Wealth International, Limited

Finance Digest for Week of July 12, 2004


Casting a Wider Net

Just about every finance textbook has at least one chart that shows the benefits of international diversification. By putting some of your money in foreign stocks, you can decrease the volatility of your overall portfolio without sacrificing returns. Putting this theory to work takes some patience, since there are long stretches when the diversification does not accomplish much at all. Over the past ten years the S&P 500 index has averaged an 11.3% annual return with a 15.7% volatility (annualized standard deviation of monthly returns). A 50-50 mix of the S&P and the Morgan Stanley Capital International EAFE (Europe, Australasia & Far East) Index would have just barely reduced volatility and chopped the annual return to 7.6%.

Jeffrey Everett, president of Templeton Global Advisors has a notion about what is wrong with the theory. It focuses too much attention on country allocations and not enough on stock picking. Foreign index funds, filled with big multinationals that tend to track the broad U.S. market, just are not going to deliver the diversification you need. Get foreign funds that own a lot of smaller companies. Or buy your own stocks. The ones available as American Depositary Receipts, and there are plenty of those, are easy to get. “Investors have come a long way in understanding the case for international investing over the years, but one thing they’re still missing is the huge opportunity in picking individual stocks,” says Everett, 40, who guides the firm’s large funds along with George Morgan and Murdo Murchison. “There are pricing inefficiencies overseas that just aren’t here in the U.S.”

Link here.

It’s a Small-Cap World

Of the $300 billion that Americans have invested in international mutual funds, a mere tenth is in funds devoted to small-company stocks, according to Morningstar. Take a closer look at this neglected specialty and you can find some very talented stock pickers.

Link here.

The Indiana Jones School of Investing

And you thought Enron was bad. Terrorism, wars and civil unrest usually are not the best way to attract investors. The truth is, though, that good stocks lurk in troubled places.

Link here.

Neglected Tigers

Hear mention of Asia these days and you think about China’s enormous potential, India’s software prowess or Japan’s long-overdue rebound. But what about the Asian “tigers” -- Hong Kong, Singapore, Taiwan and South Korea? Some of these are worth a closer look, says Paul Matthews, chairman and founder of Matthews International Capital Management in San Francisco, who along with Mark Headley, manages $2.4 billion, all invested in Asia.

Link here.

DIY Overseas Investing

It is a big world out there -- 49,000 stocks trade on overseas markets. You can throw up your hands and have a mutual fund do the picking for you. Or you can be your own portfolio manager. Below we provide a jumping-off point for your search. These are 125 foreign stocks that are cheap by at least one of three different classic measures.

Link here.

Exchange-traded funds offer a cheap and easy wayto invest in foreign markets.

International stock funds are usually burdened with high expenses (1.5% or worse). Exchange-traded funds provide one solution for the global do-it-yourselfer with limited research time. Barclays Global Investors pioneered international ETFs with its first offering in 1996, and it still dominates this field. The firm’s current lineup includes 15 ETFs that track Morgan Stanley Capital International developed market indexes and 6 for MSCI emerging markets. Barclays also offers 5 global sector ETFs, such as in energy and telecommunications. ETFs are bought through a broker, just like stocks, but behave like index funds. Unlike closed-end funds, which can trade at substantial premiums or discounts to the value of their underlying portfolios, ETFs rarely stray far from net asset value.

Link here.

Ever-volatile Latin America is like the Samba: three steps forward, two back

In the mid-1970s money manager Peter Gruber was living in Buenos Aires and investing his own money. Argentina was a mess, politically and economically. An inexperienced Isabel Perón, widow of the iconic Juan Perón, was president. The inflation rate was 300%. The stock market had collapsed. In 1976 the military took control. Buy when blood is running in the streets, says the proverb. Gruber bought ten Argentinean blue-chip stocks, investing his own money. A year later they had appreciated sixfold and he sold them.

Today Gruber runs $600 million today through his Globalvest Management, out of an office in St. Thomas, U.S. Virgin Islands. All these assets are in hedge funds. Gruber, who in the 1980s invested in Latin America for the value-oriented Sir John Templeton, looks for openings in countries emerging from crises. No shortage of those in South America. Gruber, 75, is bullish on the region. Last year it had five of the world’s ten best-returning stock markets. So far in 2004 Latin markets have disappointed, however. The economic fundamentals in the region lead Gruber and his comanager, David Wheeler, to expect markets to rebound in the months ahead. But Gruber is selective in his attachments. He likes Brazil the best.

Link here.

Demography Plays

William sterling has been a big-picture guy on Wall Street for 18 years. Ask the man, a self-described “recovering economist”, about the case for international investing, and he will bend your ear with a barrage of opinions on everything from America’s external accounts to Japanese real estate prices. So how does Sterling, 50, who oversees $5.2 billion as chief investment officer of New York’s Trilogy Advisors, zoom in on a list of stocks? Demographics play a key role.

Demographic information comes with a comforting level of certainty, no matter what the market. If you know the number of 15-year-olds alive today, it is not too hard to guess how many 25-year-olds will be around a decade hence. “There’s almost nothing else you can say about ten years from now with that amount of confidence,” Sterling says.

Demographic longs include medical devices, especially implants and prosthetics, as well as cruise ships, recreational vehicles and low-end real estate. The latter category plays more off the “echo boom”, or the children of the baby boomers, now headed into their twenties. An example of a demographic short would be winter sports. “Not good,” Sterling chuckles.“Fifty-year-olds might like to think they’ll do a lot of skiing, but they’ll probably take a cruise instead.”

Link here.


Pity the Fed. With its first quarter-point increase in late June, the central bank is trying to unwind years of leaping financial leverage and speculation without heavy casualties. Ironically, the problem is largely the Federal Reserve’s own doing. When Chairman Alan Greenspan made his December 1996 “irrational exuberance” speech, the stock rally was 14 years old, a good time to curb excesses. But rhetoric was all Greenspan deployed. The gun-shy Fed did not even send a sobering signal by raising margin requirements, the amount investors must put up to borrow for stock purchases. So rampant dot-com speculation unfolded. The bubble, rivaling that of the late 1920s, spilled over to make the economy hyperactive.

