Finance Digest for Week of September 6, 2004

“IF YOU’VE GOT IT, FLAUNT IT” IS BACK

So long, Gap. Indulgence is back. There are waiting lists at stores like Saks Fifth Avenue for items like a new $5,000+ Louis Vuitton handbag with a woven LV logo. Dolce & Gabbana fans are lining up for a $1,330 purse that they can personalize with their zodiac sign. Dig out those intertwined-C Chanel earrings from the back of your jewelry box. The logo is hot again. Politically incorrect fur is once more the rage in stores and fashion spreads for luxe floggers like Prada, Versace and J. Mendel. (If a protester splashs you with red paint, just buy another coat.)

FORBES RANKS CHINA’S BEST CITIES IN WHICH TO DO BUSINESS

Lauded for its beauty by Marco Polo, Hangzhou remains one of China’s top tourist attractions. Its West Lake and green hills beckon stressed-out executives from nearby Shanghai looking to spend an easy weekend. The historic city has the added distinction of being the best business location in China, according to a survey published in the September edition of FORBES CHINA, the Chinese-language edition of Forbes magazine.

The Forbes China ranking of 100 cities is loosely based on formulas used in the Best Places for Business and Careers survey of the U.S. magazine. In determining China’s best business addresses, it takes into account market size, the percentage of the work force with a college degree, the cost of doing business and transportation infrastructure. Reflecting the growing importance of entrepreneurism in China’s reforming economy, the list also factors in a city’s success in attracting new investment from private companies.

Fortune magazine publishes top 100 Chinese listed companies.

The September 13 issue of Fortune appraises and selects the “top 100 Chinese listed companies 2003” in accordance with their annual business incomes. The first 10 companies ranked in order respectively are: Sinopec, Petro-China, China Mobile, China Telecom, China Life Insurance, China Unicom, the People’s Property Insurance of China, Five Minerals Development, Baoshan Steel Group Co. Ltd. and the China National Offshore Oil Company. The threshold for the inclusion of “top 100 Chinese listed companies” this year has again dramatically raised, with the business volume being raised from 4.45 billion yuan in 2002 to 5.99 billion yuan, a 35% increase.

JOBS, JOBS, JOBS

Americans’ spending is slowing down. At least, that is what the nation’s largest retailers say. Auto sellers, too, report a lack of interest in new wheels. Why would the world’s best spenders lose interest? They are running out of money, is our guess. Studies show clearly that consumer spending is tightly correlated with consumer income. Makes sense. When you do not have any money, it is hard to spend. But the studies also show that recently, incomes and spending have parted company. Americans have spent far more than they have earned. In July, for example, spending exceeded income by an 8-1 margin.

How can you spend more than you make? You can borrow. Or you can spend the money you get back in tax refunds. But neither borrowing nor cutting taxes (without also cutting government spending) provides much of a foundation for long-term, solid growth in consumer spending. Eventually, the lines -- real income and real spending -- have to come back together. Why not now? What provides consumers with more real spending money are more real jobs. We do not like to be the bearer of bad tidings, dear reader, but we do not expect much wage growth in America for, say, the next 50 years!

Ships are arriving from Asia at Southern California ports in record numbers. Also in record numbers are they returning whence they came -- empty, deadhead. We import; we do not export. We consume; we do not produce. Gadgets and geegaws are coming in; money is going out. We sail towards our own destruction, not to glory. The golden age of the West is dying. People in Houston can no longer expect to earn 10 times more than people in Haiphong. Now, they will have to compete with the rest of the world... and bid for the world’s energy... its gadgets and geegaws... its Monets and Modiglianis... and even its food... in a market crowded with rich foreigners.

THE TWIN DEFICITS: MYTHS AND TRUTHS

Open the business section of a newspaper today and you are likely to find some mention of (a) America’s wide trade gap, (b) the increasing Federal budget deficit, and often (c) the two of these, yoked together as “The Twin Deficit” problem. As usual with such issues, there is a deal of truth in the figures marshaled by the commentators and there is, indeed, a good deal of substance to the anxieties to which the numbers are giving rise. However, there is also enough false logic on display to fill a major law practice and, consequently, there is no shortage of erroneous prescriptions dealing with how to address the matter. It might be worthwhile to see if we can review the subject with seriousness.

Firstly, let us ask whether the two deficits are related causally, rather than being a coincidence. In other words, if the US government spends more than it routinely steals from its citizens, does this necessarily imply that trade balance will plunge into the red? Well, no -- not exactly. The key thing is to note that though the Federal government deficit may well contribute to the trade deficit, it will only do this to the extent that it helps exhaust the monetary savings being made elsewhere in the system. The Deficit Twins, are, at best, fraternal, not identical. Nevertheless, today -- though by dint of circumstance and not through an unavoidable linkage of cause and effect -- in some senses the Twins are indeed joint offspring of the same womb.

In the last six years US defense spending has risen 60%, and four-fifths of this increase has taken place just since the present Administration took office. US defense spending has now hit a running 12-month total of $522 billion -- a gargantuan sum which is almost a dollar-for-dollar partner to the trade deficit and which is a fairly good match for the total Federal budget deficit. Thus, not only do we have Twin deficits at present, but one of the Twins wears combat fatigues and carries an M-16 rifle. Regardless of ones political views of the situation, America today finds itself just about able to provide its citizens with the all the Butter it wants (alas -- only on the basis that the dairyman extends his customers credit every time he sells them a pound), while then relying on foreigners to give it the wherewithal with which to buy its Guns. One can easily see that this state of affairs contains within it a series of vicious circles and gives rise to heightened risks, both military and economic.

