Finance Digest for Week of June 14, 2004

100 YEARS OF MEDICAL ROBBERY

This past weekend (June 11-13, 2004), the American Medical Association (AMA) celebrated the 100th anniversary of its Council on Medical Education. The medical establishment understandably sees the formation of the Council as a good thing. However, some patients are not ready to celebrate yet, and their instincts may be good. For the sake of all our health, hopefully there are not too many more anniversaries to come.

MOST U.S. TREASURY BONDS IN FOREIGN HANDS

Demand for US government bonds at foreign central banks has for the first time lifted overseas holdings to more than half the paper in circulation. Figures from the Federal Reserve reveal that $1.65 billion, or 50.6% of liquid Treasuries, were held by foreign investors at the end of the first quarter. Foreign ownership of the bonds rose by $170 billion between January and March, with central banks -- mainly in Asia -- estimated to account for about $96 billion of this.

The appetite for Treasuries has been fuelled by attempts to slow the appreciation of national currencies by buying dollars and investing the cash in Treasury bonds. The Bank of Japan, the biggest foreign investor in US Treasuries, spent Y15,200 billion ($138 billion) on currency interventions in the first quarter. The surge in foreign central bank holdings has defied a sharp fall in Treasury prices, and a concomitant rise in yields, raising fears the market could fall if buying by the small number of official sector buyers slows.

Ten-year Treasury bond yields have jumped 1 percentage point since the beginning of May to 4.81% last Friday. But yields remain low compared with US economic growth, driving expectations of more losses. A further threat to the Treasury market comes from the surge in oil prices, which puts upward pressure on inflation and interest rates. Tuesday’s US consumer price data for May are expected to show the annual inflation rate rising towards 3%.

The Fed is expected to begin tightening monetary policy at its next meeting on June 30. Interest rate futures last week implied a significant chance that the Fed will raise US rates by 50 basis points to 1.5% this month. Developments in Japan are also worrying bondholders. Growing signs that Japan’s economic recovery is sustainable sent yields on local government bonds to 3½-year highs last week. If Japanese government bond yields continue to rise, domestic investors may bring some of their overseas investments back home.

LONDON LEAPS TO #2 ON MOST COSTLY CITIES LIST

The surge in the value of the pound has catapulted London close to the top of a league table of the world’s priciest cities. Britain’s capital leapt from seventh to second place, overtaking Moscow, Osaka, Geneva, Hong Kong and Beijing -- although it was still far short of Tokyo. London is now 19% more expensive than New York, a massive increase from last year when the two cities had roughly the same cost of living. The survey, produced by Mercer Human Resource Consulting looks at the cost of living for expatriate workers rather than the local residents.

INVESTORS LOOK AT ALTERNATIVE FUELS

High oil prices and political instability in the Middle East have led to an increase in interest in alternative fuels which could in turn benefit investors, say experts. “The growing demand for alternative technology with which to distribute energy means there are more prospects for investors interested in this sector,” says Brian Dennehy at independent financial advisers Dennehy Weller & Co. “Green or environmental funds are benefiting because alternative energy sources now seem a lot more economically viable.”

Following the power blackout in the north-eastern US and parts of Canada that affected more than 50 million people last August, the Merrill Lynch New Energy fund jumped by 10% in one day. American Superconductor, which makes superconductor wires used in electricity utilities, was the most heavily weighted stock in the fund and rose by more than 40%. In spite of a disappointing start after its launch three years ago, the Merrill Lynch New Energy Technology trust has risen by 51.6% in value over the last year.

Other funds in this sector such as the Morley Sustainable Future UK Growth fund rose by 15% and Henderson Global investors Global Care Income fund rose by 9.4%. Sarasin’s Multi Label New Energy sterling fund, based in Luxembourg, rose by 32% over the last year. Dennehy warns that although firms are constantly seeking out alternatives, many will fall by the way side. “That’s when it helps to be in a fund because while some companies may not work others will do very well so you are spreading the risk. Within a fund you can afford to have one or two failures.” However, he advises that while these funds offer high returns they should only make up a small part of your portfolio.

For investors, playing the energy game can be tricky.

The price of crude oil can be a mirage. Oil is off its recent high of $42.38 a barrel to the $37 range since Saudi Arabia agreed to boost production. But it is hard to find anybody who does not expect a lot more volatility over the next few months. The fear factor of terrorism, a prolonged strike by Nigerian oil workers and the loss of a major Iraqi pipeline due to sabotage could push up the price of crude. “Wall Street believes the real price of a barrel of oil is in the mid-$20s,” said Jim Melcher, president of Balestra Capital, a New York firm that runs the Balestra Capital Partners hedge fund. “We think it’s well into the $30s. In five years, it will be $10 or $20 a barrel higher than it is now.”

The disparity in views about the future price of crude is just one reason why it is tough for investors to play the energy game. Another is the number of choices. Should you buy drilling companies, for example, or pipeline companies or energy mutual funds? For tips on investing in energy, here is advice culled from Melcher; Michael Kitces, director of financial planning for Pinnacle Advisory Group, a money management firm in Columbia, Md.; and Bob Spira, chairman of Chapman Spira, a New York investment banking firm, who has been investing in oilfields for many years.