When the Fed finally got serious and started to tighten in June 1999, it was too late. Then, as stocks collapsed, the credit authorities shifted to massive easing to save the economy from a horrible recession and to fight deflation. Unfortunately, this did little to stamp out the excesses, which simply shifted into housing and consumer spending. With low rates, money for mortgages and credit cards remained ample. Tax cuts and leaping government spending helped fuel the spend-a-thon. Securities speculation has lived on as well, merely changing form. Despite the NASDAQ’s 78% fall from peak to trough, memories of the 18-year bull market proved hard to extinguish. Those investors who still believe 20% annual returns are their birthright moved from equities to hedge funds, which leveraged their $800 billion with derivatives and doubled-up trades. Low rates spurred the hedge funds, banks and other financial players to pour into the carry trade. With a 1% federal funds rate here and a zero central bank rate in Japan, they had a lovely time borrowing short term and investing long, where the yields were higher.

Speculators also borrowed cheap short-term money to buy commodities, foreign currencies, U.S. junk bonds and emerging market debt and equities. Sure, other reasons existed for strength in these areas. As usual, however, speculation carried price rises to extremes. But when strong employment gains appeared in early April and the Fed made clear its rate-hike plans, markets immediately ran way ahead of the central bank. Since Apr. 1 the year-end federal funds rate anticipated in the futures market has jumped a full percentage point. The same occurred with inflation-sensitive ten-year Treasurys. Junk bonds, emerging market stocks and bonds, commodities and foreign currencies all nose-dived.

Still, few speculative trades have been unwound so far. This is vexing since leverage is much greater than in 1994 when Fed rate increases also caught speculators off guard and killed broker Kidder Peabody, the finances of Orange County, California, and the Mexican economy. Which large financial institutions might succumb this time? Hedging techniques are better than they were ten years ago. But remember that hedging can transfer risk but not eliminate it. The basic question: On balance, is risk being transferred from weak to strong hands or from strong to weak? I would bet on the latter.

The Fed is in a tight spot. To avoid appearing impotent, it must confirm market anticipations with much higher rates. And that could be deadly for leverage speculators who have been encouraged by Fed inaction and actions since 1996. These are worrisome times that require equity investor caution. If troubles come, Treasurys will benefit as safe havens amid, I expect, a shift from inflation fears to deflation fears.

Link here.


The consensus among Fed watchers and Wall Street traders of various stripes has been thus: The Federal Reserve can finally move away from its “emergency” low federal funds rate of 1% that it has maintained for some time. Starting with the recent 25 basis point hike, the central bank will methodically -- albeit likely at a “measured pace” -- give us a number of similar baby steps over the next year or two. Eventually, the Fed will move the federal funds rate up to one the markets deem “neutral.” Based on the most recent readings on core inflation (and I’ll pretend for the purpose of this commentary that the government’s misleading numbers are correct) this means the federal funds rate will ultimately reach a level of 4% or thereabouts. At that point, the pundits say, all will be well with the world, and the Fed will no longer be regarded as “behind the curve”. Whether we get to such a level on the funds rate is not being seriously debated; only how quickly. Well, don’t hold your breath.

That rates will be hiked modestly has not been in doubt; after all, the Fed would blow what little credibility it has left if it did not do something to acknowledge that prices are rising at least a little, and that there might be some sustainability to the stimulus-induced bounce of the last year or so. But make no mistake: Greenspan and Company are not quite as stupid as they often sound. They do know that the economy is not on strong footing of its own accord. They do know that the various bubbles they have blown must not be allowed to lose their air quickly.

In short, their dovish stance on inflation is not unwarranted. This is not because prices are not rising; it is because consumption, wage growth, jobs and all the rest still suggest an economy that would have done little had it not been for the Fed’s emergency rate. The Fed will remain loathe to hike rates any more than it absolutely has to. For a while to come, nobody will care whether consumer prices continue to rise. After all, if Greenspan says these price rises are to some extent “transitory” that is good enough for the hoi polloi in the markets right now. They, like Greenspan, are far more interested in “growth” continuing via any means possible. At some point, though, I have to believe that many others will begin to wake up to the fact that we have already entered a type of environment that I call “70’s lite.” Back in the 1970’s, it was called “stagflation”. Growth is slowing. It will get harder to make ends meet for millions. Yet, prices will keep rising.

I am not smart enough to know exactly when this will sink into the markets, and cause traders to trash the dollar (which in recent days has still refused to confirm a new downtrend) anew, sell off U.S. government debt (prices of which have rallied sharply this week) and cause gold and other dollar-contrary assets to spurt higher. It could be next week; it could be months from now. We will know when the technical behavior of these various markets confirms what should already be happening, but is not. One last note about the Fed. In my view, the only reason that the dollar is not already going into the tank is because the other two major currencies -- the yen and the euro -- are themselves unexciting.

Link here.


Inflation has been a reliable barbarian for so many years. We know it so well. Each time it threatened, we knew how to beat it even if we sometimes lacked the will. What o’ what shall we do without inflation? We fought it for so long, we did not know it had become a friend -- a reliable foe. A foe that was a gentle redistributionist. It took from the present and gave to the future. If things swung too much one way or the other, we knew that the redress at least was simple: higher or lower interest rates.

But now we need inflation and it will not come. The bond market sees a something at the gate and believes it to be inflation. The Federal Reserve does not seem to know that inflation has waved us a long goodbye. The Fed cannot entice it back, not even with once in a lifetime low short-term interest rates. Worse, the Fed will be impotent when deflation comes. The preemptive action taken to stem the effects of the millennium bubble has left it depleted. The Fed has a miniscule 1.25% to combat the much larger deflation that is to come when the real estate and financial-complex bubble bursts.

