Finance Digest for Week of June 28, 2004

THE BEST THING ABOUT MONEY

Lusting after wealth is not always becoming, not always rewarding, rarely flattering or dignified. There is something vulgar about the hustle a real business needs... like sweat-stains on a starched shirt or a cold cup of coffee and stubbed out cigarettes. A man who wants to make a real fortune usually has to grub for it; it is hard to be elegant or refined when you are scratching for cash or market share. But grubbing for money is still better than a lot of other things men do. What follows is a long, rambling reflection on what the lust for money is better than.

First, we pause to deliver a shocking update. People love myth, fraud and claptrap -- especially when it flatters them. Maybe their food, life expectancy, crime rates, transportation, liquor, women, and architecture are nothing to brag about, say Americans to each other, but when they grub for money, they grub good. “Old Europe,” they say, making a comparison, “is too rigid, fossilized, hidebound... a museum.” And yet, even this is a fraud. Despite Laffer’s curve, Greenspan’s Bubbles, Friedman’s monetarism and Reagan’s revolution, the U.S. economy has done no better than Europe. Last week’s Economist examines the evidence.

Of course, everybody knows that America grew a lot faster than Europe over the last 10 years. But the figures, in terms of GDP/person are very close -- 2.1% per year for America against 1.8% for Europe. Take out Germany -- which has struggled with absorbing its formerly communist cousins from the East -- and the two regions are exactly the same. And productivity? “A study by Kevin Daly, an economist at Goldman Sachs, finds that, after adjusting for differences in their economic cycles, trend productivity growth in the euro area has been slightly faster than that in America over the past 10 years,” says the Economist. And get this: “GDP per hour in Germany and France now exceeds that in America.” It is true that Americans earn more and spend more than Europeans... but they work a lot more hours. But what about the “recovery?” Has it not been much more vigorous in America than in Europe? Well, only on the surface...

The best thing about money, part deux

Most Americans used to be too vulgar, too shrewd and too innocent to get involved with cubism, collectivism or ironicism. Most important, they were too busy money grubbing. But since then, the world has turned. Now, Americans no longer grub for money -- they spend it. And now, Americans come up with the new fashions in the art world. Americans used to mind their own business while Europeans invented new “isms” to justify bossing people around. Now, it is the Americans who have become the world improvers.

“It’s too bad,” Irving Kristol was lamenting Americans’ residual instinct to mind their own business. “I think it would be natural for the United States... to play a far more dominant role in world affairs... to command and to give orders as to what is to be done. People need that.” Grubbing for money is no longer enough for America’s elites. Minding your own business is “cowardly”, “frivolous”, and “decadent”, say the neo-conservatives. Besides, it is so much more fun to mind someone else’s. After years of pushing loopy domestic spending programs on the American people, the neo-cons finally wised up. Realizing that trying to reform the guy next door was a waste of time, they decided to reform whole societies on the other side of the planet! When you spend taxpayers’ money -- or borrowed money -- on domestic programs, you quickly run into conservative opposition. And everyone can see that the programs are a waste of money. But if you squander money on an overseas military campaign the conservatives love it.

And so military spending soars... and the nation embarks on a grand design to bring democracy, capitalism and women’s rights to the tribes of the hindu kush, the Mesopotamian desert, and who knows where else. The history of efforts to make the world a better place -- by force -- has many chapters. But few make uplifting reading. Few have happy endings. We give you a bit of one of them, another example of something that grubbing for money is better than ...

AN ACCOUNTING BIAS PENALIZES EARNINGS OF COMPANIES WITH STRONG R&D EFFORTS

Corporations are too preoccupied with making the quarterly numbers to build their futures. So goes the common reproach about American business. Is it deserved? Not at all, if you look at research spending. R&D spending has expanded enormously, moving from 1.8% of nonfinancial corporate revenue a quarter-century ago to 3.2% in 2003. The payoff is here: scanners that peer into coronary arteries; silicon chips that store a galaxy of data; cell phones that double as cameras. “It’s really those [R&D] expenditures that are going to drive long-run corporate performance,” says Leonard Nakamura, an economist with the Federal Reserve Bank of Philadelphia.

How odd then that accounting rules treat spending on factories much more kindly than they do spending on R&D. Last year Pfizer spent $7.6 billion on R&D for drugs and $2.7 billion on plants and equipment. The drugmaker deducted the entire $7.6 billion R&D expense from earnings because the accountants do not consider R&D a long-term asset whose value can be quantified. But it deducted only 5% of the $2.7 billion plant-and-equipment outlay because machinery and buildings are “hard” assets with a quantifiable life expectancy. This might make sense to accountants, but it is not a very useful way for investors to value businesses.

The folly of treating R&D as a regular expense like the electricity bill is getting more attention lately, including from academics. We list the 30 U.S. companies (table here), whose price/R&D-adjusted earnings show the biggest differences from their P/Es as traditionally calculated.

THE “MINING INDEX” GOING FROM FIRST TO WORST IN SIX MONTHS DEMONSTRATES A MANIA’S BEHAVIOR

The Wall Street Journal online includes a useful feature called “Dow Jones Industry Group Center”, which measures stock performance within the major economic sectors: energy, health care, technology, etc. You can see how these industry sectors have performed over several time periods, ranging from one week to five years; it will even show you the “10 Best” and “10 Worst” performing sectors for those periods. If you select the 10 Best/Worst performing sectors over the past year, the Dow Jones Mining Index heads the “Best” list with an impressive rise of 219%. This group, which is heavily weighted with precious metals mining stocks, stands well ahead of the second-best performer, the Consumer Electronics Index at 141%.

Select the 10 Best/10 Worst for the past six months, and the Mining Index appears at the top again ... but in this case it is the top of the “Worst” list, with a 14% drop. How is this possible? Because most of the rise in this index came during the parabolic move higher from about August 2003 to March of this year, closely reflecting the rise in gold and especially silver over the same period. From the March peak, the Mining Index plummeted and still holds its “Worst Performer” rank despite a recent bounce. Yes, the 219% rise looks better than the 14% drop, but remember this: Most of the buyers who drive a parabolic move higher do so by piling in during the last stages of that move. That is the rule in manias; good luck finding the exceptions.

IF “AN ECONOMIC ERA” BEING “LAID TO REST” IS NOT WORTHY OF “PANIC”, THEN WHAT IS?