TEN LAWS OF 21ST CENTURY FINANCIAL SCIENCE: A CORE COURSE IN FINANCIAL ENGINEERING

As visitors of this site are well-aware there are many developments in the financial and political arenas that give cause for concern. Included are the war on Iraq, the notion of increased wealth due to higher asset prices and the easy credit fostered by the Fed. Right along these lines is the quarterly “Flow of Funds” report issued by the Federal Reserve last Thursday where it reported that U.S. household wealth grew to a record-high $45.2 trillion in the first quarter of 2004, boosted by rising real estate and mutual fund values. At our college’s commencement ceremony a few days ago, as I was contemplating on these events and the responsibility of Colleges and Universities in developing the “human geniuses” that have driven these developments my attention turned to the discipline du jour -- “Financial Engineering.”

Back in the dark ages (the ‘70s) when I was in college, engineering referred to the application of scientific principles, especially those related to the properties of matter, to create physical products useful to the human race. How grossly ignorant have I been all these years! We have come up with “software engineering” to bestow scientific grandeur to the practice of writing software (hacking). Nowadays leading educational institutions like Columbia, MIT, Northwestern, etc. all offer programs leading to degrees in “Financial Engineering”. I have started preparing my course material for FE 101, Ten laws of twenty-first century financial science (revised 2004). Once you have mastered these ten laws, you can then take FE 201: TAPS (Taking Advantage of People’s Stupidity) and FE 202: SITS (Sock it To Shareholders).

THE FORTUNE OF LOSS

“People who cannot know what will make them happy tomorrow might be unable to resist short-term oriented investment strategies today.” -- Seth Klarman, Annual Letter 2003, Baupost Limited Partnership

Harvard psychologist David Gilbert studies the question: How good are people at predicting how future events will affect their happiness? Gilbert studies something called “impact bias”. If you think getting a big pay raise will make you very happy for a long time, and it only makes you marginally happy for a few hours, your impact bias is large. If you do not expect a raise and do not get one, your impact bias is zero. For most people, Gilbert concludes, impact bias tends to be rather large. In other words, most people simply do not know what they want. People are not unhappy because they cannot get what they want. People are unhappy because they do not have a clue about what they want in the first place.

The consistent failure of those who frequent the public equity markets and other gambling establishments falls hard upon Gilbert’s findings. People who do not really know what they want cannot resist short-term, momentum-oriented “investing” strategies. Yet it is well known that about 90% of all day traders in the market today will be out of money within a year. It is even better known that nearly every mutual fund manager will fail to beat the market. They all think buying stocks will make them very happy very soon. An enormous impact bias awaits them.

What about those successful investors? What is their experience like? Does their long-term investment success feel good every step of the way? Is it made up of a series of pleasurable short-term gains? Or does getting rich investing in stocks require significant periods of underperformance, and the pain of holding losses, sometimes for years at a time? Consider the track records of Warren Buffett and those of funds and investors who follow a Buffett-like, long term value investing, approach: The Oakmark Fund, Longleaf Partners, Third Avenue Value Fund, Clipper Fund, Tweedy Browne...

All the most successful investors under-perform in the short-term sooner or later. If you want to get rich in the stock market, you have to know what to expect, not merely for the next few days or months, but for the next several years -- no matter what the spam in your e-mail inbox tells you. You have to be able to stick to your guns for five years at a clip without even beating the S&P 500. You have to be so confident in your approach that you never waiver from it, even when there is zero short-term success to brag about. (Oh yes, and your approach has to be one that works.)

Conclusion: 1.) you need rational expectations and a long-term view to get rich investing, and 2.) that a disciplined, highly selective, value-oriented approach, adhered to religiously over a period of many years, is your only hope of getting rich by investing in stocks.

DOES THE MARKET HAVE “A LIFE OF ITS OWN”?

The Treasury market saw a large price jump today: If you bother to read about it in the financial press, the stories will attribute the move to “the Fed”, “consumer prices”, “less concern about inflation”, etc. -- some explanation that is external to the market’s action. What you will not read from those conventional sources is a single word about pattern, sentiment, or cycles -- the internal measures that focus exclusively on the market itself.

If there has ever been a “distinction with a difference”, this is it. Externals are an arbitrary, helter-skelter, after-the-fact method of analysis: somebody said something, or somewhere something happened. Internals, on the other hand, begin with the fact the market has a life of its own. Best of all, the market’s internals allow you to look forward -- you can spot important turns and trends before the fact.

AS U.S. REAL ESTATE TRUSTS COOL OFF, THINGS ACROSS THE POND ARE HEATING UP

U.S. real estate investment trusts, commonly known as REITs, have delivered sterling five-year returns, averaging 19% a year. Little surprise that $4.5 billion was plowed into mutual funds holding REIT shares last year. These trusts, which hold property like office buildings or malls, pay plush dividends from rental rolls.

Great for those who got in early, less so for those buying late, after the REIT share price run-up. Dividend-hungry folks now are staring at a 16% premium to the net per-share value of underlying assets for the average REIT stock. That is triple the premium in the last decade. A correction is under way as interest rates creep up. So thus far this year American REITs are down 1%.