Alas, alas. What is to happen to us? A few examples of what the Classical School of Economists wrote of deflation follow. This is a difficult topic and has received only minimal attention because this form of deflation has not been seen since The Great Depression. Japan’s current deflationary woes are different. There, domestic consumption and production declined. However, they are not dependent on external funding for their debt as we are today. The Japanese had prodigious savings to draw on even after the bursting of the bubble. As a result they were able to pursue an expansive monetary and fiscal policy. This has led to a very soft deflation in Japan. The population was spared the type of deprivations associated with The Great Depression.

Our deflation will be different. We receive significant funding from overseas. We do not have the liberty to maintain a zero rate of interest; not even on short-term rates. Perversely, as deflation increases and our productive capacity decreases, interest rates will increase since foreign funding will have to be sustained. We could decrease our level of dependence on external funding -- cut our spending both private and public. Or, we could default, a prospect that is too terrible to envision.

Link here.


The Japanese economy grew 6.1% in Q1 of this year, while the Nikkei stock index has rallied some 40% from its 2003 lows. Positive articles have shown up this month in Investor’s Business Daily, Reuters, Bloomberg, and The New York Times, among others. We are still a long way from the late 1980s, when the whole world was in awe of all things Japanese. U.S. business people went by the planeload to learn from their Japanese counterparts, and U.S. politicians debated the merits of adopting Japan-style state capitalism, where the Ministry of Economy, Trade and Industry picks corporate winners and losers.

Yet beginning in 1989-90, Japan became a relentless frustration to the best minds within its borders (and elsewhere). Investors, government officials, politicians, monetary policy and tax policy makers, economists and others tried and failed to fight the trend. Financial news about Japan in the U.S. media went from pessimistic to drying up altogether -- unless you searched it out. “Searching it out” meant learning, for example, that as recently as 2002, Japanese households held the equivalent of more than $10 trillion (with a “T-R”) in bank savings accounts that earned simple interest at a rate of 0.02%. People are not “supposed” to settle for so little interest on their savings, of course. Any Economics 101 text will tell you that the average person will make a more “rational” financial choice.

But the average individual in Japan did not follow the script from an economics text. They followed each other. The long-term social mood took a path of its own in that country, and even the most heroic levels of human intervention did not derail it. Three-year-long deflations were not “supposed” to happen either. Especially in advanced industrial economies. Like Japan. Right? That is what conventional wisdom says. It was wrong. Again.

Link here.


The U.S. credit reporting system is one heck of a story. The story comes with stars and villains (often the same business people), out-and-out crooks (identity thieves and credit repair clinics), would-be rescuers (legislators and regulators) and often-innocent bystanders (consumers). The growth of credit reporting also parallels the growth of the information economy in the last half of the 20th century and the integration of information technology into our lives. No one has written a proper history of credit reporting, and the subject cries out for serious treatment. Today’s book, Credit Scores & Credit Reports: How the System Really Works, What You Can Do, is not that history, but it does offer a comprehensive current look at credit reporting and allied activities, together with some history and policy.

The book’s main feature is an instruction manual for consumers on how the credit reporting system works. A credit report is a consumer’s passport to economic activities. Credit reports affect whether consumers can obtain credit, what price they pay for credit cards, car loans and mortgages, whether they can find employment or insurance and, maybe, whether they can get on an airplane.

The book is a step-by-step, realistic guide to addressing credit reporting problems, with no hype or magic cures. Consumers have more rights than in the past, but it is not always easy to exercise those rights. Hendricks describes the system accurately, and he tells consumers what is and is not possible. Though all consumers will learn from the book, credit grantors and others who interact with the credit system as users of credit reports also will benefit from an overview of this ornate system of obligations and institutions. The book does a particularly good job in describing credit scores, a relatively recent development. Trying to improve your score is a complex and often counterintuitive activity.

Readers also will find an abundance of references to Internet documents from agencies, credit bureaus, hearings and court cases. Those with a pressing need to pursue their rights will find these references useful, yet disheartening. They show how difficult it can be for a consumer to make the credit reporting system respond to problems.

Link here.


Expat savers are reaping the rewards of rising interest rates after four Bank of England base rate increases in eight months. The most recent rise took place on June 10, when the Bank of England’s Monetary Policy Committee increased the base rate by a quarter of a percentage point, from 4.25% to 4.5%. This could spell misery for those with mortgages against their homes, but it is good news for savers. Many of the best offshore accounts are “tracker accounts”, which, as their name suggests, track Bank of England base rates, so if rates go up the rate of interest they pay automatically goes up on your account. With many experts predicting that rates will continue to rise, it may not be wise for people to lock their savings into long-term fixed rate accounts when there may be better deals around the corner.

Link here.


Let us say your area is not one where there is a bubble and home values in your neighborhood still drop 20% in the next recession. If you do not need to move or sell, while you will be uncomfortable in the interim, over time values will rise and you will pay down your mortgage. If you have to sell at the wrong time, you will lose money over what you could get today. If you know you are going to need to sell within the next few years, you might want to consider what your local market will look like during a recession. If your area is somewhat immune to employment and demand fluctuations, then your decision will be different. Think of homes that appeal to retiring boomers in very desirable retirement areas. There are a lot of wealthy boomers looking for that perfect spot for the golden years. I would also expect that mortgage interest rates will drop during the next recession, which will help bolster sagging values.

There are lots of facts that should make us nervous and others that give us reason to be a housing bull. But that still does not answer the question, is there a housing bubble? I believe the short answer is “no” for all but a few areas of the U.S. Over the long-term, I think most homeowners will see reasonable returns from their homes. But that does not mean you should rush out and buy an investment house or that housing prices cannot drop significantly from where they are today.

And what about my predictions for the future of home prices over the next 10-15-20 years? Except for bubble areas, I would think that average U.S. home prices ought to rise in line with inflation. Near-term, the recent rapid rise over inflation suggests a slowing of increases or even a retreat back to “trend”.

