ignore the possibility it could happen to the dollar.

Most of the world’s hundreds of trillions of dollars of debt is denominated in dollars, and this debt represents, implicitly, a massive short-position against the dollar. As such, all borrowers of dollars should be praying for inflation, since it would allow them to pay back what they owe in cheapened money. But unless Murphy’s Law is suspended for the next ten years, we may reasonably infer that borrowers are not going to get off quite so easily, especially since all it would take to crush them is a modest rise in lending rates.

This is the very crux of the coming deflation as well as the basis for a potentially sensational rise in the dollar that almost no one expects. As a mechanism to cleanse the economic system -- to cleanse capitalism, if you will --- the scenario has the “virtue” of outfoxing not only gold-bugs who trust that the dollar’s inevitable decline will make bullion far more precious, but also financial world-beaters like Warren Buffett, who perforce do not come naturally to the idea that cash may be the best asset to hold for the next several years. A strong dollar -- one impelled by uncontrollable market forces rather than by Fed whim -- seems the most likely catalyst for a deflationary collapse, albeit the one least expected. For gold bugs, such a volatile period would pose a particular dilemma, since bullion’s eventual rise, though absolutely assured, would come only after the pain of deflation had caused the central bank to shovel money out the door. Meanwhile, we should not pretend to be mystified if the dollar’s supposed bear rally steepens and bullion remains leaden. A “worthless” dollar may yet have the last laugh on all those who have rightfully disparaged it.

Link here.


Investors should never allow fear to drive their decisions. Fear has the near-universal effect of making individuals exit a winner too soon, and cling too long to a loser. This emotion is also the most infectious at the worst moment -- during times of panic selling or even panic buying. Still, there is a context when fear can actually be financially beneficial: namely in a “context” where you are on the outside looking in. This can happen if you understand the role of fear in crowd psychology, and have the means to measure the level of fear at a given juncture.

In general, fear is the most widespread near a major stock market low; conversely, fear diminishes near a major top. As for actually measuring the emotion, one of the best gauges is an index that measures the premium that traders place on a certain basket of equity options. Right now, this index stands near an eight-year extreme -- fear has all but vanished.

Link here.


Credit spreads continue to widen as rates increase. From the “narrow” of 286 bps in early April, spreads for Turkish obligations, over treasuries, have widened to 568 bps today. The yield went from 7.05% to 10.45%. On the same move, Brazilian issues have widened from 462 bps to 670 bps as yields increased from 8.55% to 11.47%. In the U.S., the high-yield spread widened to 252 bps on Friday. The breakout is at 265 bps and this is lagging other issues with spreads for medium and high-grade corps making new “wides” for the move. This represents a serious loss of global liquidity which was led by the bellwether 10-year swap spread, which reversed to widening at 36.5 bps on March 23. Now it is at 54.25 bps.

The Problem: Spreads are coming off a unique speculation. The breakdown in base metal prices this week sets a cyclical bear which, in the past, has been accompanied by a cyclical decline in S&P earnings. This is anticipating a serious reduction in the ability to service debt.

The Outlook: Credit down ratings could be the theme by October. Beyond this cyclical problem, the unwinding of the massive “carry” trade will likely force some big defaults -- perhaps not as big as Long Term Capital Management though.

Link here.

The Echoes of History

As the Fed prepares to raise interest rates, the financial markets are bracing themselves for a reversal of fortune every bit as painful as the one they suffered ten years ago. When the Fed doubled rates in 1994, to 6%, bond yields shot up, the mortgage-backed securities market fell apart and stockmarkets had a horrid time. So did emerging markets: spreads over Treasuries on emerging-market debt soared and the year ended with Mexico’s tequila crisis. Memories of that carnage continue to haunt dealing rooms around the world, which is one reason why markets have been so spooked by a mere hint from the Fed that it will put up rates at some point.

Many strategists are wondering, and worrying, about a possible repeat of 1994. The Fed -- whose chairman, Alan Greenspan, was also in charge back then -- is all too aware of this. But investors are always prone to think that this time things are different. Few of those that were around in 1994 are the ones making the decisions now; everyone is under pressure to generate stellar returns in an environment of rock-bottom interest rates, and they all seem to think that they can get out before being trampled under foot by everyone else heading for the exit. For a variety of reasons, events might turn out even nastier than they did in 1994.

Link here.


How clever, we thought: Jim Carrey’s new movie. According to the reviews, a couple decides to divorce... and to scrub their minds of all the unpleasant memories of their union. We can imagine what happens next... the way is now clear for the couple to fall in love again.

All memory of the unpleasant way things often turned out in the ‘30s, ‘40s, ‘50s, ‘60s, ‘70s... and much of the ‘80s and ‘90s, too, has been laundered out. Our minds are spotless. It is too bad. We need history. Few imaginations are wild enough to compete with the actual facts. From our minds, all memory of what happens to markets has been erased; we think prices only go up. Our spotless minds hold no dirty examples.