But the party is just getting started in France, the Netherlands and soon in Great Britain, where the REIT concept is just beginning to catch on. New Zealand, Australia and Japan have REITs, too. Germany, whose banks hold a lot of property and would like to free up capital, is considering introducing REITs. The fever to join in also is rising in Finland and Italy. Because Europe is only now pulling out of its economic doldrums, its REITs are the cheapest, selling at a discount to their underlying property valuations.

IT’S THE BUBBLES, DUMMY

The creation of a huge carry trade in bonds was crucial in lowering mortgage rates. Consequently, a massive mortgage refinancing bubble was provoked, characterized by massive home equity extraction. This freshly created equity provided the funds for simultaneous bubbles in housing and stocks. Soaring pseudo wealth was then offered as collateral to facilitate the borrowing binge. All of a sudden, sliding asset prices have hammered these highly leveraged asset and credit bubbles. Ironically, the trigger was pulled by a string of strong economic data. Fretting about higher inflation and a possible hike in short-term rates, heavily leveraged investors started cautionary liquidations. But given the leverage, more and more selling was bound to follow. In short, investors had simply become too optimistic, giddy from the artificially low interest rates.

There can be no question that, in time, badly performing financial markets will take their toll on general sentiment. The change in sentiment always comes after the markets have already declined dramatically -- falls that most people are not prepared for. Thanks to all the bubbles, the American consumer borrowed a mind-boggling $879.9 billion last year, having borrowed $775.7 billion the year before. However, most of the borrowed money went into housing and stock purchases, fueling the rise in their prices, rather than into living expenses.

In the late 1990s, the necessary funding for the stock market came primarily from American and foreign corporations through huge stock buybacks and frenzied merger and acquisition activity. Since 2000, all buying on these accounts has vanished. Last year, private households stepped in as the standalone buyer. With poor income growth and virtually no savings at their disposal, their stock buying implicitly depended on heavy borrowing from the mortgage-refinancing boom. But having largely depleted this source of funds, we see a grossly overvalued stock market without any potential buyers.

During the past two to three years, the U.S. economy and its financial system obtained an unusually high dose of monetary and fiscal stimulus. Yet it was really the interplay of three bubbles -- in bonds, housing, and mortgage refinancing -- that enabled the consumer to sustain such an elevated level of spending. Manifestly, these policies, having involved heavy rigging of markets, were a palliative that prevented disaster for the U.S. economy in the short run. But instead of redressing the economic and financial imbalances from the prior boom, these policies propelled the imbalances to new extremes. It is our view that the leverage used in the carry trading of bonds, in particular, has grown to such an absurd scale that orderly deleveraging is now impossible.

To point out the obvious: The asset and credit bubbles that have been inflating consumer spending undefined bonds, stocks, mortgage refinancing undefined are plainly deflating. The property bubble will soon follow for lack of funding. In short, we see savage deflation for the asset markets, but stagflation for the economy -- and it is so obvious that no one can see it. This will soon change.

MONEY “MANAGERS” WITH ONE EYE SHUT?

It is not news that most investors have made mutual funds their financial vehicle of choice. This choice is measurable. The number of U.S. mutual funds actually surpassed the number of publicly traded stocks during 2001; and as the number of funds held steady for the past three years (around 8,300), the number of publicly traded stocks has been shrinking since 1997. By holding some $6.4 trillion in assets, the mutual fund industry can collect $100 billion in costs and fees each year. What do fund investors get in return? In two words: Not Enough.

Most stock mutual funds underperform the S&P 500; most investors in mutual funds underperform the funds themselves, because they hop from one “hot” fund to the next -- a practice that is hardly discouraged by the fund industry. All this said, I was recently reminded of a Wall Street Journal story that revealed one of the most amazing facts I have ever read about mutual funds: Nearly half of all funds do have permission to “short sell” stocks ... yet just 6% of them actually did so during a recent six-month period, according to the S.E.C. Thus, in a market where trends go in two directions, the people who manage the money are either forced or choose to invest in only one direction. This amounts to deliberate and/or willful blindness to opportunities that can and do appear in the market. What is more, it dooms investors to being stuck with that one direction, when the long-term trend goes the other way.

THE STORY OF THE FED IS A STORY OF A CRIME

“The magnitude by which [the reality of the Federal Reserve] deviates from the accepted myth,” writes G. Edward Griffin, “is so great that, for most people, it simply is beyond credibility.” But as he makes abundantly clear in his landmark book, The Creature From Jekyll Island, now in its fourth edition, the case against the Fed is overwhelming. Creature, as Griffin explains, is four books in one: a crash-course in money and banking; a history of central banking in America; a discussion of the Fed itself and its role in American and world affairs; and finally, a detailed look at how the Fed and other central banks become “catalysts for war”. Without central banking, much of the carnage of the past 90 years would not have been possible.