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


The news has not been good lately for banks in Russia. Last week, Guta Bank, one of the top 25 consumer banks, failed and was sold to a state-owned bank. Meanwhile there was a run at the largest privately owned bank in the country, Alfa Bank, as smaller banks were delaying payments to depositors. Get this: Alfa actually began charging customers a 10% commission to withdraw their cash. But it is not just Russia’s banks that are having trouble. How about its stock market, which has plunged 32% from its April 12 high.

Let us leave Russia for now and travel down the yellow brick road to China and India instead. These two countries in the East have been heralded as shining economic lights for the 21st century. But their stock markets are not booming, either. In fact, they have been declining fairly precipitously -- just like Russia’s. Since early April 2004 the Shanghai Composite is down nearly 23%, while India’s Sensex fell by 33% from January. If China and India are the world’s growth leaders, why are their stock markets not booming?” Will another liquidity crisis roll in from the East?

Link here.


In a recent New York Times article, writers Kirk Johnson and Dean E. Murphy write that there exists a real possibility that a long cycle of drought could drastically alter how westerners live and work. Not surprisingly, as one might expect of mainstream journalists from the nation’s “newspaper of record”, the reporters demonstrate at best only a partial understanding of what is happening and what can be done about it. While the Times portrays the federal government as the ultimate savior in this growing mess, history tells us otherwise. The American West faces severe water shortages because of U.S. Government policies of this past century; the solution is not for the government to further assert itself, but rather to end the water socialism that it has imposed. The command system of economics that has led nations like North Korea and Cuba into ruin has also created the crisis in the West.

What the Times does not tell us is that water in the western states has been distributed politically, and that agricultural interests have held sway. Unlike the riparian system that governed water rights in the eastern USA, the West has developed under a “first user” principle that has operated on the principle of “use it or lose it” allocations, which is a sure recipe for waste. In other words, the use and distribution of water in the West ultimately is an economic issue, something that the Times reporters have missed.

Such obvious waste cannot go on indefinitely, since government can only provide subsidies, not create new sources of water. Under a private system of ownership -- or even a semi-private one in which those with water rights would be permitted to sell them to whomever they would choose -- the water would go to users willing to pay for them. Would that mean the end of some farms in California and elsewhere in the West? Yes, that is exactly what that means. To put it in a way that Austrians would understand, government policies have resulted in malinvested resources and development that cannot be sustained. As in Austrian Business Cycle Theory, which stresses that recovery cannot begin until the malinvested capital has been liquidated, the American West cannot begin to see true “sustainable” development until new policies are implemented. Changes will occur whether or not the government acts to get itself out of the water business. That is because government can only create hot air, not water itself.

Link here.


It is commonly thought that the U.S. economy reaps the benefits of an entrepreneurial economy and its stock market is merely along for the ride, providing participants double-digit returns as far as the eye can see. Stock ownership has in recent years come to the masses, who fully expect to profit not from their own unique vision, but because “stocks always go up in the long run,” or so they are told. Can the multitudes profit in the investment sweepstakes? Is capitalism, in fact, democratic? Are we entitled to all get rich together? Looking at the great bull market from 1988–1999, the answers appear to be “yes”. The S&P 500 returned 19.0% per annum with dividends reinvested. Even if the 2000–2002 bear market is included, stocks gained 14.2% annually for the 1988–2004 period.

Unfortunately, the typical investor did not achieve these returns. First, he was late to the party. In 1989, at the onset of a decade that saw the Dow Jones Industrials Average quadruple, just 31.6% of households owned stock. By 2001 stock ownership had swelled to 51.9%. Second, investors chased momentum to their detriment, in essence navigating the markets through a rear-view mirror. According to a recent study by financial research firm Dalbar, from 1984-2002 the S&P 500 returned 12.2% annually, yet the average stock investor earned a meager 2.6% per year.

How can Austrian economics in general and Ludwig von Mises’s wisdom about entrepreneurial profit in particular improve an investor’s returns? We think in several ways: 1.) Invest in market entrepreneurs with a margin of safety (sustainable businesses, reasonable valuations, and solid balance sheets); 2.) Look for investment opportunity in foresight apart from the consensus; and 3.) Avoid the economic errors of the crowd.

The interplay of wealth creation (entrepreneurship) and destruction (government intervention) is constantly at work; it is the focus and mood swings of investors that change. Major stock market lows are often set when the failures of the state are exposed and become engrained in the public psyche. Depression (1932), world war (1941), expected return to depression (1949), inflation (late 1970s), and deficits (late 1980s) created the best buying opportunities for investors of the past 75 years. How does the future -- viewed through the lens of an Austrian economist -- differ from the outlook of the typical investor? Are investors justified in their optimism? From an Austrian perspective, there appear to be several likely events, in order of their unfolding.

Link here.


This week’s New Yorker magazine includes commentary on the 78-year-old chairman of the Federal Reserve and this related bit of trivia: “Greenspan’s lugubrious face and nasal monotone are as familiar and as comforting to ordinary Americans as Prozac and ‘The Simpsons’, both of which débuted in 1987, the same year President Reagan appointed him to office.” This is a great throwaway line, which I suppose the writer did not want to dwell on because he had more “serious” Greenspan-related matters to address: the recent 1/4-point rise in the Fed funds rate, a monetary policy that had amounted to “essentially giving money away”, the way Mr. Greenspan “publicly endorsed” the Bush Administration tax cuts, blah, blah, blah....

But I would rather rewind to the Prozac/Simpsons quip. The poster-drug of the pharmacological feel-good revolution and a vulgar prime-time cartoon both take the stage in the same year as Mr. Greenspan’s appointment? That is not a coincidence; that is a metaphor. Artificially happy and too easily amused, why shouldn’t the public have faith in the wonderful Wizard of Fed?