A decision to “raise rates” from the Federal Reserve this week is a foregone conclusion, at least in today’s financial news: the headlines runneth over with “what it will mean” for stocks, consumers, the economy, politics, lending, borrowing, et cetera, et cetera. And if you still do not grasp how momentous it all is, try this lead sentence from one of the three rate-rise articles in Monday’s New York Times:

“When the leaders of the Federal Reserve gather this week around the massive mahogany table at their headquarters in Washington, they may want to pause for a moment of silence. By the time their two-day meeting ends on Wednesday, they are all but certain to have laid to rest an economic era...”

With the suggested moment of silence came other subtle exhortations, such as this headline: “Advice for Investors: Don’t Panic Over Rates”. But if the end of “an economic era” is not worth panicking over, then will someone please tell me what the heck is? Do you get suspicious when the conventional wisdom is this loudly certain of anything? We happen to know that whatever the Fed does is irrelevant to the dominant trend in any financial market. In Treasuries, for example, our forecast is based on a price pattern that has kept subscribers ahead of the trend for months: Nothing the central bank does (or does not do) will change our forecast, because the Fed cannot and will not change the major trend.

Rising rates, debt bubbles, and unanswered questions.

A New York Times quote asserted that a rise in the Fed funds rate this week would mean the end of “an economic era”, that “era” being more than two decades of supposedly falling interest rates. This assertion of a long-term decline in rates is only partially true, at best. The Fed funds rate fell below double-digits in 1985, and stayed in a range mostly between 4%-8% until 2001. This is not the sort of trend that defines an “era”.

Do any other broad financial measures reach era-level standing? Existing single-family home prices, perhaps? Nope: in 1980 the median price was around $120,000; today that median price is just below $175,000 (a generous average estimated gain of 2% per year). How about a bull market “era” in stocks? Not quite: the crash of 1987, and the 2000-2002 bear market erased too much value, and that is before you look at the actual gains and losses of real investors and fund shareholders since 1980 (their returns are at best half of the percentage gains in the broader stock market).

In truth, the only broad financial constant over the past generation -- where you see strong, steady, and unbroken increases -- is in debt, specifically in “revolving” debt, of the credit card and auto loan variety. Federal Reserve data (in round figures) shows that in January 1980, total revolving consumer credit was $56 billion. That figure underwent a 14-fold increase into April 2004, to $751 billion, or 3/4 of a trillion dollars. Plotted on a chart, there are no reversals or downward bumps in the growth of this debt. It climbed steadily higher over the entire period.

Even as many lending rates did indeed decline sharply during the past three years, the average credit card interest rate barely budged: the average assessed rate in 2000 was 14.8%, while in Q1 of 2004 that rate was 12.4%. What happens to debt bubbles when interest rates start rising? You will not even hear that question get asked in the flood of “Fed rate hike” stories, never mind any answers. Questions and answers of this sort take too much research and analysis, and the very few economists and Wall Street types who bother will not like the result they get.

THE TRILLION-BARREL TAR PIT

Alberta sits atop the biggest petroleum deposit outside the Arabian peninsula -- as many as 300 billion recoverable barrels and another trillion-plus barrels that could one day be within reach using new retrieval methods. (By contrast, the entire Middle East holds an estimated 685 billion barrels that are recoverable.) But there is a catch. Alberta’s black gold is not the stuff that geysered up from Jed Clampett’s backyard. It is more like a mix of Silly Putty and coffee grounds -- think of the tar patties that stick to the bottom of your sandals at the beach -- and it is trapped beneath hundreds of feet of clay and rock.

This petroleum dreck is known in these parts as heavy oil, and wildcatters are determined to get it out of the ground and into a pipeline. If they succeed, the stereotypical oil zillionaire may be not an Arabian emir but a folksy Albertan fond of ending sentences in a question, eh? Like Jim Carter, president of Canada’s largest oil company, Syncrude. A coal-mine foreman by trade, Carter talks as if he just got out of a cut-rate business seminar, spewing jargon like “going-forward basis” and “continuous-improvement mindset”. He is the kind of guy who straps a snowplow on his John Deere mower and clears the streets just for fun. But he clawed his way out of the pits to a corner office, and now he has a plan to make Canada’s oil reserves pay off.

Heavy oil is not a new discovery. Native Americans have used it to caulk their canoes for centuries. Until recently, though, it has been the energy industry’s stepchild -- ugly, dirty, and hard to refine. But the political winds are favoring the heavy stuff, as “energy independence” -- aka freedom from relying on Middle East oil -- has become a war-on-terror buzz-phrase. Better yet, recent improvements in mining and extraction techniques have cut heavy oil production costs nearly in half since the 1980s, to about $10 per barrel, with more innovation on the way. The petroleum industry is spending billions on new methods to get at the estimated 6 trillion barrels of heavy oil worldwide -- nearly half the earth’s entire oil reserve. Last year, Shell and ChevronTexaco jointly opened the $5.7 billion Athabasca Oil Sands Project in Alberta, which pumps out 155,000 barrels per day. Venezuela’s Orinoco Belt yields 500,000 barrels daily, and that number should spike when a new ChevronTexaco plant goes online this year.

THE REAL BUBBLE IS IN THE BOND -- NOT THE HOUSING -- MARKET

Many people, economists and laymen alike, are suspicious of the recent behavior of house prices, particularly in coastal urban areas. However, I would argue (and other economists would agree) that the bubble is in the bond market, not in the housing market. That is, if interest rates remain close to where they are today, then there is no reason for house prices to collapse. However, some of us think that interest rates ought to rise more than the market expects.

The intrinsic value of an asset is equal to the income from the asset, discounted at the real interest rate [ed: Assuming the income from the asset increases at the rate of inflation]. In the case of a house, the income is the rent that someone would pay to live in that house [ed: Less property taxes, maintenance, etc.]. In the case of a stock, the income is the profits of the company. Over the last two years, by one estimate, the real ten-year interest rate has fallen from just over 3 percent to slightly over 2 percent. The drop in the real interest rate of one percentage point from 3 percent should have raised the intrinsic value on stocks and houses by 33%! So, if house prices in your area have gone up 33% in the past two years, that may seem dramatic, but it is not out of line with the drop in the real interest rate. (The Dow Jones Industrial Average is also about 33% higher over the period.) Because houses are risky assets, they ought to be priced below intrinsic value by a “margin of safety”.