In November 1910, seven men representing roughly one-fourth of the world’s wealth took a clandestine train ride from New Jersey to a resort on Jekyll Island, Georgia, ostensibly to hunt ducks. But instead of shooting birds, they shot us the bird and drew up plans for a cartel, which served as the blueprint for the Federal Reserve Act of 1913. For years, most people left the Jekyll Island tale for the fringe that loves conspiracy theories. But gradually the story leaked out, beginning with an article by B. C. Forbes, the future founder of Forbes magazine, in Leslie’s Weekly in 1916. Following discussions with Paul Warburg, the Fed’s chief architect and one of the Jekyll attendees, Forbes confirmed the trip in his opening paragraphs. Later writers, including some of those in attendance at Jekyll Island, corroborated Forbes’s story.

The American people, of course, have been handed a thoroughly scrubbed version of the Fed: It exists to stabilize the economy and protect the public. Never mind the crashes in ‘21 and ‘29, the Great Depression from ‘29 to ‘39, recessions in ‘53, ‘57, ‘69, ‘75 and‘q81, another crash in ‘87, a bear market in 2000 that wiped out $7 trillion in stock market wealth by 2003, and constant inflation eating away 95% of the buying power of the dollar. As economist Antony Sutton noted, “Warburg’s revolutionary plan to get American society to go to work for Wall Street was astonishingly simple ... The Federal Reserve System is a legal private monopoly of the money supply operated for the benefit of the few under the guise of protecting and promoting the public interest.”

Griffin is detailed and clear about how the Fed works. In the old days, when governments wanted more money but were afraid to increase taxes, they printed it and forced citizens to accept it by making it legal tender. It was too crude a scheme to fool most people, but now, with modern central banking, the theft is virtually imperceptible. In his 1919 book, The Economic Consequences of the Peace, John Maynard Keynes wrote that by “a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens ... and, while the process impoverishes many, it actually enriches some. ... The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” Griffin lifts the curtain on the Fed’s operations and exposes it for what it is: a counterfeiting cartel in partnership with government soaking the blood and treasure of our country.

FOR THE CAUTIOUSLY OPTIMISTIC

In a 2001 Barron’s interview Jeremy Grantham unveiled the conclusions he had drawn following an extensive study of market bubbles, including stocks, bonds, commodities and currencies -- 28 bubbles in all. Grantham and his associates defined a bubble as “a 40-year event in which statistics went well beyond the norm, a two-standard-deviation event.” Grantham noted that, “Every one of the 28 [bubbles] went back to trend, no exceptions, no new eras, not a single one that we can find in history.” If you were a bully and you pressed our backs tightly up against a chain link fence, in fact you would sooner hear us squeal “Dow 3000” than 13000... or even 12... However, today’s essay is a nod to optimism, albeit a cautious one.

We have just put down friend and colleague John Mauldin’s new book, Bull’s Eye Investing: Targeting Real Returns in a Smoke and Mirrors Market, and would like to recommend that you buy a copy and read it. Today. Mr. Mauldin argues forcefully, for six chapters, that we are in the early stages of a secular bear market in U.S. stocks. Mauldin shows -- citing studies that would make any market historian swoon -- that when valuations reach the levels they are at today, investors have always been better off investing in money market funds over the following ten years. But what fun is that? After Mauldin gets done thoroughly discouraging his readers... he offers many a ray of hope -- cautiously, of course.

John cites research that found that neither “under-confident” investors nor perma-bearish sentiment could survive in the market. Massively “over-confident” or bullish investors likewise lead themselves to the slaughterhouse. Only the investors who are cautiously optimistic were able to, not only survive, but also win.

Investors, Mauldin suggests, continually make the mistake of substituting familiarity for value-based research and reason, basing their investments and their future on false confidence that, in the end, leads to disaster. Just because we know a lot about an investment does not mean it is a good one. So where does Mr. Mauldin find the right kind of confidence? In a true sense, that search is the unstated theme of his book... and it comes from several sources. First, it is the steady march of history. Mauldin sees the stock market, currencies, commodities, bonds, interest rates -- in short, everything -- as subject to historical, economic and fundamental forces. Finding these forces and investing with the trend -- rather than against it -- is the key to confidence.

Every chapter of Mauldin’s book is grounded in history... yet he steps out on occasion and deigns to predict the future. Mauldin believes that value is the driver of market cycles. His chapters on value investing may be considered as essential reading for the individual investor. Mauldin’s data mining on “behavioral investing” is worth an entire book of its own. How can you be in the top 10% of all investors over the next ten years? You do not have to shoot for the moon or take great risks. If you can beat the average -- each and every year -- in the end you will be among the most successful of investors on the planet.

CAVALIER EXPECTATIONS IN CALIFORNIA

Recently, I visited a house that was advertised for rent in the Orange County Register. The house was approximately 15 years old, 2,600 square feet in size, and located on a 10,000 square foot lot in a gated community about 30-40 minutes inland from the Pacific Coast. They wanted $3,900 per month in rent. There was nothing particularly special about this place, it had a nice view of the hills, but there was no swimming pool, Jacuzzi, upgraded flooring, elaborate stonework or even an in-built barbeque. This was just a typical middle-class residence. When I arrived, the real-estate agent who was representing the owner, and upon whose advice this property was recently purchased as an investment, greeted me.