Back in the late 1990s foreigners could be persuaded that they were wisely investing in the new technological frontiers being carved out in Silicon Valley. And indeed, they sent their surplus dollars their exporters earned straight back into the US stock and bond markets. We all know how dramatically that illusion was dispelled, but, so far, it has not fully dawned upon them that, in place of buying bogus claims on a more prosperous tomorrow, America’s foreign suppliers are now merely working for the purpose of supplying the arsenals and to fill the commissariats of a mighty US war machine. Further, they do not see such militarism as either a direct or an implicit threat to their own disparate interests. America’s vendor finance agents are not doing themselves much good neither on economic grounds nor on geopolitical ones. Correspondingly, the US is diverting so much of its people’s toil and treasure to the legions that it is risking both financial exhaustion and physical capital anemia.

To the twin monetary deficits of budgets and trade, perhaps we should add two other, less quantifiable, but much more dangerous siblings: The mental deficit which has leads otherwise reasonable men and women into this hazardous entanglement and the moral deficit which allows them to continue along this path, regardless of the longer-term consequences. We face enormous gaps between what government spends and what it taxes, between what people make and what they buy and between free commerce and coercion. In mitigating these risks, we can hope for a steady and sustained economic readjustment and we fear a sudden financial upheaval. Lastly, a return to collective sanity must be the subject of our prayers.

In conclusion, the belief that the US dollar is the least sound of the major currencies and the faith that money and credit will everywhere continue to be created much faster than the hard-won fruits of toil can accumulate -- and hence that these latter will go on rising in price -- will remain a guiding principle of our investment policy, as it has for some good while past.

SOME STOCKS ARE CHEAP

As of late August the S&P 500 is down 8% in price terms since the index's 52-week high in February. Investor confusion is at the root of the market’s problem. Only four months back investors were frightened by the prospects of an overheated economy and accelerating inflation. The stock market dropped with each new indicator reaffirming a powerful economic expansion that would force the Federal Reserve to hike rates. But lately it appears that the economic expansion is faltering, thus curbing demand for credit. The July employment report, for instance, showed a paltry increase of 32,000 nonfarm jobs from June. So the market has fallen some more.

The big unknown is whether costly oil will start an inflationary spiral. The bond market does not think so, apparently believing that slower growth will cool down or stop any inflation. The prices of long-term bonds have recovered sharply from their recent bottoms, and their yields are again approaching 40-year lows. This view ignores common sense. The rising price of oil will force all kinds of manufacturers to raise prices, just as they did after the 1973 and 1979 oil shocks, to cover higher raw material and shipping costs.

If the stock market makes you uneasy and you must be in fixed-income investments, at least keep your maturities very short, even if that means accepting a negative return after inflation and taxes. Long bonds are not the place to be while prices are rising. Sure, the stock market is down lately, but look where most of the suffering is concentrated -- in the tech, biotech and (Google notwithstanding) Internet sectors. The outlook for the rest of the market is much more positive. Stocks are trading down near historical price/earnings ratios for the first time in almost a decade. Value stocks as a group are approaching, or are in, the bargain range. Don’t let some inflation worry you. Inflation may be harmful, but not to stocks. As I wrote in my June 7 column, normally after a shaky start stocks provide positive returns through most inflationary periods. In light of all this, here are several stocks to consider.

FIND STOCKS WORTH HOLDING FOR A DECADE

Seventeen of the 70 securities held by my firm have been in our portfolios for at least a decade. Over time many of them have paid off. This steadfastness is noteworthy in an industry where the average annual turnover is in the neighborhood of 100%, which corresponds to a holding period of only one year. The following stock picks are some of my favorite long-term holdings. These companies, which have endured their rough patches, remain attractively valued, offering plenty of upside for patient investors.

WALL STREET IN DREAMLAND

Financial markets and the U.S. economy parted company in the late 1990s as Wall Street lost touch with economic reality. That great disconnect still exists. By the late 1990s the post-1982 bull market’s length and intensity put fear to flight, leaving nothing but intense greed. So powerful was that 18-year bull market that even the following 3-year bear market, which cut the Nasdaq index by 78%, did not put the financial world back in touch with economic reality. Massive monetary ease and huge fiscal stimuli actively promoted a continued separation. The nosedive in interest rates encouraged housing and cash-out mortgage refinancing. Tax cuts and leaps in defense and homeland security spending pumped big money into the economy.

Result: Financial speculation survived largely intact but shifted from stocks to residential real estate and hedge funds. Those private partnerships, along with banks, brokers and other pools of capital, took advantage of cheap short-term money to invest in Treasurys, junk bonds, convertibles, emerging market securities, currencies and commodities. Sure, like most services, the financial sector grows faster than the overall economy. Still, many measures of financial services remain far afield from consistent post-WWII trends; correcting the huge 1990s speculations should have pulled them below trend, at least temporarily.