As Brad DeLong said, “P/E ratios -- of all kinds -- should be high when interest rates are low now and are expected to be low in the future. Interest rates are very low now. Long-term interest rates tell us that short term rates are not expected to rise that much. How should we expect house prices to react to low interest rates?... Personally, I think we are in an interest rate bubble -- and that high housing prices are (outside of New York, SF, and LA) probably a rational reaction to very low interest rates.”

So the drop in real interest rates helps to justify a rise in housing prices. But this raises the question of whether real interest rates can remain low. Many economists are skeptical that real interest rates will remain low. It appears to us that investors are ignoring the potential for large increases in borrowing by the U.S. government as deficits accumulate. If the real interest rate doubles in the next five years, then the intrinsic value of houses would drop by 50%. Home prices would not necessarily fall by the full 50%, as the margin of safety could simultaneously contract. Interest rates are low today in part because foreign investors have been willing to increase their holdings of U.S. assets. They cannot go on raising the share of U.S. assets in their portfolios forever.

Another plausible scenario involves an increase in expected inflation, with a corresponding increase in nominal rates. In that case, home buyers with fixed-rate mortgages will enjoy a benefit. They will see their incomes rise relative to their monthly payments. In the late 1970’s, homeowners experienced this sort of drop in their debt burdens, and they made out really well. The savings and loan industry, which lent the money for those fixed-rate mortgages, got clobbered.

So, what is the bottom line? I think that there is some reason to be concerned that both real rates and expected inflation could increase more than the market expects over the next five years. The advice implied by that perspective starts with not borrowing using an adjustable-rate mortgage.

WHY BUYING AND SELLING THINLY TRADED STOCKS IS AN ART FORM

Choosing the best price to bid for a stock can make a significant difference in terms of overall returns. Over-eager investors often select the market price to make their play, deciding they must have the stock now. While this does guarantee a purchase, it rarely delivers the best value or longer-term return on investment. This difference in returns can be even more pronounced when taking positions in more thinly traded stocks. When there is a particularly wide bid-ask spread, then selecting a good price at which to buy, rather than letting the market price dictate when you buy, is especially important.

Instead of having to buy a stock in a hurry in order to start a position, I would rather scan where the stock price has been trading for the prior week or two with particular attention on the prior few days. Then choose an area near the bottom end of the stock’s recent trading range. Sometimes this means missing out on that particular stock, but after two decades of trading I know that another purchase possibility always comes along. Maybe it is in this stock, or maybe another one. But something always does come along. In my experience, it is best to be disciplined and patient -- although often difficult to be so.

HONG KONG HOUSING AUTHORITY PREPARES TO SELL CITY’S FIRST REIT

The Hong Kong Housing Authority plans to sell the territory’s first real estate investment trust (REIT) to be issued since the passing of new regulations allowing the securities last year. Facing a cash squeeze because the government no longer allows it to sell housing, the Housing Authority is planning to sell 130 shopping malls (around 11% of the city’s retail space), and around 100,000, or 60%, of the city’s car parking spaces in a deal that analysts expect to be worth some $2.5 billion.

THE ONCE AND FUTURE KING (OF ASSETS)

Quick: What is the most undervalued investment right now? What is the one asset you would not even think of holding? Hint: According to the Investment Company Institute of America, this asset represented 77.1% of all mutual fund assets in 1981. Gold was popular back then. But if you said gold, you are wrong. Like gold, people buy this asset when they are scared, like they were in 1981. In 1999, this unloved asset fell to an all-time low of 23.7% of all mutual fund assets. Investors hold as little as possible of it when they are very optimistic, like they were in 1999.

Today, 27.7% of all mutual fund assets are in this safe, liquid instrument. In historical terms, that seems pretty optimistic. Perhaps by now you have guessed that the answer to these questions, the most unwanted asset today, the one thing nobody seems to want to own, the one asset people cannot seem to get rid of fast enough, is... cash. The statistics quoted above are the amount of total mutual fund assets invested in money market funds.

I am about to tell you that you should be holding plenty of cash, and I can explain it in, what I believe to be, the most compelling of terms. The simple explanation is that every investor who really knows what he is doing is holding a large cash position right now. By “every investor who really knows what he is doing,” I am referring to some of the greatest investment minds of our time. Warren Buffett, Staley Cates & Mason Hawkins, Jim Gipson, Tweedy Browne, the Sequoia Fund and Alan van den Berg. Buffett is holding $34.68 billion in cash. That is equal to about 25% of the $138 billion market cap of his Berkshire Hathaway empire. Berkshire Hathaway stock is selling for around $89,750 per share, and he is holding $22,521 per share in cash

A few months ago, Van Den Berg told his clients that, “Today, I’d say that, once again, you’re better off being in a money market fund. Even if you’re only getting three-quarters of 1% on your money, if the economy recovers, interest rates are going to go back up. Short-term rates will rise 3-5%. So you’re not going to be at 1% forever... the most hated investment today is cash. Everybody hates cash. Nobody can stand to be in cash. By contrast, everybody just loves being in stocks. At the bottom of this bull market -- back when it began -- 50% [sic] of mutual funds were money market funds.” Note that Van Den Berg says you are better off in a money market fund than anywhere else. Money market rates, puny as they are, outperformed the S&P 500 over the last five calendar years.

Contrarian money manager David Dreman writes in his latest annual shareholders letter, “Anybody can own what they like. The challenge is to own what you hate.” I could not agree more. I recommend that you take Dreman’s challenge, sell overvalued stocks and bonds you may be holding, and make cash -- the most hated asset today -- your largest holding. No matter what you are doing with your money right now, be aware that cash is king; make sure you have more cash than anything else.

Taking advantage of rising rates.

After years of flogging free checking and coffee-mug giveaways, banks are finally giving consumers something they want: More money. With interest rates rising banks will soon compete on increased yields for CD and money market accounts. These are solid investments for those who want to avoid the risk of equities or bonds and for retirees who seek to preserve their principal. It pays to shop around for the best rate because not all money market and certificates of deposit are created equal. Look for the small or regional banks to boost yields first. The recent increases are modest, but are almost certain to continue as the Federal Reserve continues to hike interest rates into 2005.

DOLLAR SET TO RESUME DECLINE?

