Wealth International, Limited

Finance Digest for Week of September 20, 2004


To appreciate the new math of the Los Angeles real estate market, consider the $10 million home. Tom and Michelle Rhodes did. Not that that is what they had wanted. What they had wanted was to trade up from the five-bedroom tract house they had bought eight years ago in one of Newport Beach’s most family-oriented sectors. It soon became clear that the dream house they had pictured -- half-acre lot, great ocean views, wine cellar, home theater, elbow room commensurate with the price tag -- was going to run them eight figures. And in fact, now that they have it, they say it was a bargain at $10.9 million. “It’s amazing,” Tom Rhodes now marvels, “what that kind of money won’t buy anymore.”

Once upon a time, $10 million was the tippy-top of the housing market, even in Los Angeles, in one of the nation’s most rarefied markets for real estate. Ten million bucks was, in the 1970s, about 10 times the then-record price of the Playboy Mansion. It was, in the 1980s, what Aaron Spelling paid for the 6-acre former Bing Crosby estate. Even in the mid-1990s, even among rich folks, $10 million was freakishly big money; only a handful of homes each year sold in that range. Not Madonna, not Cher, not Arnold Schwarzenegger lived in $10 million houses, at least in those days. Now, however, even with the market momentarily cooling, real estate agents say $10 million is your basic starter mansion. “In the high bracket,” said Beverly Hills real estate broker Cecelia Waeschle, “$10 million is now almost the norm.”

DataQuick analyst John Karevoll says the high end of the housing market tends not to be driven by the same variables that affect most home buyers, such as mortgage rates. Sales more than $10 million tend to be all-cash or complex asset swaps and rarely hinge on the availability of a conventional mortgage. Thus, he said, the demand for high-end homes has risen in part because the doldrums on Wall Street have made real estate a comparatively more attractive investment. Indirectly, however, at least some of the $10 million-plus market has been fueled by current low interest rates. Cheap mortgages, he said, have heightened demand for $1 million and $2 million houses, and as those owners have traded up, demand has shot up at the top of the market. In that sense, Karevoll said, “everybody’s floating on the same rising tide.”

So what will $10 million buy, house-wise? “Not what it used to, that’s for sure,” said Malibu agent Mark. “It’ll still get you parts of the Westside and the Valley, but you won’t be the biggest kid in town. You wont even be the biggest kid in the neighborhood, really. It’ll buy you a nice house, but it’ll only put you on the edge of the beginning of the big, big boys.”

Link here.


Real estate will make you rich, eh? If everyone thinks so, how can it be true?

Forget book clubs and poker nights. America’s property craze has spawned a new social network: The real estate investment club. Across the country, dentists, retirees, janitors and even teenagers gather each week in hotels, buffet halls, synagogues and the like to sniff for scuttlebutt and attend get-rich seminars with titillating titles like “Turn an Ugly House into a Pot of Gold” and “Exploding Profits Through Bankruptcies”.

California now has more than 40 such clubs, Florida 50. The Georgia Real Estate Investor Association has grown so large -- its main monthly meeting can draw 1,000 -- the group recently bought a building to host an almost daily schedule of confabs. In Texas, Randy Steadham, a former oil services exec who is president of the Realty Investment Club of Houston (none too subtle acronym: RICH), says his membership has quadrupled since 2001, to 2,100 people. “I for one,” he drawls, “have pulled all my money out of the stock market and put it into real estate.”

Hmm. Substitute the words tech stocks for real estate, margin loan for interest-only mortgage, and the housing boom takes on an ominously familiar tone. The question is not whether home values across the country will vaporize all at once, as the NASDAQ did. (They will not.) It is whether too many people are acting as if nothing bad could happen.

Let us be clear: No one knows when home prices will top out in your area. History suggests, however, that it will happen not long after homeowners and buyers reach maximum certainty that they have discovered the fail-safe key to riches. Considerable anecdotal evidence suggests that fateful time may be near. As economists like to say, if something can’t go on forever, it won’t.

Link here.

Regulator’s Fannie Mae findings pummel stock.

Fannie Mae’s stock fell 7% Wednesday after a critical report from its regulator renewed the accounting questions swirling around the giant mortgage buyer. The company said the regulator, known as the Office of Federal Housing Enterprise Oversight, has found serious accounting irregularities that “raise doubts concerning the validity of previously reported financial results.” The board at Fannie, a government-sponsored financial services provider, said it takes OFHEO’s findings “seriously”. Fannie’s board hired former Sen. Warren Rudman to work with its independent directors in addressing the regulatory concerns. Rudman, a former Republican senator from New Hampshire, is an attorney with the New York law firm.

OFHEO informed Fannie of its findings last week. The regulatory agency had been investigating allegations of accounting irregularities at Fannie for nearly a year. OFHEO began its inquiry shortly after a similar accounting scandal broke last year at Freddie Mac, the nation’s second-largest mortgage buyer and a close cousin of Fannie. The accounting scandal at Freddie led to the firing of a number of top executives and the payment of a $125 million fine to OFEHO.

The Securities and Exchange Commission also is investigating the accounting issues at both firms. The reported infractions at Fannie are similar to the ones uncovered at Freddie. Regulators accuse Fannie of using improper methods to value its many derivatives transactions and engaging in earnings management. Specifically, regulators contend Fannie used a so-called cookie jar reserve, built on the delayed recognition of profits, to smooth its reported quarterly earnings.

The accounting scandal is already provoking louder calls for stronger regulation of the mortgage-investment company and clearer financial reporting. Policymakers and Congress are debating whether a new agency is needed to police Fannie Mae and Freddie Mac, or whether OFHEO should step up its oversight of the companies. Critics argue that Fannie Mae holds an unfair advantage over rivals because of its lower borrowing costs and the false perception among investors that Fannie Mae’s mortgage investments are fully guaranteed by the federal government. Critics also say that the government and taxpayers will be forced to bail out Fannie Mae in case of a financial collapse.

More on this story here and here.

Warnings shadowed Fannie Mae’s and Freddie Mac’s rapid growth.

The disclosure that government regulators have raised safety and soundness questions about mortgage finance giant Fannie Mae has given new ammunition to critics of the company and its sister firm, Freddie Mac. Such critics, who recently have included Federal Reserve Chairman Alan Greenspan and Treasury Secretary John W. Snow, worry that the firms have grown so big so fast that if they get into financial trouble, they could imperil the nation’s entire financial system.