Compare the Dow Jones Wilshire 5000 Market Capitalization Index, which contains almost all U.S. stocks, to the GDP -- the ratio (if you multiply the index by a billion) is now well below its 2000 peak, but at 96% it remains substantially above the 1971-96 norm, which is near 60%. Stocks in the financial services sector, of course, benefited from the late-1990s surge, and their market caps now sum to 20% of the S&P 500 total. Pay in the financial sector did even better. Of the Forbes 400, the richest Americans, 77 made their money in finance or real estate.

Almost no one wants the financial sphere to reunite with the economic world, since the coming down to earth of speculative prices would be a financial shock that would cause a lot of real damage. The Federal Reserve has broadcast its intention to raise the federal funds rate it controls. But that is not a plan to squeeze speculative excess out of the financial markets. Certainly Alan Greenspan cannot aim for sharply higher rates; that would be curtains for spread lenders and house prices. But suppose the Fed succeeds in raising interest rates slowly enough that speculators can adapt without big failures. Most would probably figure that Washington had again raised the safety net so they could climb to an even higher perch. The Fed thus would have fostered the dangerous illusion that Wall Street can live permanently divorced from reality. History says the two worlds will rejoin sooner or later.

Don’t buy a bigger house than you need, and don’t buy stocks on margin. Buy Treasurys.

HEDGE FUNDS RETURN TO ASIAN MARKETS

Major US hedge funds which deserted Asian markets during financial crises in the late 1990s are returning, according to industry reports, driven by the weight of new money that has poured in during the last 18 months, seeking better returns than can be got in the West, where arbitrage openings have dried up as stock markets go sideways. Also Asian securities markets are less heavily researched than those in the US and Europe, so that stocks may trade below their actual value, offering arbitrage opportunities for hedge funds and other investors.

Hong Kong and Singapore are the favorite destinatons. Both are tax-friendly, and both have established hedge fund sectors. Singapore has the more friendly legislation, but Hong Kong is trying hard to catch up.

FORTUNE MAGAZINE COME UP WITH A LIST OF THE 40 RICHEST PEOPLE UNDER 40

A billion dollars may be a bit harder to come by these days, but some youngsters are still finding their pots of gold. See the list of the young and rich. When Fortune’s 40 Under 40 list debuted in 1999, the ranking was made up almost exclusively of New Economy millionaires. Over time many of them have faded, replaced by athletes and entertainers. The list appears in the Sept. 20 issue.

Topping the list is Michael Dell, 39, chairman and founder of Dell Computer. With wealth of $18 billion, Dell has held the No. 1 spot since the list was started in 1999. Larry Page and Sergey Brin of Google, both 31, hold the No. 4 and No. 5 spots with total wealth of $4.2 billion each, more than four times their wealth last year when they first debuted on the “40 Under 40” list.

THE TRADER-ECONOMIST HYBRID -- A CAUTIONARY TALE

What are emerging market bonds? “Emerging market” is the politically correct euphemism to define a country that is not very developed (as a skeptic, I do not impart to their “emergence” such linguistic certainty). The bonds are financial instruments issued by these foreign governments, mostly Russia, Mexico, Brazil, Argentina and Turkey. These bonds traded for pennies when these governments were not doing well. Suddenly, investors rushed into these markets in the early 1990s and pushed the envelope further and further by acquiring increasingly more exotic securities.

At some point these bonds became the vogue and went from pennies to dollars; those who knew the slightest thing about them accumulated vast fortunes. Carlos -- who I used to meet at a variety of New York parties -- supposedly comes from a patrician Latin American family that was heavily impoverished by the economic troubles of the 1980s, but again, I have rarely run into anyone from a ravaged country whose family did not at some juncture own an entire province or, say, supply the Russian czar with sets of dominoes. After brilliant undergraduate studies, he went to Harvard to pursue a Ph.D. in economics, as it was the sort of thing Latin American patricians had gotten into the habit of doing at the time (with a view to saving their economies from the evils of non-Ph.D. hands). He was a good student, but could not find a decent thesis topic for his dissertation. Nor did he gain the respect of his thesis adviser, who found him unimaginative. Carlos settled for a master’s degree and a Wall Street career.

The nascent emerging market desk of a New York bank hired Carlos in 1992. He had the right ingredients for success. He was the kind of person banks felt comfortable putting in front of their customers. What a contrast with the other traders, who lacked polish! He was generic among this community of emerging market traders; they are a collection of cosmopolitan patricians from across the emerging market world that remind me of the international coffee hour at the Wharton School. Unlike my experience with real traders, they are generally urbane, dress well, collect art, but are nonintellectual. They seem too conformist to be true traders. Carlos thrived as a trader-economist. He had a large network of friends in the various Latin American countries and knew exactly what took place there. It would be perhaps erroneous to call him a trader. A trader buys and sells (or sells first and then buys, when selling short). Carlos just bought -- and he bought in size. Shorting, in his opinion, made no economic sense.

Starting in 1995, Carlos did exponentially well in his new function -- the bank allocated a larger portion of its funds to his operation, and so fast that he was incapable of using up the new risk limits. The reason Carlos had good years was not just because he bought emerging market bonds and their value went up over the period. It was mostly because he also bought dips. He accumulated when prices experienced a momentary panic. The year 1997 would have been a bad year had he not added to his position after the dip in October that accompanied the false stock market crash that took place then. Overcoming these small reversals of fortune made him feel invincible. He could do no wrong. He believed that the economic intuition he was endowed with allowed him to make good trading decisions.