Being curious, I asked the agent how much money his client had paid for the house. The house had sold for $1 million he replied. I then inquired how much his client might incur as a result of the annual taxes, homeowner’s fees, gardening, insurance, routine maintenance, and other monthly expenses in owning this house. He estimated such expenses to be no more than $1,500 per month. I then pointed out that, with a monthly rent of only $3,900, and monthly expenses of $1,500, the net rental income of $2,400 would certainly leave his client in a position of negative cash-flow after interest expenses.

I than asked him why he would recommend making such an “investment”? His reply was that since his client had plenty of income from other sources, that this particular purchase did not put him in a negative cash flow position. I reminded this agent that each investment must be evaluated on its own merit, that this particular “investment” reduces his client’s income and that his client’s past successes did not justify making foolish investments now. At this point, not surprisingly, the agent became defensive. “Do you realize how much this property is going to appreciate?” he foolishly exclaimed. “Why, it’s in a community of multi-million dollar homes and will probably be worth at least $1.5 million in just a couple of years!” he boasted.

The debate continued. How can you be so sure about that, I asked? What if the price falls? He responded, almost in disbelief, “What do you mean, if the price falls? Real estate prices don’t fall, not here; they’re not making any more land you know.” (As it happens, I drove by miles of undeveloped, flat land, on my way to Coto de Caza). I then posed the question: “If this property produces a negative cash flow now, with a million dollar cost, why would anyone buy it for a million five, with an even greater negative cash flow?” His reply was that rent had nothing to do with it, and that I obviously did not understand real estate investing. As proof of my ignorance he referenced examples of houses his client had bought last year that also produced negative cash flow but which had already appreciated substantially. He also reminded me that the rent could rise. What he failed to understand was that it could also fall, or could become zero if the property were vacant, as it was currently. He was right about one thing, apparently -- I just did not get it.

Then again, perhaps I do. As I recall, such arrogance, unbridled confidence in absurd rationalizations, a complete disregard for logic, history and time-honored, widely accepted investment prudence typified the stock market bubble of the 1990s. Dividends did not matter, earrings did not matter... the only thing that mattered was price, which, it was thought, could only rise. The only mistake was to refrain from buying or, heaven forbid, sell. The higher stock prices climbed, the more arrogant buyers became as the Nay Sayers, the people who just did not get it, were increasingly proven wrong with each up-tick, until the bubble burst and all that remained were the memories of the paper profits that were never taken.

Only an “investor” whose judgment was impaired by the intoxicating effects of a bubble, or in this case by an equally inebriated, over-zealous real estate broker, would have purchased this property. The reason for placing the word “investor” in quotes is that investors buy assets that generate superior current rates of return. That said, the purchaser of this property can hardly be called an investor. In fact, even the term speculator would not be appropriate because speculators purchase assets based on the rational anticipation of price appreciation. In reality, this individual is simply a real estate fool, buying assets solely on the expectation of selling to an even greater one. The most likely outcome for this fool is that he and his real estate equity will soon part. When interest rates rise and the economy slows, not only will the cost of servicing his adjustable rate mortgages rise, his other income, currently funding the negative cash flow, will most likely fall.

While most accept that those who forget the mistakes of history are doomed to relive them, few appreciate just how short people’s memories really are. Since even those who remember such mistakes seem to repeat them, it is likely that history’s mistakes will repeat indefinitely whether they are remembered or not.

Alarm over California home prices.

Remember how the price-earnings ratio for stocks soared before the market crashed? Well, the price-earnings ratio for homes in the Bay Area and greater Los Angeles is also skyrocketing, according to a forthcoming report from UCLA economist Ed Leamer. He says homes are so overvalued that prices are likely to fall when the Federal Reserve raises interest rates.

A P/E ratio shows how much investors are willing to pay for a dollar of earnings. It is one way to measure the public’s enthusiasm for a particular asset class. The higher the ratio, the greater the zeal. In the stock market, you calculate P/E by dividing a company’s share price by its annual earnings per share. In the housing market, you divide the price of a house by the annual rent it could fetch. Leamer calculated the average P/E for homes in several California metro areas by dividing the median price for a single family home by the average annual rent for a 2,000 square-foot apartment in each region. (You can get more and better data for apartments than rental homes, and the two tend to track each other.)

His findings: In the Bay Area, the average P/E for a house shot up to 13.8 in the first quarter of 2004, compared with 7.2 in 1999 and 2000. Today’s ratio is more than a third higher than it was 1989, just before housing prices started a multi-year descent. In Santa Clara County, the average P/E is 15.8 today, compared with 10.3 in 1989.

In the Bay Area, P/E ratios are skyrocketing because rents are falling while home prices are escalating. In San Francisco, the average rent has skidded to $22.01 per square foot from $31 per square foot in 2000, while the median home price has risen to $606,000 from $450,755. In Southern California, where the economy is stronger and more diverse, rents are rising, but housing prices are rising even faster.

In a 2002 paper, Leamer warned about rising P/E ratios for homes, but did not see the bubble bursting “in the immediate future”. But, he warned, “this could turn around rapidly if Mr. Greenspan decides to increase short-term interest rates.” With the Fed likely to raise short-term interest rates this summer, Leamer says now is the time to worry about a bursting bubble.