Greenspan and Snow have called for tighter regulation and restrictions on further growth. The companies say that they are carefully managed, that they hedge risks effectively and that they have repeatedly tested their systems and found them to perform well under all sorts of economic conditions. A study by the former chairman of the Bush White House’s Council of Economic Advisers, R. Glenn Hubbard, released last week by Fannie Mae, concluded that the company’s “level of safety and soundness is comparable to or better than” that of most large banks and that the chance the company will fail in the next year is one in 10,000. But in view of the newly released findings and last year’s disclosure that Freddie Mac had used improper accounting methods to manage its earnings, critics say they no longer have confidence in the companies’ assurances.

Link here.


The International Monetary Fund has warned that rising interest rates in some of the world’s biggest economies may slow global house price growth. Most at risk are some of the world’s richest countries, where the property market has boomed in recent years. Since 1997, house prices are up by at least 50% in nations such as the UK, Spain, Ireland and Australia. The IMF said it is hard to justify all the gains and should house prices dip, then the global economy may suffer.

“In cases where house prices may have exceeded fundamentals -- which may include Australia, Ireland, Spain and the UK -- there is a danger that higher interest rates could trigger a much larger downward adjustment in house prices,” the IMF said in a report that is to be included in its World Economic Outlook. “Just as the current upswing in house prices has largely been a global phenomenon, any downturn is also likely to be highly synchronised across countries, with corresponding implications for the world economy,” the IMF said.

Earlier this week, the US Federal Reserve raised its benchmark interest rate by a quarter of a percentage point to 1.75%, the third rise this year. The Bank of England has raised interest rates five times since last November, most recently in August. Its key borrowing rate is currently at 4.75%. Many analysts are now predicting that borrowing costs could continue to rise as the global economic recovery shows further signs of sustainability.

Link here.


Last week we referenced a recent report that showed how the U.S. retirement plans, known as 401(k)’s, are failing to fulfill their purpose. Well, it turns out that in the U.K., many people who entrusted British pension funds with their retirement savings are in no better shape than their U.S. counterparts. The results of a new study published by the Financial Times are really quite shocking: “findings have showed that investors in a typical UK personal pension would have lost money during the 10 years ending last February [2004] if it was not for tax relief. A UK investor putting £100 into a balanced pension fund over the 10 years to last February [2004] would have built up £11,515, below the total payments of £12,000.”

If you wonder how many pension funds showed this dismal performance in 1994-2004 -- well, more than one. The combined amount of cash that has “underperformed for 10 years” is nearly £25 billion. That is quite a few “nest eggs”. And the advice for those “whose pensions have performed badly” is not very comforting. Financial planners suggest they “remember the income they could earn as part-time consultants or non-executive directors after retiring from their main jobs.” In other words, forget about that retirement and keep on working.

This is neither the first, nor the last example of how the false comfort of having “professional money managers” worry about your retirement may leave you empty-handed. The only solution is to take control of your own investments.

Link here.


What with the U.S. presidential election coming and all, I have waited patiently for a financial news story to pop up and pronounce some clear-cut link between the candidates and the stock market. My patience had its reward this morning. The nation’s top business daily published an article with this lead sentence: “A ‘Bush Rally’ is buoying stocks in the market’s historically weakest month, underscoring the increased attention investors are paying to politics and terrorism.” Before I go any further, dear reader, please do not even bother to think that I have a partisan interest in either candidate. In my opinion, the campaign charade so far might as well be “Dumb and Dumber Part III”.

That said, there is no denying that President Bush has had a better month so far than has Senator Kerry. I cannot imagine a more sure sign of trouble than an outpouring of unsolicited “How to Win” advice from talking heads and pundits, which is precisely what the Democratic challenger received from the Sunday morning talk shows and numerous recent editorial pages.

And the stock market? Well, the article in question went on to say that after being mostly lower on the year, “the Dow Industrials are up 1.1% in September -- a month that has had an average loss of 1.23% since their inception in 1896.... The interpretation seems obvious: When investors think Mr. Bush is going to win, stocks tend to rise.”

Maybe you are thinking what I was thinking: When the premise of an entire news article is at stake, 1.1% ain’t very far “up” as the 20th day of the month begins. And -- wouldn’t you just know it! -- at the end of today’s session, the Dow Industrials closed down 0.78%. You can check my math, but I think that means the “Bush Rally” amounts to a whopping 0.32% in September.

Critiquing a “news” article like this one is akin to shooting fish in a barrel. It would not be worth the bother, except that you can expect to see more of the same from the media over the next six weeks. The truth is, the fortunes of either candidate has nothing to do with the trend in the stock market between now and November 2.

Link here.


The Perth Mint’s gold, silver and platinum bullion coins are renowned for their purity. But it is not the intrinsic value of the precious metal alone that make these Australian legal tender coins an attractive addition to any investment portfolio. The Perth Mint restricts the mintage figure on its smaller bullion coins, offering the potential for numismataic appreciation. Investors riding the rising gold price can have “double the pleasure” as a result of their decision to invest in low-mintage bullion and collectible coins.

According to the Mint, its 1oz., “Year of the Horse" gold coin, from the Australian Lunar Gold Coin Series, is fast approaching sell-out. Its predecessor, the 1oz., “Year of the Dragon”, recently sold out its full mintage of 30,000. These Dragon coins have been selling at a premium of $170 over the gold spot price on the secondary market. This kind of appreciation is usually associated with collector coins -- highly polished proof versions subject to low mintage restrictions. The Perth Mint is one of the world’s leaders in this field, with 105 years of minting expertise.

Link here.


During the period running from the October 2002 closing lows through this year’s closing hights, my so-called equity-market “tracking group” was up, on average, 65.2% (median advance of 54.1%). Gains ran in a range of 92.6% for the NASDAQ 100, to 47.4% for the DJIA. A few weeks ago, I opined that the market probably had reverted to the primary secular trend -- down. Although the rally between 8/12 and last Friday might cloud the timing of this contention a little, it probably is only a little.