It was the summer of 1998 that undid Carlos -- that last dip did not translate into a rally. His track record up to that point included just one bad quarter -- but bad it was. He had earned for his bank close to $80 million cumulatively in his previous years. He lost $300 million in just one summer. What happened? When the market started dipping in June, his friendly sources informed him that the sell-off was merely the result of a “liquidation” by a New Jersey hedge fund run by a former Wharton professor. The problems, he deemed, had nothing to do with Russia. “Read my lips: It’s a li-qui-da-tion!” he yelled at those who questioned his buying.

Then came July. The market dropped a bit more. The benchmark Russian bond was now at $43. His positions were under water, but he increased his stakes. His bosses were starting to become nervous, but he kept telling them that, after all, Russia would not go under. He repeated the cliché that it was too big to fail. “These bonds are trading very close to their possible default value.” In other words, should Russia go into default, and run out of dollars to pay the interest on its debt, these bonds would hardly budge. Where did he get this idea? From discussions with other traders and emerging market economists (or trader-economist hybrids). Carlos put about half his net worth, then $5 million, in the Russia principal bond. “I will retire on these profits,” he told the stockbroker who executed the trade...

HEDGE FUND INVESTORS CHANGE TACTICS ACCORDING TO NEW STUDY

The study found that hedge fund investors were pulling out their assets from strategies which they deemed more risky, and investing in less risky instruments. Strategies such as emerging markets and global macro strategies experienced a net outflow of assets during the second quarter, while equity funds benefited from new asset inflows. There is also significant investor interest in the fund of funds categories, which became the single biggest investor in hedge fund vehicles with over $414 million in hedge fund allocations during the second quarter according to the survey.

The 38 companies included in the survey invested about $781.9 million into hedge funds according to the poll. Of this total, $426.8 million was devoted to equity funds, which became the most favored strategy during the said quarter. The second preferred strategy was convertible arbitrage according to the poll; this strategy gained $143 million during the same period.

Non-banks such as hedge funds borrow more this year.

Hedge funds, securities firms and companies other than banks increased borrowing in the first quarter, taking out loans equal to 77% of last year’s total, the Bank for International Settlements said. While the BIS does not provide an industry breakdown, the data suggest hedge funds borrowed a significant share of the money. Hedge funds, private partnerships for the wealthy, typically borrow money or securities to buy investments.

THE GREAT MACRO PROFIT ILLUSION

Is the U.S. economy stalling out, or is it resuming its strong growth, gaining traction for a self-sustaining expansion with healthy job and income growth? In the consensus view, the economy’s weakness in the second quarter was nothing more than a “soft patch”. We are no less sure that “traction” will remain elusive. It is the essential outgrowth of an upturn that has been of miserable quality right from the start.

With its advance estimate of GDP growth in the second quarter of 2004, the Commerce Department’s Bureau of Economic Analysis also released benchmark revisions to the national accounts data back to 2001. Notable adjustments include a markedly lower personal savings rate and a downward revision to economy-wide corporate profits for the past couple of years.

In the consensus view, business investment spending continues to post healthy gains, thanks to exceptionally strong profit growth in the past two years. We have strong reservations about both the strength of investment spending and the exceptionally strong profit growth. Another highly popular argument of the bulls is the U.S. economy’s excellent profit performance in the past two years, as trumpeted by most Wall Street analysts. Here again, we must plead to keep things in perspective. At their high in 1997, nonfinancial sector profits amounted to $504.5 billion. In the first quarter of 2000, just before the start of the economy’s downturn, they were down to $426.2 billion. At their low, in the fourth quarter of 2001, they amounted to $236.5 billion. In the first quarter of 2004, they had recovered to $420.7 billion.

For us, most striking, and also most telling, is the difference in the profit performance between manufacturing and retail trade. In 1998, manufacturing earned $157 billion, far more than retail trade, which earned $66.4 billion. But just six years later, in the first quarter of 2004, manufacturing profits were drastically down to $81.5 billion and retail profits sharply up to $80 billion. That is, of course, what has to be expected in an economy in which consumer borrowing and spending reign supreme.

WHY GREENSPAN IS STAYING THE COURSE

When Federal Reserve Chairman Alan Greenspan kicked off his credit-tightening campaign on June 30, there was no question why he was raising interest rates. Inflation was picking up, and the recovery appeared to be on solid ground: GDP had grown at a 5.3% annual rate over the previous three quarters, and even the sluggish jobs market had finally sprung to life.

Now, though, the case for tightening is not as obvious. Despite a 40% leap in oil prices since late last year, inflation has ebbed. Meanwhile, the jobs market has softened. While the 144,000 rise in August payrolls was double the dismal 73,000 increase in July, it was well below the heady 295,000 monthly pace of the spring. That has led some at the Fed to wonder whether they should pause before moving ahead with further hikes.

But despite the uneasiness of some of his colleagues, Greenspan left little doubt in congressional testimony on September 8 that he is intent on raising rates when the Fed meets two weeks later. While taking comfort in the recent dip in inflation, Greenspan believes price pressures will pick up eventually if the Fed keeps rates low for too long. Something that bears watching: Labor costs -- considered by Greenspan to be a key factor behind inflation -- have turned up.