So if I had to arrange matters on a scale of “seriousness”, be assured that the Fed funds rate, monetary policy, etc., would all rank below the most serious of all Fed-related issues, which is: How seriously mistaken most “experts” and investors are for believing that Mr. Greenspan’s decisions have anything whatsoever to do with the dominant trend in the stock market.

Link here.


Wholesale prices fell by 0.3% in June and big industry production was down as well, unexpected developments that one analyst likened to the economy hitting a speed bump. A retreat in food and energy costs caused the drop in the Producer Price Index, the biggest in a year, the Labor Department reported. That came after wholesale costs shot up in the prior two months, reflecting sharply higher prices for energy and food. Wholesale prices had risen by 0.7% in April and by 0.8% in May. The latest reading on the PPI, which measures the prices of goods before they reach store shelves, surprised economists, who were forecasting a 0.2% rise in wholesale prices in June.

Separately, the Federal Reserve reported that industrial production at the nation’s factories, mines and utilities dropped 0.3% in June, it marked the largest decline since April 2003. That followed a 0.9% advance in May. June’s performance was weaker than the 0.1% rise analysts were predicting. Factory production dipped 0.1% in June, down from a 0.6% advance. Output at utilities, which jumped 3.7% in May, declined 2.3% in June as temperatures returned to more normal levels after being unseasonably high in the previous month. Mining output nudged up 0.1%, after being flat in May.

Link here.

The CPI cannot predict inflation.

Ask any mainstream economist what the best gauge of inflation is, and you can bet your non-bottoming dollar on the reply -- the Consumer Price Index (CPI). These days, economists’ eyes are focused on the steady rise in the CPI to confirm the official comeback of inflation in the U.S. economy. And, if you have any doubts about the weight Wall Street places on the index to identify the inflationary trend, then just consider a few recent news items.

We could not DIS-agree more. The CPI is the least reliable indicator of future inflation. Any questions? We thought so. All right. Prices in the CPI may be on the upswing -- slightly. But, if you look at a snapshot of the various components that make up the index, you will see this: The majority of that UPswing is due to soaring prices in such sectors as education, housing, and medical care. Can you think of what these three groups have in common? Try Uncle Sam. Price rises for these goods and services are due NOT primarily to inflation, but rather to government control, subsidy, and restriction.

In order to locate the true inflationary effect, it is more proper to track the prices in those groups relatively untouched by government “meddling”. For starters: Automobiles, television, and clothes, all of which are relatively unregulated by the government; the PPI; and gold, commodities, and bonds.

Link here.

Wanting explanations when explanations are wanting.

You may recall my discussion of the Semiannual Economic Forecasting Survey, published by The Wall Street Journal at the beginning of July. The opinions of the 55 economists were uniformly upbeat about the second half of 2004, both for stocks and the economy overall. This consensus view indeed spoke with one voice about the trends that should accompany growth -- inflation, increased industrial output, more consumer spending, earnings gains, a rising stock market, etc.

Well, here is what has happened in the two weeks since these forecasts were published: industrial production has declined, capacity utilization is down, the producer price index has fallen, inventories are backing up at major tech companies, initial unemployment claims jumped, and the major stock indexes have fallen from about 3% to 7%. Yes, two weeks is far too soon to draw conclusions, since the “experts” were looking six months ahead. Yet, when these expert folks have been asked why the data has been coming up short, their replies sound like a mix of the desperate and the bizarre.

Last week, it was a lower-than-expected retail sales report for the month of June, and the alleged culprit was “unusually cool summer weather” that “stifled business”. And today, when industrial production not only fell short of the consensus estimate for growth but actually declined, a certain “chief U.S. economist [at] a research firm in New York” actually came up with: “One factor holding down output last month may have been the national day of mourning for the late President Ronald Reagan.”

Link here.


Whereas the bulls are convinced that the market will rise strongly for the rest of the year on the back of what they perceive to be “great economic news”, the bears feel that the market is on the edge of a collapse. There is a third possibility, which would be particularly unfavorable for the hedge fund industry. The markets could enter a long and tedious trading range. I am leaning towards the view that, for most markets, including developed and emerging stock markets, as well as for bonds and commodities, we saw the highs for this year in the January to March period.

From here on, I think that additional gains will be minimal and that the rewards will not compare favorably to the eventual downside risk. But, as was the case in Asia where most markets peaked out between 1990 and 1994, and were then followed by a trading range with a downward bias until the real collapse occurred in 1997/98, it is also possible that U.S. asset prices (homes and stocks) can continue to hold on to their gains for some time. Still, I am convinced that only a very serious crisis can correct some of the blatant imbalances that our global economic system has created. So, at the very least, investors should gradually take out some insurance against what, in my opinion, is an eventual inevitable crisis, by being well diversified in every aspect of the investment universe. I am leaning towards an overweight position in hard assets over paper money and financial assets, knowing full well that, in a crisis, hard assets might also decline in value (except possibly for gold and other precious metals), but likely less so than financial assets.

Being diversified in terms of the “investment universe” also means holding assets in different jurisdictions. I have repeatedly advised our American readers to hold accounts outside the U.S. I am well aware that this has become increasingly difficult, and, under pressure from the U.S. authorities, some Swiss banks are extremely reluctant to accept such accounts. Singapore is, however, a viable and safe alternative to Switzerland. Still, the fact that the U.S. authorities have made the opening of overseas accounts so difficult should serve as a warning signal of things to come -- that is, foreign exchange controls.

In terms of financial assets, I would overweight Asian equities, due to their lower valuations when compared to U.S. equities and the relatively favorable macroeconomic conditions in Asia (current account surpluses and undervalued currencies). But, as I have pointed out before, whereas Asia may eventually de-couple economically from the U.S. business cycle, there is still a very close financial connectivity in place, with the result that at present the Asian markets track the movement of the S&P rather closely.