On 3/18/2003, I published a piece entitled, “Do Stocks Have Life After War?” The conclusion was that stocks would indeed have life -- lots of life. Which, of course, they did! That piece of writing, coming from me, surprised a lot of people, since it expressed a great deal of bullish sentiment on both the economy and the equity market. And as readers might recall, it came at a time when there was a paucity of bullish sentiment -- from bulls and bears alike! But as I pointed out at the time, you cannot have the secular bear episode I was and am envisioning without period bullish interludes of significance. Among other things the article lays out the history of the 1965-1982 bear market. It includes specific market levels at various stages, using the DJIA as the proxy. While I will not venture an opinion whether the present episode will last the 16 years, 7+ months of the 1965-82 episode, I do believe the current event has years yet to run.

For those shocked at “years yet to run”, consider this. The current bear market is roughly four and one-half years old. This far exceeds the length of a cyclical event. Therefore, it is difficult (as in impossible) not to acknowledge that it already is secular in duration. A question I am asked frequently is whether the bellwether measures will make new lows. I simply do not know. My gut instinct is that in the absence of an exogenous event, such as another domestic terrorist attack, they likely will not make lows lower than those already in place. But at present, it is somewhat immaterial, since the established lows are far below current prices. For instance, the Dow would have to decline 29.2% to match its low. The S&P 500 would require a drop of 31.2%. As for the NASDAQ 100, its magic number is a hefty 43.4%.

The 1965-82 experience might prove helpful in this regard. On 1/11/73, the DJIA set a then all-time high of 1,052. (Interestingly, this was a mere 8.5% higher than its close on 12/31/65, over seven years earlier.) People were gleeful, believing the allusive 1,000 had finally been scaled for good. That was not to be, however. On 12/6/74, the Dow closed at about 578, representing a 45.1% bashing over that approximate 23-month period. But the December 1974 low did turn out to be the overall cycle low. Nevertheless, the bear market had the better part of another eight years to run. The Dow industrials fell back again to the final (but not new) low of about 777, set on 8/12/82.

Within this overall topic, there is more to be said, of course, on items like valuations, economic considerations, the upcoming national election, etc. But when I take these areas into account, along with the material that has been covered here, I remain -- and comfortably -- a secular bear!

Link here.


The business of running oil tanker fleets has already made several generations of entrepreneurs rich beyond their wildest dreams -- including the late billionaire tycoon Aristotle Onassis. His heiress, 19-year-old Athina Onassis, is now the world’s richest teenager, with an estimated $2.7 billion fortune... and another $2 billion awaiting her on her 21st birthday. It is a business the world economy could not do without, yet you hardly ever read about it in the financial papers. Families and entrepreneurs with an interest in this business simply prefer to keep their matters private, not least because they were earning such high returns that outside investors simply were not needed.

Approximately 46% of the world’s oil production is seaborne. And today, most new oil finds occur offshore rather than onshore. As a result, a staggering 80% of all new oil production capacity coming on-stream worldwide relies on oil tankers. By 2011, it is estimated that 95% of all new oil production capacity will use oil tankers. Without the world’s oil tanker fleet, the global economy would come to a standstill. And for the first time, the stock market is about to take notice.

Jeffrey Goetz, CEO of tanker broker Poten & Partners in New York, recently stated that the oil tanker business is running at close to 100% capacity. And Magnus Fyhr, a Houston-based shipping analyst, predicts that by the fourth quarter of 2004, demand will be higher than capacity. Charter rates for tankers are already exorbitant. They have rocketed more than fivefold during the last two years... but now they are likely to go even higher.

You cannot build a pipeline from the Middle East to China or India -- which is why demand for oil tankers is on the up. At the same time, it can be said with great certainty that supply is not going to keep up, thanks to a little-noticed change in regulations. In December 2003, the International Maritime Organization, an arm of the United Nations, agreed to eliminate single-hull tankers by 2010 and to accelerate the timetable to phase out certain single-hull vessels by May 2005. This agreement means that 13% of the world’s tanker fleet will have to be scrapped by April 2005. By 2010, a staggering 40% of the world’s oil tanker fleet needs to be replaced.

The scrapping of a considerable part of the fleet comes at a time when every single tanker in existence is in operation 24/7 -- the 100% capacity utilization mentioned above. About 80% of the world’s tanker fleet is owned by independent operators -- a vast chunk of that by Greek shipping tycoons. It is a fragmented business with little transparency and few publicly listed companies. But that is about to change, too.

The sector has three factors weighing massively in its favor right now -- a low stock market valuation, at least two more years of high charter fees, plus the increase in the sector’s visibility and, therefore, valuation. I believe that oil is going to rise a lot more. But even if OPEC found a congenial way to pump a lot more oil all of a sudden, and the price of crude oil plummeted, it would merely increase the need for oil tankers further. The oil tanker industry is the one missing piece of the oil puzzle yet to be discovered by investors and analysts.

Link here (scroll down to piece by Sven Lorenz).


Gilligan’s Island is now out on DVD, reawakening the unanswered questions of childhood: why does the Skipper let Gilligan help with anything when he knows he will just screw it up? Why did the movie star take a day cruise in an evening gown? Why did two of the richest people in the world board a dinky boat with the hoi polloi instead of leasing a private yacht? And why do any of the other stranded castaways treat the millionaire’s government money as valuable while stuck on an island where no such government can enforce its value? Because it is just a dumb TV show.

But that last question stuck with me. Would fiat dollars be treated as valuable without the government around to enforce its fiat? In Episode 9, “The Big Gold Strike”, Gilligan and Mr. Howell find a gold mine on the island, which Howell convinces Gilligan to keep secret from the others. By the time everyone learns about the mine, Howell has already taken the lion’s share of the most easily accessible gold. He would like to hoard it for himself, but the other castaways begin charging him for their goods and services. Soon everyone has a small fortune in gold, which they all try to smuggle aboard a tiny escape raft. Their collected wealth, of course, ends up at the bottom of the lagoon. In later episodes, monetary exchange takes place in US paper currency. Was it impossible to recover the gold from the lagoon?

We might dismiss this as economic naiveté on the part of the writers, but recent history provides evidence that fiat paper can, in fact, outlive its government. Not only that, but post-fiat money -- dead government currency -- can out-compete American greenbacks! After the invasion of Iraq, there was no more central bank printing dinars and no more Iraqi government to put the fiat behind its fiat currency. The American military started handing out US$20 bills and expected the Dinar to fade from existence. Instead, to the chagrin of the occupation force, the Dinar’s value doubled against the Dollar in two weeks. Some saw this as patriotism: a silent protest by the occupied population against the invading force. But we need only look further north, to the Kurd-controlled areas, to find a more economic explanation.