At the same time, the Fed chief is convinced that the recent slowdown will be short-lived and that the economy is strong enough to take another quarter-point hike. Indeed, Greenspan told Congress that “the expansion has regained some traction”q He cited a July pickup in consumer spending and housing starts and continued solid business investment. Moreover, Greenspan seems unsure whether job growth has been as subdued as the latest payroll numbers suggest.

What Greenspan is focused on is the long-run outlook. And on that score, there is reason for caution. Productivity growth is slowing from its recent super-strong levels. Coupled with rising wages and health-care costs, that is pushing up Corporate America’s outlays for labor. The Fed is hypersensitive to even small signs of wage inflation because interest rates are so low. Despite two Fed rate hikes this year, the federal funds rate -- the rate commercial banks charge each other for overnight money -- stands at a mere 1.5%. That is far below the 4% or so that some Fed officials reckon is the equilibrium rate for the economy. And as long as rates are below that level, Fed officials believe monetary policy is acting to stimulate growth and push up inflation.

Cost of insuring workers’ health increases 11.2%.

The cost of providing health care to employees has risen 11.2% this year, according to the results of an authoritative national survey. It was the fourth consecutive year of double-digit increases in health insurance premiums, which has resulted in a steady decline in the number of the nation’s workers and their families receiving employer health care coverage. Perhaps the only good news in the report was its indication that the rate of increase slowed from the record 13.9% in 2003, turning down for the first time since 1996. But this year’s jump was still more than five times the national 2.2% increase in wages from the spring of 2003 to spring 2004, as reported by the Bureau of Labor Statistics.

Small businesses are being especially hard hit as the average family coverage in preferred provider networks, the most common type of health plan, has risen to $10,217, with employees paying $2,691 of the total. In response to the soaring costs, many small companies are simply no longer offering coverage of a worker’s spouse and children.

Health premiums are rising faster than the underlying cost of doctor and hospital care, as consolidation in the insurance industry has given insurers greater clout. The monthly cost of two-person coverage for workers and their spouses increased 23%, to $836.78, this year at the John G. Shelley Company, a distributor of industrial products with 26 employees in Wellesley Hills, Massachusetts. Monthly premiums for individuals rose 13%, to $418.39.

Frank Ciotola, an owner of Da Vinci Ristorante in Columbus, Ohio, is another employer grappling with premium inflation. He said he erased his company’s 31% increase by changing to a health savings plan, with a $1,700 annual deductible, for the three owners and four full-time employees in the plan. The Kaiser report said that a growing number of employers were familiar with the health savings approach, a centerpiece of President Bush’s health care program that combines pretax savings accounts and high deductibles. But the report said that only 3.5% of the employers in the survey had adopted the plans. The favorable tax feature took effect last January.

Fed on tightening path, unfazed by oil price surge.

The surge in oil prices over the summer was not enough to derail the U.S. economy and the central bank sees no reason to pause in its interest-rate rises just yet, top Fed officials said on Thursday. “While oil prices are certainly high enough to grab our attention, the situation is a far cry from what happened when oil prices shot up in the 1970s,” said San Francisco Fed President Janet Yellen. She said that after adjusting for inflation, current prices are around half of what they were 30 years ago, and the recent increase in oil would probably shave about 0.5 percentage points off economic growth this year.

Separately, Fed Governor Mark Olson noted although gasoline prices in the United States have moderated from recent highs, they are not likely to fall substantially soon. But he said the U.S. economy was less reliant on energy than it used to be.

A PIECE OF THE ACTION

On June 30, 2004 we asked this important question: “What yield would a 10-year fixed rate Treasury bond need to provide an individual investor in order to justify a purchase held to maturity?” Because risk over time cannot be quantified, readers realized that this was a very hard question to answer. Correspondence I received mentioned that 10-Year Treasury yields ranging from 7 to 15%, held to maturity, would be attractive to the individual investor. The Treasury does not pay the average individual US investor enough yield to justify holding a 10-Year treasury bond to maturity. The bid price is way below the ask.

Why then would the 10-Year Treasury yield far less than the risk-adjusted expectation? The answer, of course, is Japan. The bid and ask prices have been set across the Pacific Ocean between borrower government and creditor government -- between the United States and Japan. To the Japanese government, any rate received from US Treasuries, 10-Year or otherwise, will be much higher than the interest rates set for borrowing money from its domestic savers. Money can be borrowed on the cheap from domestic Japanese savings deposits. The deposited savings (banking liability) can be used to purchase US Treasury bonds (banking asset). The difference between interest earned and interest paid is profit. Japan makes a profit on every dollar purchased via US Treasury bonds.

Unfortunately, Japanese savers are not getting enough yield to justify the risk of default. Perhaps for this reason, I have not seen it acknowledged elsewhere that a profitable interest rate differential, or arbitrage, exists between Japanese savings and US borrowings. For this scam to continue to work, the Bank of Japan must keep domestic savings rates low and the yen weak. I believe that without Japan, the 10-Year would be yielding between 7 and 15%. The reward-to-risk ratio has been mis-priced to risk. It has been priced instead to the deflationary context of Japan. In effect, the US has been importing Japanese deflation.