$100K+ is required to buy median price home in California.

The minimum household income required to buy the median price home in California rose above $100,000 for the first time in April, the California Association of Realtors reported. Affordability will continue to decrease because price records were shattered again in May and rates, while still low by historical standards, continued moving up, said Leslie Appleton-Young, the association’s vice president and chief economist.

CROWDED MARKET FOR SELLING HOMES IN TEXAS

The number of pre-owned homes for sale in the Dallas-Fort Worth area has more than doubled in the last four years, presenting unique problems for real estate agents and buyers. The number of houses on the market is growing faster than houses are selling. For instance, in May, sales of pre-owned homes were up 1 percent while listings grew by 7 percent, according to statistics from the North Texas Real Estate Information Systems. The industry’s computerized multiple listing service is swelling with the flood of available homes.

At current sales volumes, there is just over a seven-month supply of homes on the market. “If we define a seller’s market as one in which real prices tend to rise, then the Dallas market qualifies when inventory falls under six months,” said Jack Harris, an economist with the Texas A&M University Real Estate Center. “Real prices tend to fall when the inventory goes over 12 months, although this hasn’t happened since the early 1990s. Most of the major cities in Texas are going around six to six and a half months, with San Antonio the lowest at 5.8 months,” Dr. Harris said. There is an 11- to 17-month supply of homes priced over $500,000.

FREDDIE MAC: THE NEXT LTCM, OR JUST A WELL-MANAGED FIRM WITH SOME PAST ACCOUNTING ISSUES?

It was exactly what markets did not want to see. The top three executives of Freddie Mac, the U.S. government sponsored issuer of mortgage-backed securities, were shown the door in June after it become clear they prioritized “smoot’q earnings over strict accounting controls. Just two months later new CEO Greg Parseghian also exited his corner office after a report prepared for the board revealed his hand in the accounting scandal. Now, a firm widely considered too big to fail, has dedicated 10% of its staff of 4,800 to working six days a week on an earnings restatement due by the end of the third quarter.

Investors are understandably nervous. Freddie Mac, along with sister organization Fannie Mae, backs some 40% of the mortgages in the US and the securities they issue have in many ways become an alternate form of Treasury bond because of the implied government sponsorship of these organizations (an estimated 5% of the holdings of central banks around the world are Freddie and Fannie backed securities). A meltdown at one of the so-called government sponsored enterprises (GSE’s) would be disastrous. William Poole, president and chief executive of the Federal Reserve Bank of St. Louis, when asked about the effect that ambiguity around the soundness of the GSE’s would have on credit markets, was blunt. “I don’t know and neither does anyone else,” Poole was quoted as saying.

No surprise then but a vigorous debate about the structural soundness of Freddie Mac has bubbled up in the wake of the scandal. Investors are asking whether or not the company is stable and many are looking at Freddie’s sizeable position in the derivatives market -- even larger than sister organization Fannie Mae’s exposure even though Fannie is the larger institution -- as a source of concern. A key question concerning the health of “steady Freddie” is this: Just how large is its derivative exposure?

The quick answer is massive by any measure. But its size should not be surprising. The story of Freddie Mac over the last ten years has been one of exponential growth. Between 1992 and 2001 on-balance sheet assets at Freddie Mac have grown at an annual rate of 32% (substantially more than the 18% at sister organization Fannie Mae), as the size of its retained portfolio has ballooned from just $22 billion in 1990 to over $600 billion today. By the end of 2001, according to the last published annual report, the value of the mortgages it owns or insures is $1.3 trillion, an amount equivalent to more than 10% of US GDP. (Together, Fannie and Freddie have over $1.6 trillion in assets, 44% more than Citigroup).

Of course Freddie Mac is also well aware of the risk posed by holding those mortgages, especially in terms of interest rate fluctuations. That is why there has also been strong growth in the company’s derivative portfolio, which is used largely to hedge the retained portfolio against rate movements. The size and stature of that portfolio has been the source of much of the criticism around Freddie, with some speculating the extent of its derivative portfolio puts the entire financial system at risk.

A 74-YEAR OLD QUOTE ... ABOUT TODAY?

“[It] is apparent that the public preference for stock is not only as marked as ever, but also the will to speculate is still a speculative factor not to be overlooked. The prompt return of huge speculation and the liberal manner in which current earnings are again being discounted indicate that it will be difficult to quench the fires of stock-market enthusiasm for long.” This observation from Barron’s magazine nicely captures today’s stock market sentiment, especially the remarks about “speculation”. Many of the indicators we follow have indeed arrived recently at record or near-record extremes.

The thing is, the quote is more than 74 years old. It was from an issue of Barron’s published in April 1930 -- a time when the Dow Industrials had seen a five-month rally that recovered more than 50% of the losses in the 1929 crash. But from the time the quote appeared in print, the Dow fell 86% to its 1932 low. I offer the quote here by way of noting that the Dow has recovered a good bit more than 50% of its losses from the January 2000 peak.