After the first Gulf War, Iraq changed its currency from the so-called Swiss Dinar to the more recent Saddam Dinar. When a government changes its fiat currency, it announces a transition period during which the old bills can be brought in and exchanged for the new. After the window closes, the old notes are declared worthless. To no one’s surprise, the rebel Kurds did not visit the Iraqi government to make such an exchange. They just kept using the old money. It was familiar, hard to counterfeit, and in its post-fiat status, it was no longer inflationary: that is to say, the relatively fixed supply of notes made the currency a better store of value than the new Saddam dinars being printed (and printed and printed) further south. The Swiss Dinar may have been the first successful post-fiat money.

For a brief period after the invasion -- the time it took the Occupation Authority to reestablish an Iraqi central bank and start printing new dinars -- the old Saddam dinars joined the older Swiss dinars in their post-fiat status. And lo and behold, Saddam’s dead dinars rose in value compared to the inflationary dollars of the occupation force. By the end of the year, however, the occupation government was printing new dinars, at first with Saddam still on them (for familiarity), then transitioning into something that resembled the Swiss Dinar (to promote confidence). The brief, unplanned experiment in post-fiat monetary theory was over, but the results were unambiguous: a stable money, even a completely unbacked currency, beats out inflationary government paper in both value and marketability.

While it may seem that Gilligan’s fellow castaways would reject Howell’s dollars as worthless, the case of the Saddam Dinar (and the Swiss Dinar before it) offers evidence in favor of “worthless paper”. If Robinson Crusoe had been shipwrecked with a chest full of British banknotes, they would not have done him any good. Friday would be more likely to trade for shells or gold than he would for the strange paper. But on Gilligan’s Island (and in the Kurdish rebel territories, and briefly in Baghdad), people who are already used to making their exchanges in slips of unbacked paper can continue to do so profitably without the hand of government. The invisible hand of the market serves them better -- even when dealing in government paper.

More on this story here.


Surprise, surprise. U.S. Government figures reveal that U.S. household debt has set yet another record. The ratio of debt to personal disposable income rose to 113.8% in the second quarter, from 112.7% in first quarter and 109.7% one year ago. That makes Jan Hatzius, the senior economist at Goldman Sachs in New York, all the more prescient. His latest piece is titled, in admirably straightforward fashion, “U.S. Households: Living Beyond Their Means”. His basic premise is that the personal savings rate needs to rise to 10% over the next five to 10 years “because capital gains on existing assets are likely to be below historic norms.”

“The high valuations of both equities and housing suggest future capital gains will be below, not above, the historical average,” Mr. Hatzius said. Historically, Americans’ response to such a situation would be renewed interest in good old-fashioned savings. For those not familiar with the concept, it entails setting aside a certain percentage of a paycheck into a savings account of some kind. And I am not talking about a 401(k) -- that is retirement savings and is (or should be) a different story.

Mr. Hatzius adds two important factors to the equation: 1) baby boomers may feel increasingly compelled to save to prepare for retirement, and 2) a shift from defined-benefit plans, or pensions, to defined-contribution plans, or 401(k)s, transfers the onus for retirement savings from the company to the worker. The other reason for the ever-shrinking savings rate? Loose lending standards and a runaway housing market have depressed the savings rate. The result will be restrained consumer spending in the years to come as households rein in their expectations and expenditures.

Link here.


Southern governors, whose states hold the largest percentage of elderly in the U.S., are looking to New York for ways to prepare for a graying population. At a recent Southern Governors Association (SGA) meeting members delved into details of New York’s Project 2015, which enlisted representatives from 36 cabinet-level state agencies to assess the impact of an increasingly older population. Southern governors care about aging because 36% of U.S. citizens over 55 live in the South, the U.S. Census Bureau reports.

The past decade has been the calm before the storm for state agencies working with the elderly because of the much-feared aging of baby boomers, the largest generation in American history who are now between the ages of 40 and 59 and who soon will rely more on state programs. While the South leads the nation in percentages of elderly people, California had the highest number of people 65 and over in 2003, followed by Florida, New York, Texas and Pennsylvania, according to the Census Bureau.

In 2002, New York’s Office for the Aging followed Republican Gov. George Pataki’s order to study how state agencies can change their mission to accommodate the elderly. Project 2015 looked at demographic projections for aging in New York in the year 2015 and produced recommendations on how to prepare for increased demand.

An aging population is expected to bring a revenue decline and a spending rise that some believe will make the states’ financial burden heavier. People over 65 spend less, which translates into lower sales- and use-tax collections. While some will continue to work, many will receive the majority of their income from non-taxable sources. States such as Kentucky offer homestead exemptions for people over 65 that shield elderly property owners from higher taxes. The New York project won southern governors’ attention because it is the “most progressive, systematic approach to aging,” said Virginia Gov. Mark Warner, whose interest in state programs for the elderly was inspired by his desire to help his father find services and answers for his mother, who is suffering with Alzheimer’s disease.

Link here.


While Delta Air Lines appears headed for a corporate nose dive, its pilots have opted to pull the financial ripcord. Faced with a management that has decided to use the threat of bankruptcy as a negotiating weapon, senior pilots have been filing for early retirement by the hundreds and then taking their pension in a lump-sum payout. Every retiring pilot takes a haircut: A senior pilot at Delta gets a one-time payment of about $300,000, only half of what he or she would receive in monthly pension checks over the lifetime of the pension.

But the Delta pilots know that pilots at US Airways stand to receive only about 25 cents on each dollar of their promised retirement benefits as a result of that company’s repeated bankruptcy filings. Welcome to the bankruptcy economy, where companies and governments walk away from long-standing promises to workers, and where workers scramble to collect as much as they can now in fear that even less will be available tomorrow.

Sure, management incompetence and shortsightedness have contributed to the creation of the bankruptcy economy. But the underlying causes are demographics -- a rapidly aging population as the baby boom generation gets set to retire -- and global competition. U.S. companies are struggling to cut costs so they can compete with overseas companies with younger workforces that receive few benefits, such as pensions or health care, in retirement. The bankruptcies of U.S. steel companies and among U.S. airlines are certainly the most visible signs of the bankruptcy economy.