Everyone from Tokyo to Tallahassee, will be casting their gazes towards Washington this week, to see how large will be the puff of smoke emanating from the Federal Open Market Committee. Airwaves will be filled and forests felled with discussions, learned and otherwise, parsing the utterances of the members of that august committee of interest-rate setters, and particularly those of its chairman, Alan Greenspan, for clues as to how fast interest rates will rise in coming months. Precious few eyes, it is safe to aver, will be on an annual survey of America’s net investment position released on Wednesday June 30th by the Department of Commerce’s Bureau of Economic Analysis. But since everyone knows what the Fed will decide on the same day, Buttonwood wonders whether the BEA’s is not the more important statistic coming out of Washington this week, since it will provide reasons aplenty why the dollar has further -- a lot further, perhaps -- to fall.

Last year and earlier this year, if memory serves, financial markets were abuzz with talk of the dollar’s dismal prospects, perhaps even its imminent collapse. There was much discussion of America’s humungous twin deficits (its budget deficit and current-account deficit); fuming about Asian central banks trying to stop their currencies rising against the dollar (though less fuming about how their purchases kept down long-term interest rates); and raging about how none of this was sustainable. The dollar, most right-thinking people agreed, needed to drop, though in an orderly fashion so as not to scare off those nice Asian central banks who had bought squillions of dollars’ worth of Treasury bonds. Naturally, the dollar went up, and talk about it doing otherwise has dwindled to vanishing point.

Perhaps that is why, in recent weeks, the greenback has begun to slide again, while gold has staged a comeback to $400 an ounce. Since mid-May, the dollar has fallen by 4% on a trade-weighted basis. On the face of it, this seems peculiar. The dollar has started to fall again even as the chatter about interest-rate rises has got louder. Naively, you might expect a currency whose interest rates are about to rise to go up, not down. One explanation why the reverse has been the case is that the Fed has been late in stamping on inflationary pressures, so real interest rates -- i.e., adjusted for inflation -- are falling even as nominal rates are expected to rise. There might, however, be another explanation: that rising rates will make an already awful current-account deficit worse still, and that markets are again starting to realize that the only way in which this can be corrected in the long term is by a sharply lower dollar.

When interest rates go up, this net surplus on America’s investment income will turn into a deficit. A yield on ten-year Treasury bonds of 6%, says Goldman Sachs, would in the space of a few years add 1% of GDP to the current-account deficit, solely through higher interest charges. Whether or not yields reach such giddy heights depends mainly on two things: how much inflation is actually picking up; and foreigners’ continued willingness to supply the giant hedge fund known as the United States of America with cheap finance. In the longer run, Jim O’Neill, the chief international economist at Goldman Sachs, for one, thinks it “virtually impossible to be a structural bull on the dollar.”

THE LIMITS OF CENTRAL BANKING

Every system has limits. No one knows exactly where these limits are. All systems are complex, and no theory deals successfully with all of this complexity. There is a saying, “you can’t change just one thing.” It is accurate. Over time, all systems change, but they do not change very much most of the time. These changes produce ripple effects throughout the connected systems. But changes are usually slow, so we barely notice them. When we do notice them, we get used to them.

In the 1930s, the economic system stopped working. Economists still debate over why it stopped working. John Maynard Keynes had an answer in 1936: not enough government spending. Milton Friedman had an answer in 1963: not enough money creation by the Federal Reserve System, 1929–1932. Murray Rothbard had an answer in 1963: too much money creation by the Federal Reserve, 1924–1929, and too much economic regulation by the Hoover Administration, 1929–1932. Keynes won the debate in academia for forty years, and in politics still has won it. Friedman has won the debate in academia, but not in politics, since about 1975. Rothbard’s answer is acceptable only to those few people who trust neither the politicians nor the central bankers to fix the system. I am with Rothbard.

The Great Depression has cast a long shadow over the voters and the politicians ever since. No one wants that to happen again. Keynesians say it will not happen again because politicians will always run deficits large enough to prevent one. Friedman says it will not happen again because central bankers learned their lesson. They will not again allow the banking system to run short of monetary reserves. Rothbardians think that it will happen again. They debate over whether central bankers will first destroy the monetary units by inflation before the next Great Depression arrives. Meanwhile, they predict, central bank money creation will lead to a series of asset bubbles, all of which will eventually pop, and any one of which may trigger the next depression. But the economy keeps rolling along. Most Americans are getting by. Most Asians are getting by. Most everyone is getting by. The system holds. The free market system seems to be able to beat the many government-imposed systems that seek to thwart men’s ability to buy and sell with each other. So far, so good.

Things usually change at the margin. At the edge of any system, trouble begins. The question is: Will trouble spread to the system as a whole? On June 4, Warren Pollock published a disturbing report in his Macroeconomic Newsletter. He reported on a statistic that I had been completely unaware of: “settlement fails”. I was well aware of what it deals with: bank settlements. Banks must settle accounts with each other daily. Bank A owes Bank B, which owes Bank C, which owes Bank D, which owes Bank A. The system is enormously complex. It is interconnected. If the settlement system ever fails, we will get what Greenspan has called “cascading cross-defaults”. Cascading cross defaults are the greatest single threat to the world economy. They could push the world’s banking system into gridlock. Then our plastic, credit-based money would no longer buy things. This would create a monumental crisis.

On two occasions, once after 9/11 and in August 2003, the system came close to going into gridlock. The FED intervened both times to inject liquidity -- fiat money -- into the banking system. The system failed in July and August of 2003 when an unexpected market driven spike in long-term interest rates occurred. Rates were managed downward and the problem was temporarily solved. The same condition of failure occurred in May of 2004. The failure was directly related to the recent rise in interest rates. Given this condition, how can the FED raise interest rates to levels needed without blowing up the entire system? The problem is that the market will raise rates if the FED fails to do so.

The Federal Reserve System has intervened repeatedly because entrepreneurs always push every profit-based system to its limits. Someone will always press against the rules of the game. The 1998 failure of Long Term Capital Management provides an example of entrepreneurs who went beyond their ability to fulfill their debt contracts in the highly leveraged financial futures market. The FED has bailed out the system so often that it has created a sense of abandon among entrepreneurs. These entrepreneurs have access to enormous lines of credit through the futures market. This is what the carry trade is all about: borrowing short to lend long, with an inverted pyramid of interconnected debt. No one knows how large this pyramid is. No one knows the limits of the system. The web of credit and debt is too complex. We see the FED playing the role of the sorcerer’s apprentice. To understand Alan Greenspan and the system he represents, visualize Mickey Mouse in Fantasia, with the sorcerer’s pointed cap on his head, and the brooms hauling in water (liquidity) and dumping it -- no matter how he pleads with them to stop.