The US has been living high on the Japanese savings hog. It has been enjoying the deflation of cheap money much in the same way the country enjoys the deflation from cheap goods from China. If the 10-Year Treasury rate were set between 7and 15%, the US would suffer an immediate fit of bankruptcy. The side effects of folly lurk in the background.

THE LAZY INVESTOR’S REWARD

The average P/E ratio for the S&P 500 since 1926 is around 15. Typically, 21-22 is in the upper end of the range with 8-11 being the lower end of the range. Over long periods of time (secular bull and bear markets), the market fluctuates around the mean. I think it is quite possible that in 2030 we may be at the end of the next bull market. Valuations, after dropping into the low teens (or lower) this decade, will turn around and a long bull run will commence. What will the S&P 500 be in 2030 if we are once again at a P/E of 21?

Somewhere in the neighborhood of 4,800, give or take a dime. That 4,800 is less than 25% of what it would be at a 12% compound rate. At 3% inflation, a dollar will only be worth 46 cents. It will take $2.15 to buy what is worth a dollar today. That is a compound growth rate of (surprise, surprise) 5.7%. But “objective” profits in that rearview mirror may be smaller than they appear. Your return will be less than that, because you have to pay taxes. The S&P 500, if past is prologue, will change 250-300 companies through mergers and through dropping and adding companies due to growth. As the dropped and added companies are bought and sold, that will create taxes due. And do not forget dividend distributions and capital gains, for which you will have to pay taxes in the meantime. Not to mention that even though the average return for the S&P 500 for the last century was 7.2%, the compounded return was a far more modest 4.8%. That is because when the market drops 20%, it must climb 25% to get back to break-even. So assuming 5.7% may be aggressive if we experience a few recessions and a bear market or two in the coming decades.

The real reasons the S&P 500 compounded at 12% the last 26 years are twofold. First, we started with a P/E ratio of 10 at the end of 1975. Over the ensuing years, we simply valued a dollar’s worth of earnings at a much higher rate. Perhaps not as high as the bubble levels of 1999 (over 40), but still historically quite high. As has been shown through research, 80% of the growth of the S&P 500 was simply due to increased valuations and not to earnings growth. Second, we had the highest period of inflation in the last century in that period. An inflation calculator shows 326% inflation for the entire period. For just the first six years alone, it was 70%.

Are these two items likely to be repeated in the next 26 years? Anything is possible, but not all things are likely. It is doubtful we aspire to a P/E of 40, let alone 97, once again in our lifetimes, and if we do, it will prove to be just as ephemeral. Say what negative things you will about the Fed; does anyone really think we will ever see sustained 10% inflation again? And let us not forget the Reagan tax cuts and the coming of the Digital Age, which drove the markets. And that does not even take into account the third and fourth derivatives of demographics and international trade. Investing is far more complex than simply buying the S&P 500 and hoping you can retire on 12% compound growth.

One day in the future, I will also become a believer in buying and holding the Vanguard 500 as part of a reasonable asset allocation program. But that is not this day. I believe that by using a few facts, some logic and an eye to history, it is in fact possible to do well. But it takes more than being a lazy investor. Assuming the next few decades will be like the last few violates the first rule of investing: Past performance is not indicative of future results.

DECLINING OIL ... STRONGER DOLLAR?

I dare anyone to find a group of articles from this past January/February that proves more downbeat about a market than the coverage was then of the U.S. dollar. For the first time since 1996, the Dollar Index had fallen below 85. The euro stood at record highs against the greenback. A well-known weekly financial publication compared the dollar’s plight to the calamity that befell the currency of a certain Latin American nation: “As any Argentine must know by now, the markets, like the mills of the gods of old, grind slow, but they grind exceedingly fine. At the moment, the markets threaten to grind the dollar to powder.” An international economics magazine declared, “It is hellish hard these days to find anyone who is bullish on the dollar,” a comment that included the magazine itself.

The Dollar Index began a solid three-month rally. What now for the U.S. dollar? Interestingly enough, bearish sentiment still prevails. Some argue that the dollar’s rally was driven by climbing oil prices, a curious notion indeed given that the dollar got stronger during oil’s recent 14% decline.

A BROOKLYN BRIDGE BULL

In Brooklyn there is plenty of bull talk but much of it is of another sort. Not the sort that one discusses amongst an august audience. However, in the land eponymous with the ultimate scam: the sale of the Brooklyn Bridge, I have coined a phrase that elegantly illuminates the financial foolishness of our time. In the financial world, one is known as a bull if one believes that prices will increase. What though is a Brooklyn Bridge Bull?

As a realist, I find myself merely bullish but on very different things. I am bullish on protectionism and that trade barriers will increase. Bullish on wage deflation in the U.S. and Western Europe. Bullish on taxes, higher taxes that is. Bullish on the re-emergence of labor as a force. Bullish that interest rates will be higher. Bullish on asset price deflation. Bullish that U.S. economic growth will disappoint. Bullish that the era of Brooklyn Bridge bullishness is near a close. I portend that the next twenty years will be unlike the previous twenty. Old eras end and new eras begin unannounced. An era has passed us, definitively. It was the era of asset appreciation. Houses, stocks, bonds, paintings, collectibles, tchotchkes, etc., all marked the end of this era with prices in the stratosphere. They will need to pass an era buried in the dirt.