But the phenomenon is not limited to those two industries. Bankruptcy, either formally declared in the case of troubled companies or informal in the case of cities or the U.S. government, will restructure the entire economy in coming decades. This restructuring is part of a new economy just now emerging that radically shifts costs and risks in our financial system. Today’s column is the first part of a series, to run occasionally for the rest of this fall, on what that new economy will look like.

The federal government does not go bankrupt. It just borrows more money. Run the presses a little longer, or stick taxpayers with a higher bill. The final costs of a bankruptcy economy are not simply measured in cash, however. Workers who do not trust management at many private companies will believe even less in management promises. Workers in the public sectors who thought their pensions were guaranteed will experience a rude and bitter awakening. Social Security recipients will get less back just as current workers are asked to put more in. And taxpayers will get socked with the bill and be left with more anger and cynicism.

Link here.

San Diego report depicts public pension meltdown.

Combine equal parts of accounting fiction, political games with budgets and optimistic assumed investment returns, and you get a multibillion dollar public pension headache for states and localities over the next decade. Consider, for example, what is going on in the city of San Diego. Back in January, the city sent out a special disclosure notice saying that its Employees’ Retirement System (SDCERS) was only 67.2% funded. There was more than $1 billion between what the system needed, and what it had on hand. The announcement set off alarms at the rating companies, which lowered the city’s credit rating, as well as at the SEC and the U.S. Attorney’s office, both of which began investigating what happened and why.

The city hired a law firm to review its disclosure practices from January 1996 to February 2004, and to represent it before the SEC. Attorneys Paul Maco and Richard Sauer, who wrote the report, both used to work at the SEC, Maco as the head of the Office of Municipal Securities. The firm last week released a 276-page report on its investigation, which makes for the most compelling municipal market reading since the U.S. Attorney’s lawsuit against the ex-treasurer of Philadelphia and his friends back in June.

That lawsuit depicted a pay to play culture in operation in Philadelphia. The San Diego report is not quite so lurid, yet it describes a much bigger and more widespread problem than municipal corruption. The report said there was no evidence the city meant to deceive investors, but said its disclosure was prepared “in a routine and occasionally careless manner that focused on current issues while regarding long-term concerns as speculative and inappropriate for disclosure.”

There are so many excellent parts to this report, which takes you right inside city government, that it is hard to know where to begin. Perhaps the one section every municipal official should read, though, is the one dealing with the concept of “surplus earnings”. This is where the city’s troubles began. And the fundamental source of trouble: Politicians think short-term, and pension plans are long-term. Big problem.

Link here.


A friend of ours recently described the stock market as boring and lethargic. It is true that the indexes display little volatility and that all the volatility indexes are hovering near multiyear lows. But not too much importance should be assigned to the present low volatility, except that it indicates complacency among investors because, during major market sell-offs such as we had in 1987, 1998, 2001 and 2002, volatility picks up sharply.

Nevertheless, volatility can stay low for years, as was the case in the 1991-1996 period, when the stock market was rising. Therefore, if for years volatility stayed low while the market was rising, I suppose that volatility could remain at very low levels for a long time while the market is sliding the slope of “the mother of all hopes” among the investment community.

I should remind our readers that historically low returns on cash -- courtesy of the Fed -- are a colossal, and dangerous, incentive for not only hedge funds, but also all investors to speculate in just about anything -- from art, propert, and direct investments in oversaturated industries in China; homes in the United States, the UK and Australia; foreign currencies, commodities, emerging market bonds and stocks; and funds of funds; to a plethora of the most imaginative derivative products. Like in a casino or lottery, some players who are particularly skilful or lucky will leave with huge profits, while the majority will end up with losses.

So, what should the prudent and wealth preservation-oriented investor do in this environment? As I have explained in earlier reports, the least desirable asset today is cash. Therefore, a contrarian investor should consider holding above average cash positions. I am purposely writing for the average investor. Now, I am perfectly well aware that every investor is convinced that he is an above-average investor, but, as one can imagine, this cannot be the case from a mathematical point of view.

The question then arises of what kind of cash to hold. There is at present a widespread consensus that the U.S. dollar is in trouble, and while this may be true as far as the long-term is concerned, counter-trend rallies will repeatedly occur, as (with the exception of the Asian currencies) paper currencies such as the euro do not appear to be particularly undervalued against the U.S. dollar. Over the longer term, all paper currencies will lose their purchasing power, as they have done so since the invention of central banking and the end of currencies that are fully backed by gold. Hence, it makes sense to hold some cash in gold and silver.

The other widespread consensus that stands out is that U.S. bonds will decline as the economy and inflation pick up. I agree that, eventually, U.S. long-term interest rates will be higher than they are now, as inflation is bound to accelerate in the next 10 years or so. However, the question is: What will happen between now and then? From the monetary and other economic statistics I follow, I would not be surprised if the economy did not gather strength over the next six months, but then weaken once again far more than even the pessimists expect as a result of shrinking real personal incomes.

In this scenario, I believe that long-term bonds could rally another 5%, or even 10%, from their present level, as investors might panic out of equities into the highest quality bonds. If this scenario of a weak economy does come into play the dollar could surprise on the upside simultaneously with the bond market, because weakness in U.S. consumption will lead to an improvement of the U.S. current account deficit as imports falter. This view of dollar and bond market strength is not a long-term call, but intermediate in nature

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

“Comrade” Faber says China will save the dollar.

Marc Faber, the Hong Kong-based asset manager who cheerfully wears such gloomy monikers as “Dr. Doom” and “the bear’s bear”, used an unusual ploy to make his point at CLSA Ltd’qs annual investor forum last week. “I’m Comrade Faber, comrades,” he began. “You are now all members of the central committee of the Communist Party that’s getting together today for the first time in a year.” Faber’s gambit was timely, as it coincided with a real meeting of the Chinese Communist Party’s central committee in Beijing. Although the actual plenary session focused on political transition, Faber’s make-believe meeting concerned itself with another changeover -- a shift in the world’s economic core from the U.S. to China.