LUCKY GENERALS, FROM WELLINGTON TO GREENSPAN

“Give me lucky generals,” Napoleon Bonaparte used to say. The emperor did not trust skill, or training, or brains. He did not really know why some generals won and some seemed to lose. He chose the lucky ones. But on this day, 189 years ago, their luck ran out. Grouchy had not kept the Prussians back. Ney had failed to take Quatre-Bras. D’Erlon never quite got into the fight. Arthur Wellesley, Duke of Wellington, retired from the battlefield on the 18th of June 1815 as a great hero. He fought the greatest military genius of his time and won. “It was a damned close thing,” he recalled of the battle. It might have gone either way. But in the end, it went Wellington’s way.

Looking through the long lens of history, we see heroes. Vercingetorix, Washington, Wellington, Jackson. We do not know if they were smart, virtuous... or just lucky. The present chairman of the Federal Reserve is the most famous bureaucrat since Pontius Pilate. He is also probably the luckiest. And like Pilate, he merely gave the mob what it wanted. Not blood this time, but bubbles. Alan Greenspan came to the Fed when a very long cycle of falling interest rates and falling inflation was just beginning. For the 38 years until 1981, bonds had been in a bear market that peaked out with average yields on Treasuries over 14%. Paul Volcker had already done the hard work; he had slugged the inflation monster so hard it remained asleep for the next 2 decades. When Greenspan came to the Fed, inflation was out cold... interest rates were falling... and bonds were going up. All he had to do was nothing. Most likely, the great trend would continue throughout his tenure in office.

Greenspan might have been a hero -- just by being lucky. But there seems to be some failing, some pernicious gene that drives the lucky to acts of self-destruction. Bonaparte could have stayed on Elbe... written his memoires and enjoyed a satisfactory retirement. Greenspan could have done nothing. Instead, each over-reached. Mr. Greenspan cannot be blamed for Japan’s bubble of the late 1990s. Nor is he the real culprit behind the LTCM blowup or the technology bubble in America in 1998-2000. But surely he, more than any other human being, is responsible for America’s current real estate bubble, its consumer debt bubble, and even China’s capital spending bubble.

A predecessor, William McChesney Martin, once remarked that the real job of the Fed was to “take the punch bowl away” before the party got out of control. Volcker had done it; the mob burned him in effigy on the capitol steps, but he retired with dignity. Yet Mr. Greenspan did not remove the punch; he spiked it with the high-proof gin of easy credit. According to the central bankers’ code, Greenspan has committed neither sin nor crime. Yet, as Talleyrand once remarked to Napoleon, “Sire, worse than a crime, you have committed an error.” Mr. Greenspan’s error seems to be catching up to him. In the West, the armies of inflation are approaching. In the East, the forces of worldwide deflation are stalking him too. Our man is caught in a giant pincers movement, his bubbles could be pricked any day. The day Mr. Greenspan’s luck runs out cannot be far off.

BABY BOOMERS, THEORIES, AND FACTS

In theory, the 401(k) account gave the Baby Boom generation something most of their parents did not have: control of their retirement savings during their working years. The conventional wisdom assumed that more control over more choices would produce bigger nest eggs and a more prosperous retirement for millions of households. The bull market itself seemed to convert this assumption into truth, at least in the heads of many people. Thus the great migration into 401(k) accounts that began during the 1980s. Some 115,000 U.S. firms had traditional pension plans in 1985; about 31,000 did as of 2003. In contrast, “only a tiny fraction of households had 401(k) accounts” in 1983, but “by 2001, about 62 percent of older households had one,’ according to an article this week in the New York Times.

How well has the 401(k) delivered on its promise? The Times article pretty well sums up the answer: “Retirement benefits today, particularly the 401(k) account, simply are not worth as much as the older kind of benefits.... The sweeping change in employee compensation appears to be the reason, according to new research by Edward N. Wolff, an economist at New York University who analyzed 18 years [1983-2001] of household financial data collected by the Federal Reserve.

“When Mr. Wolff looked at the net worth of the median older household the... figure declined by 2.2 percent, or $4,000, during the period.... For a generation to emerge from two bullish decades with less wealth than its parents had ‘is remarkable,’ Mr. Wolff said. Based on economic growth and market returns over those 18 years, he said, their wealth ‘should be up around 30 or 40 percent.’”

Pension plans underfunded by $hundreds of billions.

More than 1,000 large private pension plans, many in the airline and steel industries, were underfunded by an aggregate of $278.6 billion at the end of last year, the governmen’qs pension insurance agency reported. The figures are actually a slight improvement over the situation at the end of 2002, when underfunding stood at $305.9 billion. But they stand in sharp contrast to 1999, when 166 plans were underfunded by a total of $18.4 billion. The underfunded plans had $641.8 billion in assets to cover $920.3 billion in liabilities.

DEBT A GROWING CONSUMER BURDEN

In a nation that loves to shop, consumer spending represents two-thirds of all economic activity. Household debt has been on a gradual rise for decades, as the pursuit of possessions eclipses such old-fashioned notions as savings and thrift. As the Federal Reserve Board prepares to raise short-term interest rates from their 46-year low of 1 percent, how Americans deal with debt will become increasingly important to both policy-makers and individuals.