Conclusion: You should have reserves that are not part of the debt system. These reserves must be non-digital. It is not enough to have a money market fund. You need some currency, some silver coins, and some gold coins. You cannot disconnect from the economy and still remain productive. But you would be wise not to place all of your capital eggs in a digital basket that is guarded by Alan Greenspan.

MONEY MATTERS NO MORE?

Although there are deep and abiding differences between Chicago school monetarists and Austrian monetary theorists, there has always been strong agreement among them on one thing: the central importance of the money supply in explaining the purchasing power of money or “price level” in the economy. This does not appear to be the case any longer. The June 2004 cover article of Monetary Trends, a publication of the St. Louis Federal Reserve Bank, long a staunch bastion of monetarism, is entitled “How Money Matters”. A more accurate description of its contents is “Why Money Doesn’t Matter Anymore”. The author, William T. Gavin, emphasizes that “money still matters” -- just not its quantity.

Gavin depicts the essential role of money in the economy today as a disembodied accounting unit whose value can be stabilized by a central bank that ignores the law of supply and demand while carefully molding the public’s expectations of inflation through the hocus pocus of manipulating, or even just making “credible” threats to manipulate, a short-term interest rate. This is nonsense on stilts and merely a sophisticated version of George Knapp’s mystical State theory of money -- demolished by Ludwig von Mises in 1912 -- according to which the value of money was not determined by market forces but directly imposed by State fiat regardless of its quantity.

Hayek once commented to the effect, “God help us, if people ever forget the lessons taught by the naive quantity theory of money.” Who would have thought that the St. Louis Fed would one day require such divine guidance?

RUBBER AND RICE

Superficially speaking, Thailand is a lot more developed than India. Not to slight Bombay. But in Bangkok, the airport is modern, the taxis are air conditioned, and there is a good expressway that runs from the airport to the city in less than 40 minutes, traffic permitting. The city also has a relatively new, elevated subway that makes getting around cheap and easy. I point these things out because I think it is worth remembering that they do not happen overnight. And by the time they do happen, and make it possible for foreign business and tourists to operate in the country, a lot of the low-hanging investment fruit has already been picked.

To put this in the context of India, when you look around Bombay, you need to think of what it will look like in ten to fifteen years, not what it looks like now. In investing, image is not everything. A gleaming city with lots of neon and great infrastructure is not a sure sign that you are going to be able to find good businesses at good values. And in India’s case... thinking down the road also means thinking of a 24% national savings rate as somebody else’s future cash flow. If you can do that, your next question is to figure out who is going to get that cash flow and how can you buy them right now, at a discount to that future cash flow. At least that is how I am looking at it.

Money moves where there is opportunity. And opportunity comes when you put natural resources and abundant labor in close contact with risk capital. You have got all the ingredients here in Asia. But do you have the required “spirit”? In China, I would say yes. In Japan, I would say it is a tired spirit. In India... I would say you have a lot of spirits... and a lot of destruction is needed before there can be more wealth creation. Here in Thailand? Too early for me to say. Two Agora newsletters readers pointed out that Thais are culturally anti-competitive. No one wants, at least visibly, to have more than other people. From what I could gather from them, there is an innate sense of egalitarianism, although they probably would not call it that.

I suppose my question about Thailand is whether the lack of a competitive culture (and an economy where prices move freely) is a serious investment disadvantage. We will see. I still think that as one of the world’s largest exporters of rice and rubber, Thailand has got a lot going for it. It can feed the Chinese and put tires on their 100 million new cars. Now, let us find us a rubber company and a rice company...

THE RODNEY DANGERFIELD OF INVESTMENTS

Mining is an innately risky business. It is an impossible business if metals’ prices are too low. In the case of silver, during the long bear market from 1980 to 2003, when silver traded mostly in the $3.50-$5 per ounce range, there were no major, public, pure silver mining companies that generated free cash flow. None. The end result was that very few pure silver producers remained in business. With the exception of a smattering of mines in Mexico, Peru and very few other locations, it has simply been uneconomic to produce silver -- other than as a by-product. Which points to one of the fundamental caveats about silver: namely that around 80% of new production is a byproduct of gold, copper, lead and zinc. So silver is produced almost regardless of its price. That makes primary production of silver even more volatile and risky than mining in general.

Of the primary silver producers (defined as companies in which at least 50% of their revenue is silver), the value of the silver they produce represents only about 3% of total supply brought to market. It is a tiny sub-sector of mining. But, understanding the risks, I think silver stocks could provide some of the best, if not the very best, contrarian returns in the years ahead. There are several reasons I say that, but the main one is the ongoing silver supply/demand equation.

At first glance, one of the more remarkable aspects about the silver bear market was that, beginning in 1990, it occurred against the backdrop of a supply deficit. Production has not kept up with demand for a very long time. For a brief period back in 1997-98, it looked as if the supply/demand imbalance had finally caught the attention of the market when Warren Buffet purchased 129.7 million ounces. Prices moved all the way to the $7.50 level before institutional short sellers and forward selling by base metals producers beat the price back to the $4 range. Once again, silver could get no respect.

Ignoring the conspiracy theories making the rounds, the primary reason for silver’s doldrums has to do with the drawdown of accumulated stockpiles. These stockpiles include old scrap and coin melt, as well as those held by various governments who used to think that backing a currency with something other than cheap talk was the right thing to do. The U.S. stockpile is now gone. The largest remaining known government silver inventories are in India, which was reported to be holding around 87 million ounces as recently as 2002. The largest unknown government inventory is likely held by China, whose currency was the last in the world to be backed by silver. We should have additional clarity on the Chinese stockpiles later this year once The Silver Institute releases its new comprehensive study on the topic. Regardless, the odds are good that we are nearing the end of the period where government silver sales are much of a factor. Institutionally held inventories (Comex, CBT, etc), have likewise fallen dramatically. Individual sellers, as is often the case after a long bear market, have begun to dry up.

Industrial usage, which is the largest source of silver demand, was up 2.87% to 351.2 million ounces in 2003. I am quite optimistic about silver industrial demand outpacing overall economic growth for the indefinite future simply because, of the 92 naturally occurring elements, it is the best conductor of both heat and electricity, as well as the most reflective and the second-most ductile and malleable. Jewelry demand, silver’s second largest use, rose 4.06% in 2003 from 2002. These two increases more than offset the decline from photography.