An Asian century, with the most-populous nation at its center, is hardly a novel idea. Still, what made Faber’s take on the topic interesting was that, unlike many other commentators, Faber’s scenario does not envision a sell-off in U.S. securities as a starting point for the transition. In fact, Faber, the managing director of Marc Faber Ltd., and the author of a monthly newsletter called The Gloom, Boom and Doom Report, argues that Beijing may adopt just the opposite strategy. “My plan,” Faber said at the CLSA conference, continuing with his imitation of an imaginary Chinese official, “is to keep the U.S. dollar very, very strong.”

Faber’s “plan” may be a big setback for any hope of an orderly reduction in the U.S. current account deficit, which is the biggest risk to the stability of the global financial system. Still, there are two compelling reasons for Beijing to keep the dollar overvalued, Faber said. First, by propping up the U.S. currency, China, along with the rest of Asia, can make more of U.S. manufacturing and service industries uncompetitive, forcing them to move to Asia. Second, the People’s Bank of China uses a big chunk of its $483 billion of foreign-exchange reserves to buy U.S. assets, helping keep American interest rates low. Continued low rates will keep a “feel-good factor going in the U.S.,” Faber said.

Faber’s mythical “comrade” believes that China will have the power to decide when to cause the demise of the overvalued dollar. If China delays an exchange-rate adjustment only to dump the dollar later in a single shot, Faber’s prognosis of gloom and doom could become a reality.

Link here.


Big-time scandals often begin to resemble a three-ring circus. The revelations, personalities, and sordid details emerge so rapidly that you cannot follow everything at once. Yet even as the pace of the entertainment becomes overwhelming, you can usually count on authentic scandals to feature a fool or a knave who draws your attention back to the center ring.

Last year’s biggest scandal was arguably the dismissal of New York Times reporter Jayson Blair, who for years plagiarized the work of other journalists. In the cascade of events that followed, the Times’s executive and managing editors both resigned. Yet it is clear that a knave was in the center ring of that fiasco. By all accounts Mr. Blair was ambitious, talkative, highly intelligent, and fearless; these are the qualities of a star reporter. Add to this mix the fact that Mr. Blair was a superb liar, and what you had was a grifter for the ages.

This year? Well, if foolishness means “knowing better but doing it anyway,” it is fair to say that the managing editor of the CBS Evening News is the fool in the center ring of what looks to be the major scandal of 2004. It is beyond belief that Dan Rather is in the sort of mess where the effort to “manage” a mistake becomes a bigger story than the mistake itself. This is precisely what defined Watergate -- the mother of all scandals, and the one that helped make Mr. Rather’s career.

How does all this relate to finance? Well, credibility is to journalism as money is to the stock market -- and Mr. Rather’s credibility had been in a very long-term bull market. One comment I read likened him to Captain Ahab in Moby Dick: “Rather had many successes, but then he went harpooning after one too many a whale.” As The New York Times was last year, Mr. Rather and other CBS executives were arrogant to the point of overconfidence. They denied the pile of evidence that grew taller by the day. The memo was their Internet stock: They wanted to believe it, evidence be damned. They did not sell until the bubble burst. Another social institution has squandered the thing that makes it unique.

Link here.


Interstate Bakeries filed for bankruptcy Wednesday. If you do not recognize the name, put it this way: Humanity now faces a future that will include fewer HoHos, Twinkies, Ding Dongs, Ring Dings, and Yodels... not to mention less Wonder Bread. By filing for Chapter 11, the corporation hopes to shed a lot of its excess and then tighten its belt. Heavy humor aside, there really is something larger behind this particular company’s hard luck: It is a trend we anticipated back in March 2000, when The Elliott Wave Financial Forecast introduced the “EWI Brand Index”.

This index includes 15 companies with established “name” products, since major brands typically represent successfully crafted bull market symbols and images. Our analysis in March 2000 said that shares in the index “should be extremely sensitive to any loss of potency in the ... tastes or subliminal appeals they have created over the course of the long bull market.”

That was the month the bear market began; we have followed the Brand Index all along, and once again showed the chart and pattern in this month’s EWFF (September issue). In fact, the Brand Index has been more relevant than ever this week. Three stocks in particular led the way down during the market’s decline on Monday -- Unilever, Colgate-Palmolive, and Procter & Gamble. News reports said they fell because of a lower earnings “surprise”. Yet this was NOT a surprise if you have followed the EWI Brand Index -- all three company stocks are among the brand names we include.

Link here.


GM is replacing and redesigning vehicles worldwide, adding new models in North America, Europe, Latin America and Asia, while building new plants in China. Reviewers agree the automaker’s quality, design and technology have never been better. The new Buick LaCrosse sedan, displayed with dozens of Saturn, Opel, Hummer and other models, including future prototypes, received much favorable comment at an exhibition for worldwide automotive media this week in Fayence, France. Vehicle interiors, a weakness in many GM models, have never looked so classy.

Nevertheless, GM is faced with health care liability costs that threaten its finances. The company sees itself in the same situation as steelmakers and airlines that have failed, or will fail, because their revenue cannot outrace ballooning wage and benefit costs. The automaker’s expected $5.1 billion outlay for health care this year, for example, matches its current capital expenditures for plants, tools and new models. GM executives forecast those costs to increase at least 8% this year over last.

The company employs about 153,000 U.S. salaried and hourly workers. Yet 1.1 million GM workers, retirees and dependents draw GM health-care benefits. GM executives do not have a solution to capping the outlays. The automaker has tried to trim medical costs with a variety of measures, such as encouraging the use of mail-order pharmaceuticals and health-maintenance organizations. The results have been disappointing.

The U.S. auto industry, led by General Motors, set the pattern for compensating union workers in the 1950s and 1960s, adding ever more generous health-care and pension benefits in order to win labor peace. The strategy worked as long as automakers could pass along higher labor and other costs to customers as higher vehicle prices. Now U.S. automakers must compete against lower-wage countries like South Korea, where health-care costs largely are socialized. Vehicle prices, meanwhile, have been falling in the U.S. for seven years. One possibility is for GM, Ford and DaimlerChrysler AG jointly to propose rationing of health-care benefits in union contract talks in 2007. And while they are discussing health care, why not propose a less financially risky defined-contribution pension plan for hourly workers, like the one that newly hired salaried GM workers now get?