In 1981, when the Fed Funds rate peaked at 20% and the stock market bottomed a year later, a new era began. It began quietly. Two years earlier in 1979, Business Week proclaimed the “The Death of Equities” on its cover. Prognosticators predicted even higher rates, permanently declining stock prices and more stagflation. But that era, marked by tremendous economic (e.g., emergence of Japan), political (e.g., a shift of the center of politics to conservative ideas) and social change (e.g., de-segregation, women’s lib) had ended just as the cries for more of the same were the shrillest.

Today, looking at the future, prognostications are once again for more of the same of what we have had recently: low interest rates, higher prices for stocks, bonds and real estate, Alan Greenspan, inflation, contained financial crises, loose credit, more consumer spending, the continued primacy of money over value or values, the belief that things simply cannot go seriously wrong without some painless fix. However, change, an unstoppable force equal to inertia has begun its inexorable work of undoing the past and remaking the present. The new era began quietly with Federal Reserve cutting rates to 1%. Today, one cannot imagine double-digit interest rates or stagnation or deflation or even inflation.

I am often asked if I am predicting the end of the world. Definitely not, but it might feel like it, particularly if you are Brooklyn Bridge bullish, stuffed full of debt and waiting for another enriching asset boom. If you are a Brooklyn Bridge bull, waiting to break even on Cisco Systems (CSCO) purchased during the boom in 2000 or planning to “flip” that home you bought a few months ago for a hefty profit, the day of atonement beckons.

HOW MANY ECONOMISTS DOES IT TAKE TO USE A MAP?

The Wall Street Journal’s Monthly Economic Forecasting Survey for September, posed several questions to 55 economists, including: “The pace of job creation has gyrated over the past 12 months. What factor is most to blame?”

“Higher oil prices” was the top answer by far (37%), with “geopolitical or terrorism worries” also making a strong showing (10%). This goes beyond shockingly ignorant, beyond chuckling and shaking one’s head. These 55 economists include some of the biggest names on Wall Street, people who are supposedly the best of their profession. Yet they turn common sense and even logic itself inside out. There is absolutely ZERO correlation between oil prices and job creation, and I welcome anyone’s time-wasting attempt to show otherwise. And if terrorism worries inhibited job creation, could there have been ANY jobs created during the past 40 years in the country of Israel?

The feeble-mindedness of those replies is too much to grasp. These economists imagine that one headline drives another drives another; unsteady job creation is in the “not good news” category, so some other piece of “not good news” must be the “factor” to “blame”. Most amazing of all, the only correct and painfully OBVIOUS answer to the question -- slow business growth -- did not even show up among the replies.

FOOD FOR THOUGHT

Smarter investors than I will make money sussing out little-known technology and manufacturing companies in Asia. Those stories are sexier. The potential payouts are enormous. So are the risks and multiples. I prefer to focus on businesses satisfying a known demand with a profitable product. The more I look at Asian stocks -- or the stocks of Western firms doing business in Asia -- the clearer it becomes that it does not make sense to take more risk than you have to. There are a lot of risks, of course. But you know that already. I mention it now simply to remind you that 70% of your total return in any investment comes from being in the right asset class. In other words, you can own the best company in the world, but if stocks are in a bear market, you are in the wrong asset class.

If you buy the stocks I am recommending below, you are counting on some combination of the three forces below being in your favor (and staying that way):

• First, you are counting on commodities being in a long-term (secular) bull market that supports food prices
• Second, you are counting on the fundamental shift in global economic fortunes from the West to the East (the Money Migration)
• Third, you are counting on the debt-burdened U.S. dollar leading to an inevitable global currency realignment -- the world getting off the dollar standard and Asian central banks dumping their trillions worth of dollar assets.

I will cover all three of these forces as I uncover the companies I am recommending. They each suggest a powerful force behind higher prices for certain stocks. It will not be a straight line up to overnight profits. Big bull markets do not work that way. In fact, China and all of Asia are entering a cycle of mini-booms and mini-busts. The important fact to note is that the overall trend is up. ( I don’t buy for one minute this business about a “soft landing” in China, but more on that later.) Asia today is similar to the United States in the 19th Century. It is a volatile place with a wildcat mentality. Back then, all of North America was industrializing, modernizing, and fantasizing about a richer future. Now it is Asia’s turn.

CHINA’S GREAT DEPRESSION

Having recently completed Rothbard’s America’s Great Depression, I could not help draw the parallels between America’s roaring ‘20s and China’s roaring economy today, and I could not help conclude that China will inevitably fall in a depression just like America did during the 1930s. The objective of this article is to present an Austrian argument as to why this must happen.

Before proceeding any further, I would urge all readers who have not read America’s Great Depression, to pick up a copy and read it. First, it is a real pleasant read, and Rothbard’s witty style of writing makes reading it fun. Second, the first part of the book develops the Austrian Business Cycle Theory, which is indispensable for understanding credit booms and their inevitable busts. Finally, the second part of the book elaborates the development and the causes of the Inflationary Boom of the 1920s and provides a basis for comparison with the economic policies of modern-day China.