In terms of commodities, I would be careful about buying markets where there are large speculative positions outstanding. I am now also concerned that, despite long-term favorable fundamentals, the oil market could, in the near term, sell off quite badly. The only commodities I still like are coffee, which has recently broken out on the upside, sugar and orange juice, which is extremely depressed. Finally, every investor should consider that, the longer the monetary- and credit-driven speculative party lasts, the worse the eventual outcome will have to be.

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


Earnings season is under way in the United States, and the proximate cause of the latest tech tumble was a series of dour pronouncements from the industry’s great and good. Many in the sector that used to be known as TMT (technology, media and telecoms) have announced results that have disappointed investors. Even some of those who have yet to post their results have been treated harshly. Nasdaq, home to many a tech favorite, has fallen by 5% in recent days. This may be because the shares in the index were priced at levels that would have made Icarus wince. Even after this latest tumble, the price-to-earnings (p/e) ratio on Nasdaq is around 60.

The question, of course, given that the broader stockmarket is scarcely a giveaway -- the S&P 500 trades at a p/e ratio of about 21, far above its historic average -- is whether the treatment meted out to tech stocks foreshadows something nasty for the stockmarket as a whole. Corporate America, you might have noticed, is fantastically profitable. While nobody thinks that profits are likely to carry on growing at current rates, there is a school of thought that says as long as they carry on growing at all, the stockmarket will follow suit.

The historical evidence, it should be admitted, is mixed. On two of the previous occasions when profits had risen this fast for this long, stocks rose thereafter; and on two they fell. There are many reasons to plump for a less rosy outcome this time round, however. The first is that shares are expensive. High p/e multiples are perhaps justifiable when profits are depressed, but much less so when they are frothy. When things can’t get any better they won’t -- and as a percentage of national income, corporate profits are already at record highs.

David Bowers, a strategist at Merrill Lynch, suggests looking at America’s inventory-to-shipment (I-S) ratio. This, says Mr. Bowers, is at an all-time low, largely due to a very rapid growth in sales. But it is set to rise. When it has done so in the past, he writes, “bonds have been a ‘buy’, earnings growth has been scarcer, industrial pricing power weaker, and high-yield credit spreads wider. Ignore this indicator at your peril.” Shipments, it turns out, have been rising exponentially. And when things are flying out of the factory door at such speeds, factories stock up. Inventories, says Mr. Bowers, could end the year 6-8% higher than they started it. Which would be fine if shipments followed suit. They are unlikely to do so because exponential growth is simply not sustainable. When final demand starts to weaken, the I-S ratio will rise, dramatically weakening corporate pricing power and (one assumes) profits.

Which is where we get back to technology. Inventories have already started to rise sharply at Intel, Texas Instruments and Cisco. Possibly, this is a foretaste of a broader problem, for America relies on demand from consumers who have, to be frank, consumed to the max and done so with borrowed money. Although consumers say they are confident, they are starting to rein in their spending. Car companies and retailers are already suffering as a result. At some point, so will the stockmarket.

Link here.

Inventory is inventory.

It used to be that you could hear or read about Intel’s quarterly earnings call and readily see how they were doing. Ranked among the hype-meisters of Silicon Valley, Intel was very low on the totem pole. Judging by this week’s report, Intel management is taking a crash course in “baffling them with bull****”. CBS Marketwatch reported that Intel met expectations but, cut its full-year gross margin target two percentage points to 60% and announced a 15% sequential jump in inventory to $3.2 billion.

Incredibly, Intel blamed the inventory growth not on the lack of a corporate replacement cycle in North America and Europe or weak IT spending growth or on a slow-down in the laptop business in Taiwan or even on a flattening of cell phone production in China. Instead they blamed it on “a new generation of computer chip making equipment (which) is manufacturing its chips at a better rate, or yield, than previously expected.” The margin reduction is a red herring. They very visibly took a little of the margin-reduction medicine now in hopes of taking our eye off the inventory growth.

Intel’s margin declined because they are starting to work off inventory accumulated over the last two or three quarters. This problem probably has a good chance of getting worse over the next two or three quarters but they are hoping for a sales rebound or other un-forecasted event to hold their margins up. Inventory is inventory.

Link here.


Everyone has probably heard the phrase (usually in ads by realtors or mortgage brokers) that the house you live in is your greatest investment or asset. This is because it is the largest dollar figure on the average American’s personal balance sheet, and most homeowners get a tax break from Uncle Sam on their mortgage interest. But Americans should ask themselves the question: Is my house really an asset? The answer can be yes and no, depending on when and where you bought your house, and how long you held it before you sold it. But unless you rent out other rooms in your residence for more rent than your mortgage payment, it is not an asset. And I will explain why if you keep reading.

One of the biggest mistakes average investors have made throughout history, is to assume what has happened in the past will continue to occur in the future. I know people that have bought houses in supposed “up-and-coming” areas of Denver -- at prices I would not touch with a 10-foot pole -- and are betting on future appreciation over the next few years, just like it has in years past. The problem with this theory is the assumptions behind it. The average American is assuming that mortgage rates will stay at 40-year lows, inflation will not be a problem now and in the future, and that wages will not be negatively affected by outsourcing of blue and white-collar jobs to India and China. And that prices will keep on rising, just like they have through the 90s and early 2000s.

Besides location, condition, square footage and amenities, the two main factors that affect all home prices are interest rates and income. Right now, a homeowner can leverage his or her annual income up to 4 times for the price of a house. In other words, if someone makes $50,000/year and has good credit, they can buy a $200,000 house. With any investment, you should know if you are in a bull or bear-trending market before you buy -- and know if you are in the early or later stages of that market. This will give you a decent idea of how much upside potential an investment may have. It will not guarantee you that you will make money in the short-term, but should ensure longer-term profits. It does not matter if the investment is stocks, bonds, real estate or Peruvian llamas. The fundamentals and principles of sound investing still apply, whether the year is 1904 or 2004.