These two proposals are not for faint-hearted managements, since they surely would provoke a strike between the United Auto Workers and the automakers that could cost billions. The alternative, however, is to keep trimming health-care costs at the margins, letting the liability grow to truly scary proportions.

Link here.


Small companies are finding that hiring the services of the four largest accounting firms is becoming increasingly hard. In the past seven weeks alone, Deloitte & Touche LLP, KPMG LLP, and Ernst & Young LLP have dropped at least eight small US audit clients. This trend is the flip side of another recent development in which more and more small firms voluntarily switch from the Big Four to small accounting firms in order to save money.

Bloomberg reported that the Big Four -- which also includes PricewaterhouseCoopers -- say they are dropping small firms because they are overworked. Their major burden reportedly is the need to help their largest clients gear up for Nov. 15, the day most companies with market capitalizations over $75 million must comply with Section 404 of the Sarbanes-Oxley Act.

Top SEC officials are reportedly not buying this excuse. “I’ve expressed my view to the CEOs of the big firms that I think it is their responsibility not to run away from the marketplace,” said SEC Chief Accountant Donald Nicolaisen. The requirements in the 2002 law “should not be a convenient tool for them to manage their business. They do have a responsibility [to] the public trust.” So far, however, the trend is not yet a “major epidemic”, Nicolaisen acknowledged.

Link here.


Hedge funds that acquire businesses are unlikely to manage them successfully because of their lack of experience, a pioneer of the US buy-out industry warned. In rare public remarks at a private equity conference in New York, Henry Kravis highlighted the trend on Wall Street towards competition between hedge funds and private equity firms, which he expects to continue.

In making his case, the founder of the US private equity firm Kohlberg Kravis Roberts referred back to Texas Genco, the energy group sold for $3.65 billion to KKR and other investors in July after an auction that saw a number of hedge funds come in as potential buyers. “If the hedge fund consortium had won, the company would have been owned by investors who had never previouslymanaged a company,” Mr Kravis said. “Hedge funds know how to pick stocks and make lots of money, but that is not the same thing as creating value through ownership of an asset over the long term in a hands-on way.”

His discussion of hedge funds which have traditionally taken positions in stocks and bonds but have avoided taking over companies formed part of a wide-ranging address. During his speech Mr Kravis described the challenges facing the private equity industry, which has grown dramatically in the past two decades but also become more competitive. “There is more transparency in business, so it is increasingly difficult to find a hidden jewel,” he said. He also hinted that the Sarbanes-Oxley Act -- the US legislation that was passed in 2002 as part of the response to the wave of financial scandals that shook corporate America -- might bolster private equity firms in the years to come:

“To the extent that Sarbanes-Oxley causes public companies to be less competitive there is an opportunity for the private equity industry in taking these businesses private and putting some energy back into growing them,” Mr. Kravis said.
Link here.


Throughout the first half of this year, investors in commodities fretted about China. They worried that its economy was in for a hard landing, as construction, property values and equities all seemed to be overheating. Such a landing could be disastrous for commodities companies, which have profited from some of the strongest global demand for resources in decades. Much of that demand has been driven by China, which now accounts for 30% of world coal consumption and 40% of steel consumption.

So far, however, the fears have generally not been borne out. Loan growth in China slowed by 7% from August 2003 to August 2004, and while inflation has remained strong, it has been below forecasts. China’s consumer price index rose by an annualized rate of slightly more than 5% in August. Many analysts now say that China’s economy will grow 9% this year. As a result, said Phil Flynn, senior market analyst at Alaron Trading, a futures and options brokerage in Chicago, commodities and shares of mining companies around the world, which have posted sizable gains over the last two years, are still a solid long-term bet.

Moreover, commodity companies do not have to deal with the same headaches as manufacturing or service businesses supplying China. After all, commodities like coal are tough to pirate, and their producers do not need to worry about winning over Chinese consumers to a brand name. What is more, said Thomas K. McKissick, managing director at TCW Asset Management and lead manager of TCW’s Galileo Large Cap Value fund, commodity prices have been so low for so long that even recent demand has not bolstered supply enough. “You were in a 20-year bear market for commodities,” which reduced capacity, he said, noting that China still had little of its own manufacturing and transportation infrastructure in place.

Michael Bradshaw, a senior analyst covering basic materials at Pioneer Investments, said he believed copper was in the shortest supply of all commodities, because there were no easy substitutes for it in industrial processes. China’s copper imports were up 20% in August, versus the same month in 2003. Accordingly, Mr. Bradshaw favors Phelps Dodge, a mining company with significant copper assets. Phelps Dodge posted second-quarter earnings of $2.30 a share. He also likes the Rio Tinto Group, a diversified miner with bases in Australia and Britain. Aluminum has also remained strong, and several metals market analysts predict that worldwide demand will climb 8% this year.

Rather than focus on companies, some investors may put money directly into commodities. But Mr. Flynn of Alaron cautioned that this could be risky, especially for people who are not willing to track the commodities daily. “Futures and commodities are highly leveraged and very volatile,” he said. “Go in with your eyes open.” Individual investors interested in exposure to commodities can invest in a fund based on a commodities index. Dan McNeela, senior natural resources analyst at Morningstar, prefers the Pimco Advisors’ CommodityRealReturn Strategy fund to its main competitor, the Oppenheimer Real Asset fund.

Link here.


Hedge funds have been defined as funds which fail to hedge risk and anyone tempted to chase this fad had better beware that it rarely pays to be late onto an investment bandwagon. The mysterious world of hedge funds emerged from its discreet offices in Mayfair, Geneva and Manhattan during the last decade, seeking more money from a wider range of investors. These unregulated, offshore investment funds have grown exponentially and now control more than £500 billion of assets worldwide. Their high charges and, in particular, performance fees have made their managers fabulously wealthy, attracting ever more ambitious and self-confident individuals to the industry.

Satisfying the industry’s voracious appetite for capital requires an ever-increasing supply of new investors. In the early years, these were mostly wealthy families with their money in tax havens. Among those who followed were charitable foundations, private banks and American pension funds. Now the salesmen are focusing on the slowcoaches: British insurance companies, pension funds and ordinary investors.

To appeal to these markets, an old solution has been adopted. Investment trusts have been set up to invest in a broad portfolio of hedge funds selected by a “fund of funds” manager. The first of these, Alternative Investment Strategies, was launched at the end of 1996 and is managed by International Asset Management. Since then, there has been a steady increase in the number and size of these funds.