Unless the reported numbers are wildly askew, there is no question silver is going much higher in price. And that is not counting the possibility of a monetary, crisis-driven mania, like the mania that took silver to $50 in 1980. I have no reason to believe the numbers are not more or less accurate and plenty of reason to expect a mania.

TIFFANY’S LAWSUIT THREATENS eBAY’S ECLECTIC MARKET

Whoever coined the old legal phrase caveat emptor, “let the buyer beware”, expressed an eternal truth. What was wise in pre-capitalist times remains wise in the Internet age. Trading on the Internet is becoming a part of everyday life. Millions of people go online to find goods, check prices and make transactionsusually without any problems. The Internet has also dramatically lowered the cost of starting a new business or expanding an old one. But, inevitably, these enormous advantages are not confined to honest traders. Consumers have to be alert. Companies, too, have to protect their good names from fakers and other cheats. As Tiffany, a New York retailer famous for its expensive jewellery, has found, that is not always easy.

Tiffany’s legal action against eBay concerns the sale of counterfeits. A recent search of eBay’s American site found 610 necklaces, 707 rings and 668 bracelets sporting Tiffany’s name. But with many items priced well below $50, most are clearly no more real than the $30 “Rolex” watches or $20 “Gucci” handbags offered in back-street markets everywhere. The basis of its lawsuit is that the amount of faked products is so substantial that eBay profits significantly from the trade, and promotes it, and so should “bear responsibility for the sale of counterfeit merchandise on its site.” eBay says it has helped Tiffany to remove problem listings promptly. Whether it has done enough is for the courts to decide.

WILL INFLATION REALLY TURN OUT TO BE AMERICA’S MAIN ECONOMIC PROBLEM?

The outlook for interest rates will be quite different if inflation is not America’s biggest economic problem. A fascinating paper, “Dicing with Debt”, by Stephen King, the head economist at HSBC, a big British bank, explains why it might not be. Mr. King’s starting-point is that the Fed and other central banks need not have been as worried as they were about the threat of deflation. Certainly, debt deflation is a particularly malign economic beast, which emerges when people curb their spending in an effort to pay off their debts. Those very spending cuts cause prices to drop, and force up the real value of debts, creating a vicious spiral. As the experience of America in the 1930s and Japan in the 1990s shows, central banks can do little about this, because they cannot set interest rates lower than zero. It was fears of just this sort that caused the Fed to slash interest rates 13 times, to anorexic dimensions.

Most commentators have cheered Alan Greenspan and his colleagues at the Fed for being so aggressive in warding off the deflationary threat caused by huge corporate debts and the popping of the stockmarket bubble. After all, one of the shallowest recessions on record was followed by a strong recovery in which bumper profits enabled overly indebted companies to reduce their debts to more manageable levels. Mr. King is not among those cheerleaders. He argues that the Fed was wrong to cut interest rates so much, because much of the deflationary pressure was of an altogether more benign sort: a reduction in overall prices caused by rapid technological change, improvements in the terms of trade and other factors.

Technological change and the integration of China, and increasingly India, into the global economy have pushed down the price of traded goods in America, thus pushing up real incomes. “And, because of these real gains, any rise in real debt levels will not be a source of potential ongoing instability,” writes Mr. King. Alas, because the Fed’s perceptions of deflation have been colored by the experiences of America in the Depression and Japan in its lost decade, it reacted by reducing interest rates sharply, a response that is more likely to bring about the debt deflation it most feared. High real growth -- so long as deflation is of the good sort -- requires high real interest rates. If rates are too low, people borrow too much and spend it badly. By cutting nominal rates to prevent deflation, the Fed has reduced the real rate of interest too much. Evidence that this has been the case comes in two forms. The first is that borrowing has ballooned in America in recent years. The second piece of evidence: what Americans spend their money on.

WHY EUROPE’S FAVORITE SPORT IS MORE AMERICAN THAN BASEBALL

There is something quintessentially American not just about baseball, but about all our major league sports. Basketball, football, and baseball engender competition and reward merit. They afford people, regardless of their background, the ability to gain fame and vast fortune. Each league marries marketing and brand-building to sex, power, and money. Sports are the ultimate market activity, with champions and losers minted every night and every season. Just so, whoever wants to know the heart and mind of Europe -- and Latin America, as well as big chunks of Africa and Asia -- had better learn soccer, the national pastime of the rest of the world.

When you look at the business of professional sports -- in both Europe and the United States -- American sports are virtually all socialistic while the European soccer leagues more closely resemble the entrepreneurial capitalism we Americans fetishize. The Austrian-born economist Joseph Schumpeter -- a tennis player, not a soccer fan -- developed the concept of “creative destruction”, the touchstone of American-style capitalism. Schumpeter famously likened the elites of a society to a hotel, one in which rooms are always occupied but by an ever-changing roster of guests. The hotel concept almost precisely describes the soccer leagues of Europe. Every year, the worst-performing teams -- three in England, four in Italy -- check out. Relegated, they must play the following year in the next-lower division. Meanwhile, ambitious upstarts who have succeeded at lower levels check in. They are promoted. This constant cycling has enormous financial consequences for the teams and their owners.

By contrast, the American professional leagues are like a Marriott Residence Inn -- once you are allowed to check in, you never have to leave. There is no great punishment for consistently propping up the standings year after year. Yes, the market value of losing teams often suffers in comparison to those of winning teams. But once you are a member of the cartel, there is a floor under the price. To different degrees, Major League Baseball, the NFL, and the NBA are examples of European-style socialism among billionaires and Fortune 500 companies. They share revenues, tightly regulate admission to the cartel, and bargain collectively with powerful European-style unions, which act as barriers against reform. Losers not only can prosper, but they get first dibs on next year’s crop of talent. In America, someone who wishes to start a major-league sports team, or who wants to upgrade a minor-league team into a major-league one, is essentially out of luck. Not so in Europe.

The European system rewards ambition and ruthlessly punishes sloth and incompetence. At the beginning of each year, every owner places every dollar of investment on the line. And in European soccer, that can mean a huge sum. In Europe, the successful and rich teams grow richer. (For assembling and stockpiling talent, the New York Yankees have nothing on Spain’s Real Madrid.) The poor get poorer, some teams fail entirely, and those intent on self-improvement have an opportunity every year to rise above circumstances. To quote a great middle-brow American intellectual (John Cougar Mellencamp): “Ain’t that America?”