Again, the two main factors that affect the price of real estate are 1) mortgage interest rates, and 2) a homeowner’s income. Since most Americans depend on a job for their income, and salaries are under deflationary pressure from outsourcing and a slowly recovering economy, it does not appear to be a bullish factor for real estate prices. Looking at mortgage interest rates, they are still at multi-decade lows. A 30-year fixed mortgage is in the low 6% range. How long these rates will stay this low is anyone’s guess. My advice would be to expect rates to significantly increase (at least 1-1.5%) in the next 12 to 18 months. My crystal ball is not any clearer than this.

The biggest reason that a house usually is not an asset, is because of Robert Kiyosaki’s (best-selling author of the book Rich Dad, Poor Dad) definition of assets and liabilities. An asset is any investment that puts cash into your pocket, and a liability is anything that takes cash from your pocket. Most successful real estate investors rely on cash flow as the measure of how good a property investment is. If someone has made money by selling a house for more than they bought it for, obviously it was a good purchase and sale for a capital gain. However, if you look back throughout history, most real estate markets are not like the ones we have seen in the late 90s and today. Rapidly appreciating prices (manias or bubbles, if you want to call them that) that boom in any market, always come back down to earth in a bust. Common sense tells me that interest rates cannot stay at these lows forever, and incomes still appear to be in a sideways to slightly-declining holding pattern, no matter what the government numbers say.

Link here.


Wealthy U.S. investors want quick returns and are not prepared to buy and hold for long-term growth, according to a poll carried out by the Chicago-based consultants Spectrem Group. Investors of bygone years would sit on their investments for years, accepting the ups and downs of the market. “Today’s investors, fueled by the boom markets of the late 1990s, are not content with achieving long-term growth,” the survey reported. “They want results now.” The survey said the percentage of affluent individuals who include so-called alternative investments like hedge funds, private equity and venture capital in their portfolios rose to 6.3% in 2003 from 1.5% in 2000.

The poll results, however, showed a low understanding of such alternative investment products. Spectrem surveyed 250 individuals with a net worth of more than $500,000 in April. Mutual funds were the most understood products among those polled, but exchange-traded funds, mutual fund wrap accounts and separately managed wrap accounts were not well understood. In a wrap account, a professional adviser allocates an investor’s assets across multiple investment managers who buy individual securities or mutual funds on an investor’s behalf.

Link here.


Federal regulators proposed new oversight for hedge funds, investment pools traditionally for the wealthy that are growing and attracting small investors but have scant federal scrutiny. The vote was 3-2, marking the second time in less than a month the Securities and Exchange Commission split over a significant regulatory move. In both instances, SEC Chairman William Donaldson and the two Democratic commissioners opted for stricter regulation while the two other Republican members opposed it.

On June 23, the panel voted in the same fashion to mandate that mutual fund boards have chairmen who are independent from the companies managing the funds -- an action that will force an estimated 80% of U.S. mutual funds, or some 3,700 funds, to replace their chairmen. This time, the SEC approved a proposed new rule ordering most hedge fund managers to register with the agency. If formally adopted after a 60-day public comment period, the rule would open the funds’ books to SEC examiners and make them subject to an array of regulations including accounting and disclosure requirements. The agency could, for example, conduct inspection “sweeps” of groups of hedge funds, something it now lacks legal authority to do.

The high-risk, potentially high-return funds have an estimated $750 billion to $1 trillion in assets and are growing, and oversight is needed to head off potential blowups that could hurt ordinary investors, SEC officials say. The two Republican commissioners, Paul Atkins and Cynthia Glassman, expressed opposition to the proposal. “I fear that we are setting off down the road of regulatory overreaction,” Atkins said at the meeting. “Fraud deterrence is a laudable goal, but so is avoiding regulatory overreach.” Tighter regulation of the funds also is strenuously opposed by other policy-makers, notably Federal Reserve Chairman Alan Greenspan, who maintains that it would hinder the flexibility of financial markets.

Link here.


It does not take an unexpected windfall to make early retirement happen. It takes a strategy, careful planning and a little sacrifice. Here is how to get started.

Link here.


The decline in analyst coverage of small companies has cost those businesses roughly 138 basis points per year, reports a study from the National Bureau of Economic Research. And Regulation Fair Disclosure (Reg FD) deserves some of the blame, according to the authors. Wall Street analysts have been more likely to ignore smaller companies since the SEC’s new rule took effect in the fall of 2000, the study determined. “We find that the adoption of Reg FD caused a significant reallocation of information-producing resources, resulting in a welfare loss for small firms, which now face a higher cost of capital,” stated the study’s abstract.

Small companies experienced a 17% decline in sell-side analyst coverage after Reg FD went into effect, reported Dow Jones, quoting the study, compared with a 5% decline for midsize firms. In contrast, large companies enjoyed an increase of about 7%, confirming widespread predictions that Wall Street firms would increasingly focus on large companies after Reg FD went into effect.

Of course, other factors probably came into play. Global stock markets began their multiyear decline around the time that Reg FD went into effect. As Wall Street firms laid off many employees, they moved coverage to more-actively-traded stocks that would presumably generate higher trading revenues from institutional investors.

Link here.


“Joe Six Pack” is the mythical character and legendary worker who fights in our wars, works in our factories, loves baseball in the summer and football in the fall, drinks beer, drives a truck and tries his best to support his family by working for an hourly wage. The Bureau of Labor Statistics (BLS) tracks all kinds of useful data, freely available to anyone who wishes to look. A major data series that tracks the wages of most employees on payrolls for service and production jobs shows average weekly earnings (determined by the hourly wage rate and number of hours worked) shows that weekly earnings have risen only 0.5% from June 2003 to June 2004 -- even as the economy has “boomed”.