In order to establish our parallel, we need some historical perspective of the relationship between a world superpower and a rising economic giant. In the 1920s, Great Britain was the superpower of the world, and the United States was the rising giant. As such, Great Britain ran its economic policies independently, and the U.S. adapted its own policies in a somewhat subordinated manner. Today, The United States is the hegemonic superpower of the world, and China is the rising economic giant. Not surprisingly, the U.S. runs its policy independently, while China adjusts its own accordingly.

Continuing our parallel analysis, during the 1920s the British Empire was already in decline, was militarily overextended, and in order to pay for its imperial adventures, resorted to debasing its own currency and running continuous foreign trade and budget deficits. In other words, Britain was savings-short, a net-debtor nation, and the rest of the world was financing her. Meanwhile, America was running trade surpluses and was a net creditor nation. Importantly from a historical point of view, the British Empire collapsed when the rest of the world pulled the plug on their credit and began capital repatriation.

Today, the American Empire is in decline, is militarily overextended, and is financing her overextended empire with the “tried-and-true” methods of currency debasement and never-ending foreign trade and budget deficits. In other words, America is savings-starved, a net-debtor nation, and the rest of the world is financing her. At the same time, today China runs trade surpluses and is a net-creditor nation. When the rest of the world finally pulls the plug on American credit, will the American Empire also collapse?

During the 1920s, the United States experienced an inflationary credit boom. This was most evident in the booming stock and the booming real estate markets. Furthermore, there was a “spectacular boom in foreign bonds… It was a direct reflection of American credit expansion, and particularly of the low interest rates generated by that expansion”. To stem the boom, the Fed attempted in vain to use moral suasion on the markets and restrain credit expansion only for “legitimate business”. Importantly, consumer “prices generally remained stable and even fell slightly over the period”. No doubt the stable consumer prices contributed to the overall sense of economic stability, and the majority of professional economists then did not realize that the economy was not fundamentally sound. To them the bust came as a surprise.

Today, in a similar fashion, the seeds of Depression are sown in China. And it is important to realize that just as America’s Great Depression in the 1930s triggered a worldwide Depression, similarly a Chinese Depression will trigger a bust in the U.S., and therefore a recession in the rest of the world. Just as the U.S. emerged from the Great Depression as the unrivaled superpower of the world, so it is likely that China will emerge as the next.

WILL THE BIG FOUR AUDIT FIRMS SURVIVE IN A WORLD OF UNLIMITED LIABILITY?

Are the Big Four accounting firms members of an endangered species, destined to die from litigation? Within the accounting profession there has been growing fear ever since Arthur Andersen vanished in a sea of liability that it was only a matter of time before another firm followed. And then, the thought goes, the others would find it impossible to persuade partners to stay, lest their net worth be decimated as happened at Andersen.

Perhaps the situation is not unlike the one that confronts the major airlines. Never has there been such need and demand for the service they provide, but as commercial ventures their viability is dubious at best. The difference is that there are a host of low-cost airlines willing to take up the slack if Alitalia or United should vanish, while it is not at all clear who could replace the Big Four.

The alternative of government auditors is an unattractive one. The quality of the audits would be suspect, if only because of the difficulty in attracting good auditors at government pay, and political influence could be a problem. Consider the way technology companies got the House of Representatives to oppose reasonable accounting for stock options, or the fact that the European Commission is on the verge of overruling an international accounting rule on derivative accounting after heavy lobbying by banks.

It is easier to understand how we got to the current situation than it is to figure out how to get out of it. Over time, the big accounting firms sought growth rather than excellence. Partners were rewarded for bringing in more business and penalized for offending clients with tough audits. There was no effective regulator. Now there are real reforms. But better audits now will not repair poor audits of the past, and the firms yearn for legal protection. In the United States, that is so unrealistic politically that no specific proposal is pending.

This may be a case of Catch-22. If auditors are doing a good job, they deserve to be protected from lawsuits that could put them out of business. But without the threat of such suits, will they do a good job? The probable outcome is that the firms will muddle through. Plaintiffs lawyers will temper their demands, knowing they need to keep the firms in business.

DEEP IN DEBT, DEEP IN DANGER

In a question-and-answer period, a professor of economics responds to student questions about disturbing reports of excessive spending and dangerous levels of debt.

Q #!: The Federal government is about to reach the Congressional debt limit of $7.384 trillion. Should I be concerned about this debt? My history professor likes to quote President Franklin D. Roosevelt who once said: “Our national debt after all is an internal debt owed not only by the nation but to the nation. If our children have to pay interest on it they will pay that interest to themselves.”

In 1939 when President Roosevelt made that speech, the Federal debt may have been an internal debt, but it surely was not owed to ourselves. It divided the nation between people who enjoyed the benefits of spending and their descendants who were expected to square the account; it created a persistent social conflict. Since the 1980s we added a rapidly growing international debt. It is estimated at some $5.5 trillion, which amounts to one-half of our gross national product of some $11 trillion. Americans would have to labor half a year in order to pay it off. It is significant that our foreign creditors like to invest their dollar earnings in U.S. Treasury obligations which enjoy highest credit rating. They now own almost one-half of the Federal debt. The Bank of Japan is our biggest creditor with some $700 billion in claims, followed by the Central Bank of China with $165 billion. You need to be concerned because our rising international indebtedness endangers not only the position and value of the U.S. dollar but also casts a dark shadow on world trade and commerce.

(Several more interesting questions and instructive answers follow ...)