The discount to net assets at which these funds used to trade has disappeared in the last year, and the average fund has risen 5% in value. Unfortunately, this does not mean that their underlying performance has been good. The average change in net assets over one year has been a fall of 3%, and over three years, they have lost 4%.

Hedge funds are finding it increasingly difficult to devise strategies which generate positive returns while avoiding the risk of losses. This does not surprise Robin Angus, a veteran expert on investment funds. “A growing amount of capital is chasing after a fixed amount of market inefficiency,” he says, “so returns are bound to fall.” Performance data provides supporting evidence, showing that returns in excess of cash have fallen from more than 13% in the mid-1990s to less than 5% now. To make matters worse, research has shown that the average fund of hedge funds has under-performed the average hedge fund by 3% per annum. Those who were once members of Lloyd’s will remember that when clubs for the rich open their doors to all comers, the best days for profits may be past.

Link here.


Inflation, as reported by the CPI is understated by roughly 2.7% per year. This is due to recent redefinitions of the series as well as to flawed methodologies, particularly adjustments to price measures for quality changes. The concentration of this installment on the quality of government economic reports will be first on CPI series redefinition and the damages done to those dependent on accurate cost-of-living estimates, and on pending further redefinition and economic damage.

The CPI was designed to help businesses, individuals and the government adjust their financial planning and considerations for the impact of inflation. The CPI worked reasonably well for those purposes into the early-1990s. In recent years, however, the reporting system has succumbed to pressures from miscreant politicians, who were and are intent upon stealing income from social security recipients, without ever taking the issue of reduced entitlement payments before the public or Congress for approval.

Changes made in CPI methodology during the Clinton administration have understated inflation significantly, and, through a cumulative effect, have reduced current social security payments by 30% from where they would have been otherwise. That means Social Security checks would be 43% higher. In like manner, anyone involved in commerce, who relies on receiving payments adjusted for the CPI, has been similarly damaged. On the other side, if your are making payments based on the CPI (i.e., the federal government), you are making out like a bandit.

As will be discussed in the final installment on GDP, part of the problem with GDP reporting is the way inflation is handled. Although the CPI is not used in the GDP calculation, there are relationships with the price deflators used in converting GDP data and growth to inflation-adjusted numbers. The more inflation is understated, the higher the inflation-adjusted rate of GDP growth that gets reported.

Link here.


There was a time when thrift was a virtue. “A penny saved is a penny earned,” dead people whisper. Accountants with sharp pencils even noticed that a penny saved was more than a penny earned, 40- 50% more; it was not subject to state, local and federal income taxes. But now thrift is regarded no longer as a virtue, but as a mental disorder. Evidence comes from a story in Real Simple, which tells the story of a poor woman named Morning Naughton, 34 years old in the flesh, hundreds of years old, perhaps, in spirit.

If the phone doesn’t ring at an expensive jewelry store this morning, it will be Ms. Naughton who is not calling. If there is no one admiring the new SUVs in a North Carolina showroom, it will be Ms. Naughton who has stayed at home. If you were to check the credit card records for sales of expensive vacations, fancy hotel rooms, extravagant fur coats or top restaurants, you would not find Ms. Naughton’s name. Alas, says Real Simple, the woman has a real problem; she is “frugal to a fault”. “She has never had credit card debt, she pays all her bills on time and she typically saves $500 each month -- on a salary of about $30,000,” we are told.

But never was there a problem under the bright sun of America 2004 that did not have some sort of fraud creeping in the shadows of its debt bubble. Reading about Ms. Naughton, economists are likely to see a threat; if other consumers were to do the same, the whole shebang would be in trouble. Psychologists, on the other hand, will quickly see an opportunity; some may prepare 12-step programs to help overcome it. Others will offer drugs and counseling. For the present, both economists and psychologists can relax. If frugality is a disorder, it is too rare to worry about. The odds of coming down with it are as remote as integrity in public office. Besides, thrift -- even if it is a disorder -- is one that comes and goes. If people are saving too much, or too little, just wait.

“Were it not for her husband and child, Morning...might not be motivated to change,” Real Simple explains. “After more than 20 years of belt-tightening, Morning knows she needs to relax. ‘I don't want [my son] Spencer to grow up with the same money anxieties I have,’ she says. ‘Being so frugal has become a burden, and I want to change. But it’s hard after a lifetime of being this way.’” We wish her luck. But we offer advice: Do not change too much. Old habits might turn out to be useful.

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


“There is virtually no intelligent economic discussion in the U.S. today! In the ‘80s,” remembers Dr. Kurt Richebächer, “it was different. Economists debated the merits of ‘cost-push economics’ and the Supply Side theory. Those days are gone.” Dr. Richebächer will turn 86 this month. Most of his contemporary economic thinkers -- the ones who learned, cared about and argued over economic theory -- are gone. And with them, the days when altruistic economists drove economic debate. Today’s meager fare we call economic discussion is nothing more than hot air designed to sell products. And today’s economist -- he is more like a salesman -- he is paid by Wall St. to produce hot air.

And now that the U.S. economy is so dependent on the stock market, America’s purse strings have become tightly wound around Wall Street’s fat little finger. The investment banks and brokerage houses pay the wages, so it is no real surprise economic reporting remains almost uniformly optimistic and modern economists are but mere shills for big sales departments. But not Dr. Richebächer. From his digs in southern France, he can afford the luxury of independence... So we sent Thom Hickling on a special mission to Cannes with a video recorder and a microphone.

“According to Dr. R.,” writes Thom in his latest correspondence, “the U.S.A. and China are the two most imbalanced economies in the world: The U.S. with its credit and consumption bubble, and China, with its extreme levels of over-investment. Both are on the path to mutual economic destruction, because when Americans can no longer afford to consume, the Chinese will also go broke.”

“The world economy is at a more critical juncture today than in 2000 when the tech bubble crashed. Then the U.S. economy was flush with cash from the boom. It cushioned the storm that followed. Now economic indicators show great weakness, but there is no cushion left to ease the fall. Monetary stimulus has little room to move. Deficit spending by the government is tapped out. Consumers have over-borrowed and there is no wage growth. The refinancing boom is over.” Did he say “refinancing boom?”

Link here.
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