In 1980, the U.S. had a positive trade balance and Americans were net lenders to the rest of the world. The country was at peace. Republicans claimed they believed in balanced budgets. People still held parties when they paid off their mortgages. Paul Volcker said he would bring down inflation rates... and meant it. Ronald Reagan was president. You could buy a stock for 6 times earnings... and lend your money to the U.S. government for a 15% yield. Lenders demanded that much, because they remembered the inflation of the ‘70s. They knew that not every investment story had a happy ending.

A quarter of a century later, everything has changed. Our minds have been cleansed of all nasty recollections. People judge it only a third as risky to lend money... as if we will live in eternal sunshine. Once again, investors have fallen in love.

Link here (scroll down to piece by Bill Bonner).


Warren Buffett once told his shareholders “correctly observing that the market was frequently efficient, [the efficient markets enthusiasts] went on to conclude incorrectly that the market was always efficient. The difference between the propositions is night and day.” The problem is that, like the contemporary mainstream economics that subsumes and inspires it, MPT dismisses individuals, subjectivism and entrepreneurship to the sidelines. To MPT’s adherents, things like flesh-and-blood individuals, their inspirations, values, plans, time preferences and the businesses they found and build, may just as well not exist. There are only aggregates, omniscient and benevolent governments, arid models, lifeless data and stylized behavior. Hence there is simply no room for the inspired (or, for that matter, misguided) capitalists, investors and businessmen whose behavior does not conform to the straightjacket into which MPT confines them.

If MPT is correct then advanced mathematics and other technical expertise, computers and automatic pilots are essential -- and historical perspective, qualitative judgement and cautious analyses of individual businesses, their operations and prospects are pointless. If it is correct then the confident “rocket scientist” armed with a Ph.D. is indispensable and the sceptical businessman-investor with skin in the game and a successful track record, like Graham or Buffett, is superfluous. MPT attenuates the individual, the particular case, common sense and tacit knowledge; and it accentuates the abstract, aggregate, technical and esoteric. In so doing, it encourages centralized decision-making in the hands of a technocratic elite. In a Keynesian world, in turn, elites of any stripe tend to be arrogant, error-prone and insulated from the consequences of their regular and occasionally mammoth blunders. Accordingly, MPT, as the Crash of 1987 and The Great Bubble amply demonstrated, actually facilitates moral hazard (i.e., risk-seeking behaviour), turmoil and the destruction of capital.

We have academics to thank for MPT, business schools to thank for academics, universities to thank for business schools and politicians to thank for universities. The policies of the best and the brightest produced disasters in the 1970s -- not to mention the 1930s, 1940s, 1950s, 1960s, 1980s, 1990s and during The Great Bubble -- and, given this sorry track record, there are ample grounds to fear that they are also doing so today.

Link here.


The NASDAQ topped out on March 10, 2000, at 5040. From there, it reached a low of around 1100 in October, 2002, and is now in the range of 2000. The price/earnings (P/E) ratio was over 200 in December, 1999 -- a classic sign of a mania. Yet the NASDAQ was considered a no-lose market, the wave of the future. It was a wave, all right, in what surfers call a wipe-out. Vitually no one in the conventional business press sounded a warning that any collapse of this magnitude was imminent. In the collapse, trillions of dollars in paper wealth melted away.

The best and the brightest young adults in the United States attend a few dozen colleges and universities. They are taught the same outlook. They adopt the same attitudes. They come into contact with each other. They create life-long networks: employment, marital, social, cultural. We hear all about diversity these days, yet we live in an era in which diversity is rapidly disappearing at the top. Educated people know the premier schools. The list does not change much, century to century. The graduates of these institutions run the nation. I do not just mean run it politically, although that is more obvious this year than ever before (Skull & Bones’s triumph). I mean in every field that requires formal screening and certification. The up and coming foreign policy elite in China are graduates of the elite American universities. They think like all the other graduates.

About 3,000 to 5,000 fund managers make most of the capital allocation decisions in the United States. They talk to each other, read the same investment magazines, and use similar formulas to assess potential risks and rewards. In short, they run in packs. They are agents of the wealthiest 20% of all Americans -- and, increasingly, the world. It was not the broad mass of Americans who were caught up in the NASDAQ bubble, but the fund managers, who are highly educated, well-paid professionals. They funded the NASDAQ mania with other people’s money.

When some entrepreneur gets rich in China or India -- and millions of them have -- they look for diversification. They get rich in one field, but they have so much money that they want to put some of it abroad, “just in case.” For them, buying investmenting in the U.S. markets is diversification. Yet from the point of view of the P/E ratio in the United States, it is mania investing. It is Son of NASDAQ. The comparative honesty and reliability of America’s state-registered capital markets has created a gigantic sink-hole of wealth. The P/E ratios of almost any asset class in the United States are so high that any successful entrepreneur can make at least five times as much in his own business. Yet in their quest for diversification, the world’s most successful investors are betting on America’s capital markets. This has created a worldwide mania. America has become NASDAQ nation.

What appears to be diversification is in fact a massive international misallocation of capital into officially approved channels. The mania phenomenon appears to be rational because most of the smart money is pouring into a narrow class of assets. It is like a roulette table that everyone knows is rigged, yet they still play. Why? “It’s the only game in town.” Find another town.

Link here.
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