THE BUBBLE BLOWER

Despite all its position of power, prestige and privilege, the economy lies still beyond the grasp of the central bank. The bank can influence, but it cannot control. It can turn on the hose, but it cannot aim it. While this was true in its earliest days, it is even more so today. Central banking was created during times when the banks were at the heart of borrowing and lending, and hence at the heart of money and credit creation, and yet today -- that situation is no longer true. The new reality of our credit-soaked economy is that control of the money supply is virtually impossible. The capital and money markets now dominate finance, with banks only a subset.

The distinction between money and credit is sometimes a blurred one in today’s world. It is sufficient to understand that credit, like money, represents ready purchasing power. Purchasing power that is increasingly being manufactured outside of the sphere of banking and used to finance the purchase of assets such as stocks and real estate. Non-bank financial institutions, notably the GSEs Fannie Mae and Freddie Mac, but also others non-bank finance companies, have driven the creation of a seemingly bottomless and borderless money market.

Through open market purchases, the Fed can create additional reserves that can then be used for lending activities that, the Fed hopes, will stimulate the economy. This is the standard playbook of any central bank. Bank reserves facilitate lending, constrained by reserve requirements, which creates a multiplier effect on the reserves. If banks can lend out 90% of their deposits, then a $10 million initial purchase by the Fed leads to $9 million in lendable funds, which (assuming the loaned funds stay in the banking system) then create $8.1 million in lendable funds for another bank ... and on and on it goes.

Even though the Fed can create bank reserves, it cannot force lenders to lend or borrowers to borrow, though there are very strong incentives for both to do. But the modern money markets no longer need the banks or their reserves to finance incredible amounts of financial assets (stocks, mortgages, etc.). No credible future historian of our era will neglect the GSEs, Fannie and Freddie, whose tremendous contribution to the credit creation process will stand out like the Petronas Towers in Kuala Lampur’s skyline. I have the distinct feeling that when the GSEs are finally stricken by crisis, it will be written as if it were obvious all along. Just as the history of LTCM -- where one is prone to shake one’s head and say “my goodness what were they thinking?” -- so too, future readers will just shake their head, as it will all seem so obvious by then.

When the post mortem of this great credit bubble era is written historians will focus on money and credit. They are not going to consult the CPI or PPI. They are not going to look at productivity figures, or job reports or manufacturing utilization rates. They are not going to pay much attention to the comings and goings of political hacks -- no, they are going to write about the massive growth of money and credit as the seed of the monetary meltdown of western civilization. They are going to write about what happened to our money.

FREE RENT

I was riding the street railway into downtown Pittsburgh this morning. I noticed a billboard in the trolley car, advertising units in an apartment complex. I happen to know that this apartment complex is real estate of significant quality. This particular rental property has architectural merit, and was recently rebuilt from the inside out, up to a very good specification. It is, in short, a very nice place to live. It is even nicer now, because the ad said “$99 Deposit -- Two Months FREE Rent.” A deposit of $99? As a matter of law, a rental security deposit is intended to serve as security to the landlord against damages to the premises caused by the tenant during the term of the leasehold. $99 will not fix much in the way of damages to any premises. So, here is a desperate landlord.

This ad is in all likelihood a come-on for a two-year lease, but with a two-month term of rent forgiveness. Reading between the lines, however, it is a reflection of how few potential renters there are with any liquidity up front. People lack funds for a month or two of security deposit, and on top of that they are receiving an allowance for “free” rent for two months. At root, the landlord’s idea is to get the tenant into the lease, and then hope and pray that the tenant does not stiff him on the rent. That is the rest of the story, still to be told, of dealing with unqualified tenants.

Thus we have a housing bubble. It is a cascading tragedy of people using funds that are not theirs, to “purchase” real estate that they cannot afford, obligating themselves to make payments that will stretch their incomes and constrain their lives. At the same time, we have landlords making unprecedented allowances to find solvent tenants. This simply cannot reflect a healthy economy. When Alexis de Tocqueville came to America in the 1830s, his intent was to study conditions in the prisons. Instead, he found and wrote about a flourishing political democracy. If someone came to America, today, to study how its democracy was working, what would he find? He would discover the new democracy of credit, which has the effect of trapping countless people in a prison of illiquidity and unpayable debt.

THE INVERSE SILICON VALLEY BOOM

Silicon Valley is experiencing some degree of recovery but, despite the headlines, it is not a boom. One interesting aspect is many business practices are the anti-thesis of 1999-2000 while some are distressingly similar. For lack of a better term, Silicon Valley’s 2004 condition is the “Inverse Boom”. It is no secret Silicon Valley aches for the good old days of 1999-2000. NASDAQ 2,000 is touted as evidence of our return to glory. News reports are anxiously scanned for the next blurb to “prove” the local economy is back. Increasingly, the mantra is pre-IPO start-ups will lead us all to the new boom! However, the prospects for small companies and IPOs to drive a new boom in the Silicon Valley economy are over-stated. For those outside the “golden inch” of IPO riches in this mile-wide/inch-deep “recovery”, a comparison of Silicon Valley business practices from 1999 -2000 to those in 2004 show these are interesting times.

Companies used to cut costs when sales were declining but accept higher costs, and headcount, when business was growing. If there is a theme within the 1999/2000 vs. 2004 comparisons, companies are now trying to grow their business and cut costs at the same time. Companies are cutting costs for equipment, the cost of offices and, especially, the cost of staff and wages. Simultaneously, house prices are up. “Interesting times” indeed!

WHAT MORE COULD THE STOCK MARKET WANT FROM THE ECONOMY?

With the second half of the year just under way, The Wall Street Journal today published its “Semiannual Economic Survey”, which allows some 55 establishment economists to make mildly pleasing economic forecasts -- mildly pleasing first for themselves that is, and then perhaps to readers who want to be mildly pleased. What they say about the stock market is utterly predictable. Only 2% of the group thinks the Dow Industrials will be below 9999 by year’s end (it closed today at 10,283), while 45% think it will reach 11,000 or more by then. This is less bullish than the group was as 2004 began, but when the Dow has gone nowhere after six months and you have to revise your mildly pleasing estimate, you tend to put more emphasis on the “mild” part. But what I want to know is, what more could these establishment guys want from the economy? Has it not given stock market investors everything they could reasonably ask for?