Joe has been fortunate to receive extra cash from two short-term sources: Home loans and a Tax Refund. For the remainder of 2004 and through 2005 when the tax refund checks have stopped coming, Joe, and millions like him, will once again be left alone with bills that are difficult to pay. You do not need to be an economist to forecast that spending at Wal-Mart, GM, Ford, etc. would start looking weak in June. The consensus economic forecast for the second half of 2004 is that the economy will pick up and accelerate. Could the consensus be wrong now that the best of fiscal and monetary stimulus is over?

Ordinarily, in a recovering economy, new establishments hire more Joes. The difference is that these new establishments have not yet been set up to be polled in the payroll survey. Fortunately for productivity, the BLS has a fancy computer model, or “black box”, to estimate the number of new establishments and number of workers they are hiring. For the world’s financial markets, much rides on the black box being accurate. If jobs are really being created, then these new workers with new earnings will likely keep the economy rolling forward. However, we believe Joe is running on empty and fewer real jobs, and particularly fewer good paying jobs, are being created than the productive computer says. It is likely that Joe and his wife will be forced to borrow more on their house and cut back on spending in 2004. If the Fed keeps raising interest rates, the ability to borrow against housing will be offset by consumers actually having to pay for the debt.

Moreover, we are skeptical that the BLS is giving the financial markets a true read on labor conditions. For an administration that justifies war with false assumptions, what is the harm in a few optimistic assumptions that cannot be refuted for a computer model? This is an election year after all. It is surprising how weak the economy really is. Wage increases across the board are not enough to pay for the current standard of living, let alone start paying interest on old debt borrowed to live well.

Link here.


Asset markets have moved to center stage as drivers of economic growth. In one important respect, this trend was borne out of necessity: With subpar job creation and ongoing real wage compression putting earned labor income under unusual pressure, wealth effects derived from asset appreciation have increasingly filled the void. The equity market led the way in the latter half of the 1990s, but now the impetus is coming largely from property. The biggest risk to this new strain of economic growth is the time-honored tendency of asset cycles to go to excess. That was certainly the case when the equity bubble popped in early 2000 and could well be the case again for the property cycle. Therein lies the greatest peril for the Asset Economy as we peer into the future.

This not a US-centric issue. The new asset-driven growth dynamic is increasingly global in scope. That was true of equities and is now true of property. In a companion report, Morgan Stanley’s global economics team assesses the state of play in 23 geographic segments of the global property market (see “Global Housing Round-Up” below). While this tabulation is far from all-inclusive, the countries covered in our round-up account for 94% of world GDP (as measured on a purchasing-power-parity basis) and approximately 96% of the value of the housing stock in the developed world. By our reckoning, housing bubbles currently exist in about 25% of the global economy, whereas we would put another 40% in the “bubble watch” category -- defined as a housing market that has some of the characteristics of a cycle that has gone to excess. In other words, we believe that property markets in about two-thirds of the world economy either are in a bubble or are at risk of moving into bubble territory. Just as the world had to come to grips with the bursting of the equity bubble a little over four years ago, the possibility of a post-bubble shakeout in global property markets cannot be taken lightly.

How did this condition come about? There are numerous factors that shape housing values -- from demography and tax considerations to the physical balance between supply and demand. Financial conditions are also key -- not just the breadth and depth of residential mortgage lending markets but also the level and direction of interest rates. Of all these factors, I believe that the interest rate, or financing, cycle is the most important consideration that separates this housing cycle from those of the past. Twenty years of disinflation took nominal interest rates down steadily from the record highs of the early 1980s. The deflation scare of early 2003 was the icing on the cake -- pushing rates down to levels not seen in over 40 years. Central banks unleashed the super-liquidity cycle that cast property investment in an entirely different light. As a result, housing affordability improved dramatically, only adding to the intrinsic demand for the asset class.

The bubble of extraordinary monetary stimulus and the super-liquidity cycle it unleashed pose the key risk to over-extended property markets, in my view. The excesses of the liquidity injection do not vanish into thin air. The concern today, of course, is that the surge of money and credit creation will eventually show up in the form of accelerating inflation. But reflecting the globalization of costs and price competition -- first in tradable goods and now increasingly in what used to be called nontradable services -- there has been a significant structural change in the forces shaping inflation. This may mean that the link between monetary expansion and the aggregate price level has changed. Perhaps if price inflation in the real economy is unusually constrained by structural factors -- precisely the case today -- then the impacts of the liquidity cycle may simply spill over into asset markets. The equity bubble of the late 1990s was but the first example of this phenomenon. After it popped, excess liquidity then flowed into bond and property markets.

To the extent that view is correct, then a turn in the liquidity cycle could have ominous implications for asset markets -- especially overextended property markets. And that, of course, is exactly the risk as the world’s major central banks now begin to implement “exit strategies” from the extraordinary monetary accommodation that is currently in place. This is likely to be a very delicate operation, to say the least. Housing markets that have gone the furthest to excess are, of course, most vulnerable to a back-up in interest rates. That is especially the case in economies where housing, according to our tabulation, is now in bubble territory -- Australia, the U.K., China, Korea, Spain, the Netherlands, and South Africa. Nor can risks be taken lightly in those economies that we have put on the “bubble watch list” -- the U.S., Canada, France, Sweden, Italy, Hong Kong, Thailand, Russia, and Argentina.

In a US-centric global economy, the state of the American housing market -- the largest property market in the world -- undoubtedly deserves special attention. In that regard, a recent Federal Reserve staff study concluding that there are significant downside risks to US land prices over the next three years cannot be take lightly. Nor can the sharp recent increase in nationwide property taxes. At the same time, signs of speculative activity are mounting in several high-profile segments of the US housing market -- especially on the two coasts.

With housing markets in about two-thirds of the world either in or close to a bubble, the impacts of the coming normalization of monetary policy cannot be taken lightly. Courtesy of property-induced wealth effects, the global economy was neatly able to sidestep the potentially devastating aftershocks of a burst equity bubble. As the liquidity cycle now turns, the odds are that the world will not be so fortunate the next time a bubble bursts.

Link here.
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