The average household debt load peaked at the end of 2001 and stayed high throughout 2002, although it has fallen slightly since then. Fed Chairman Alan Greenspan and many influential economists say that, while household debt remains high by historical standards, consumers will be able to manage the burden in part because rising home values allowed millions of Americans to refinance and roll high-rate credit card debt into low-rate fixed mortgages. Meanwhile, the value of home equity, securities, savings and other assets held by American households rose significantly faster than their debt in the first quarter, according to a new Fed report. That supports the idea that the financial health of Americans is improving and that households increasingly have the means to pay off their debt.

But critics say that rosy analysis ignores the fact that low- and moderate-income households -- many of them renters -- had no chance to refinance mortgages. Those people now find themselves saddled with variable-rate credit card and installment debt that is likely to get more expensive as the Fed starts its tightening cycle. What is more, a few observers think over-indebtedness is not merely a problem of low-income or renter households, but a societal excess that threatens to topple the economy.

“We’ve got a really horrific potential problem on the horizon,” said Robert Manning, a business professor at the University of Rochester and author of Credit Card Nation, a polemic against the debt-financed consumer economy. Manning argues that statistical averages mask debt problems because assets are not evenly distributed among households. Millions of borrowers have little or no cushion to protect them if monthly interest burdens rise.

JAPAN TECH GURU PREDICTS SLUMP

Japan’s top-rated technology analyst has said waning demand for computers will trigger a fresh slump in tech stocks next year. Deutsche Securities’ Fumiaki Sato said the downturn could force the Nasdaq index of technology shares more than 20% lower. Japan’s Nikkei index, heavily exposed to tech stocks, is also vulnerable. Mr. Sato said investors should consider selling computer, microchip, and liquid crystal display (LCD) shares. His warning will come as blow to investors hoping that the tech sector was set to continue recovering from the slump that followed the late 1990s IT and telecoms bubble.

Technology shares rose to dizzying heights during the IT boom, pushing the Nasdaq to an all-time high of 5,132 in March 2000. But the index fell steeply as the boom turned to bust, eventually bottoming out at 1,108 in October 2002. It has since clawed part of the way back, closing at 1,984 recently. According to Mr. Sato, the next downturn will begin in the second half of 2004 with a dip in demand for computers and mobile phones as the impact of last year’s US tax cuts fades. He predicts that the decline in demand will come just as a big increase in production of microchips and LCDs takes effect, causing a supply glut which will force average prices lower.

Techies revolt: “No options, no peace!”

High-tech workers will gather in Silicon Valley next week for a raucous demonstration -- dubbed the “Reality in the Valley” -- to protest a proposal requiring companies to expense all stock options for employees. For years, the tech industry has balked at expensing options, saying they give employees a financial stake in their companies’ success, which ultimately benefits all shareholders.

A QUESTION OF INTEREST

The Federal Reserve may have to push up interest rates less than you may suppose, though for the worst of reasons.

How quickly the extraordinary becomes the norm. It is easy to forget quite how breathtakingly low interest rates are around the world. In America, Europe and Japan, short-term rates are at their lowest in recorded history. Not for nothing is the Bank of Japan’s policy dubbed the zero interest-rate policy. The Federal Reserve’s might just as well be called the as-close-to-zero-as-makes-no-difference interest-rate policy. In the sweep of history the 1% Fed-funds rate is arrestingly nugatory. It is, after all, only four years (and 13 interest-rate cuts) since American short-term rates were 6.5%. And it is barely 23 years ago (though it seems another age) that, under the chairmanship of Paul Volcker, the Fed-funds rate reached almost 20%, to clamp down on inflation verging on 15%.

Successfully, as it turned out: inflation and long-term bond yields peaked in 1980, and have, with a few bumps, fallen ever since. Now they are rising again, though for how long and how far is moot. Heady growth, creeping inflation and a fear that the Fed might be tardy in raising rates, as it is universally expected to do on June 30th, had recently sent ten-year bond yields to above 4.8%, from their low a year ago of 3.1%.

Although inflation is unlikely to surge just yet, it is clearly picking up. While there will doubtless be inflationary scares aplenty in coming months, the Fed may not have to push up rates as fast as some suppose to keep it in check, and perhaps by less than most think. American consumers, whose heroic lack of thriftiness has kept the economy afloat these few years past, are now so hugely indebted that a rise in rates is likely to have a bigger impact on their spending than in the past. It is, after all, that very indebtedness that has stayed the Fed’s hand in raising rates from their present, derisory level. Unfortunately, keeping them so low for so long has made a bad problem worse, because it has caused a stampede into assets -- houses -- that are now horridly expensive by any reasonable measure; and because a big chunk of those assets is now financed with floating-rate rather than fixed-rate mortgages. In April, fully one-half of all new mortgages were variable-rate -- the highest total on record -- vs. a past average of 20% of new mortgages. Add in surges in home-equity lines of credit (helocs) and non-mortgage household debt in recent years, and almost a quarter of all household debt would immediately be affected by higher rates -- 70% higher than in 1994.