Think back six months ago to early January and imagine that you could have shown a list of everything that has come to pass this year to the 55 economists and asked them, “If all this becomes fact in the next six months, where do you predict the Dow Industrials will be on July 2?” You and I both know that their “estimates” would have gone from “mildly pleasing” to screaming off the chart bullish.

THE STOCK MARKET IS NOT PHYSICS

If you are like most people, you extrapolate the future from the trends of previous data. It appears sensible because people default to physics when predicting social trends. The Law of Conservation of Momentum makes possible our modern technological world. People rely on it every day. Despite its use in so many areas, however, it is inapplicable to predicting social change. For most people in most circumstances, the proper answer for questions on predictions concerning economics, politics, etc. is, “I don’t know.”

In 1886, you would have envisioned a future landscape combed with rail lines connecting every city, town and neighborhood. Small trains would roll around to your home to pick you up, and a network of rail lines would help deliver you to your destination efficiently and cheaply. Super-fast trains would make cross-country runs. You could eat, read or sleep along the way. Would anyone have predicted, indeed did anyone predict, that trains in 2004 would often be going slower than they did in 1886, that they would routinely jump the tracks, that they would be inefficient, that they would have little food and few sleeper cars, that the equipment would be old and worn out?

In 1963, medical care was cheap and accessible. Doctors made house calls for $20. Hospitals were so accommodating that new mothers typically stayed for a week or more before being sent home, and it was affordable. Would anyone have guessed that forty years later, pills would sell for $2 apiece, a surgical procedure and a week in the hospital could cost one-third of the average annual wage, and people would have to take out expensive insurance policies just in case they got sick?

In 100 A.D., would you have predicted that the most powerful culture in the world would be reduced to rubble in a bit over three centuries? If Rome had had a stock market, it would have gone essentially to zero. Futurists nearly always extrapolate past trends, and they are nearly always wrong. Rocks cannot change trajectory on their own, but societies can and do change direction, all the time. In the world of physics, action is followed by reaction. Most financial analysts, economists, historians, sociologists and futurists believe that society works the same way.

Knowing dramatic events in advance would produce no value for investing, so guessing events is an utter waste of time. If news is irrelevant to markets, how can the media explain almost every day’s market action by the news? Answer: There is a lot of news every day. Commentators do not write their cause-and-effect stories before the session starts but after it ends. It is no trick to fit news to the market after it is closed.

THE UNITED STATES OF SPECULATION

The United States has become a nation defined by speculation and gain from asset price inflation. Returns to asset ownership march onward and upward, despite and alongside consumer debt, deficits, falling dollars and trade deficits. Among those still happily dwelling in the sunny delusion that this is normal and sustainable are economists, esteemed employees of the Departments of the Treasury, The Federal Reserve Banking System and most employed in financial services. Recent reporting from the OECD and the 2004 Cap Gemini Merrill Lynch World Wealth Report provide the basis for my not so sanguine view below.

High Net Worth Individualss (HNWI) and leading firms invest growing after-tax receipts into equities as private pensions and hordes of small investors look for asset appreciation solutions. This is the story of how we became and are becoming, the United States of Speculation. Productivity continues running ahead of wage growth and international labor arbitrage proves profitable as speculation and debt growth keep consumers and congress spending ahead of incomes. Stock, bond and housing bubbles extend and deepen belief in asset inflation as the American way. Firms move operations overseas and import products back to bargain and luxury hunting domestic markets fueling growing current account shortfalls. Dollars are cycled back into booming US asset markets. Profits, refinancing money, housing bubble gains and high after tax incomes mix with dollars earned around the world. Booms and bubbles inflate, driving the imbalances that are noticed -- fleetingly -- when busts arrive. Thus, scary structural fundamentals march up in lock step with asset prices.

The response to the bust is to intensify the dynamics that fed the structural mutations creating growing deficits, stagnant wages, rising consumer debt and international imbalances. As the World Wealth Report suggests, asset inflations have run ahead of economic growth. Interesting and newer to the Report, HNWI are moving increasingly to diversify investments products and strategies: US HNWI doubled their foreign holdings in 2003. Like their leading corporate equivalents, HNWI are increasingly demanding CFO like advice and growing foreign revenue exposure.

Many seem overly optimistic on US equities nonetheless. However, there is evidence of a prudent growing interest in nimble and foreign assets. While this may signal recognition that things that cannot go on forever, don’t -- it is too early to tell. I can offer much more definitive certainty about the absence of recognition by American financial professionals, Fed employees and Federal officials. They seem ever more certain that things that cannot go on forever do. Thus, they celebrate and extend the drivers of the structural problems that they steadfastly refuse to acknowledge. That is the story of the rise of The United States of Speculation.

CAN RISING RATES STIMULATE HOUSING?

The continued strength of the housing market, months after the bond market began to raise interest rates -- and just as the Federal Reserve begins to follow suit -- says interesting things about the state of the economy. First, it reflects the popularity of housing as an investment. For many in America, housing remains the only investment they have made that has worked without fail. Second, the strong housing market reflects the confidence of buyers that their jobs are safe. It took longer than usual for job growth to arrive in this recovery, but it has done so. Economists may worry about excessive consumer debt, but consumers do not.

But there may also be a third reason, one that is in some ways perverse. The prolonged talk about raising rates, including the widespread belief that there will be a series of increases, may have done the exact opposite of what a rise in rates is expected to do. Rather than depress sales, it is now stimulating buying and pushing prices higher. When inflation is rampant, as it is in home prices, an increase in prices becomes a reason to buy now, before they go even higher. The apparent certainty that borrowing costs will rise has contributed to that frenzy.

Home prices are perhaps the only market where buyers and sellers measure prices quite differently. Sellers see a price of $500,000, or whatever it might be. Buyers see a price of so much a month. As rates fell, the seller’s price could soar while the buyer’s price did not. As mortgage rates rise, the reverse will be true, and those whom Mr. Greenspan is encouraging to buy now may suffer the most. Rather than focus on a gradual rise in interest rates, the Fed should be trying to set the appropriate rate given the strong economy and rising inflation. That rate is not 1.25%; it is probably above 3%. The Fed’s policy of gradualism may be politically popular, but its economic effects may prove to be unfortunate.