Finance Digest for Week of September 27, 2004

MARY ANNE AND PAMELA ADEN LIKE GOLD

Gold has been quiet lately, but not to worry. The Summer consolidation time looks like it is coming to an end. Gold shares have broken on the upside. They are likely leading gold as they often do and once gold gets going, it will be important to see if it reaches a new bull market high. If it does, gold will be showing great strength as it will be entering a stronger phase in the ongoing bull market. And when you stand back and look at gold’s big picture, you can see a potentially explosive rise coming in the years ahead (see Chart 1).

Note the massive uptrending channel gold has formed since 1967. The 1974 and 1987 peaks mark the top of the channel while the 1969 and 2001 lows establish the bottom. The mid-line connects the 1976 and 1993 lows. When gold hit its 1980 peak it overshot the top of the upchannel. Who would have thought in those days that gold would not reach a bottom for another 21 years in 2001 as it moved from the top of the channel to the bottom? The worst part of the bear market was during the tech boom from 1996 to 2001 when gold fell to new bear market lows. The negative sentiment became so ingrained it is still in the market today, despite the 68% rise since 2001 and the fact that gold broke above its 21 year downtrend, which was very bullish. Sentiment is slowly changing, however, and it will continue to change with each new bull market high.

For now, let us watch for a new high above $430. Assuming this huge channel stays intact, once gold breaks above this level, $500 will be the next target. After that, the 1980 highs would be the next stop on this big picture. This level would also coincide with gold reaching the mid-channel line. So the question is, when is a likely time for gold to rise above $430? At worst we could now see gold back and fill a while longer, similar to the mid-2002 time period. And at best, gold could soon move up above the April peak of $430.

The Midas Touch

So far, my speech this week in San Francisco had gone over well... I started out by sizing up the stock market. I showed how, even after nearly five years of stock market weakness, stocks are simply not a bargain. I showed some fancy graphs, and the crowd was with me, so far, so good... Then I compared the asset bubble in the U.S. to the asset bubble in Japan. The comparison is remarkable, for its similarities and differences. This is when I started to lose the folks in San Francisco. I said that home prices nationwide were not in a bubble, and that home prices could continue to rise. They were not buying it. This is a place where “starter” homes can cost a million dollars or more. But they were intrigued, and they appreciated the fancy graphs. In other words, I might be right, but they were not going to buy anywhere.

After outlining the present state of investments as I saw it, I then shared my favorite investments with them. I mentioned timberland (through Rayonier) and they nodded in agreement. I mentioned 40% on our cash (through Apollo Investment) and the pens were out in full force. For my next investment idea, the room went silent. The pens stopped. Clearly, this San Francisco crowd was not interested at all in one of my top recommendations: gold coins. Nothing I said got anyone to lift a pen...

To me it was a strong buy signal for gold coins. More evidence this is a truly hated investment, I thought. The intrinsic value of the coins I have recommended so far is high, and downside is very limited. I do not get it. What I do know is that gold coins are super cheap. And they are hated right now... nobody owns them. (Even people who love and trust me will not buy them!) Meanwhile, gold coin prices have been in an up trend since 2001 (after falling for all of the 1990s, gold coins have performed the opposite of the stock market for the last dozen years). Those are the three things I look for in an investment -- super cheap, hated, and in an up trend.

PRESSURE GROWS ON G7 TO AGREE TO A DOLLAR DEVALUATION

U.S. President George Bush is being urged to signal a dollar devaluation of up to 20% to rebalance the global economy ahead of this Friday’s Group of Seven and IMF meetings in Washington. Senior U.S. administration officials in Washington have over the past few days tried to influence the White House and U.S. Treasury to put pressure on the G7 to agree to a dollar depreciation in its final statement, the newspaper said. Recent data have shown the U.S. current account and trade deficits running at record levels, and economists have said a dollar depreciation is needed to rein these in. The G7 will also call on the world's oil producers to take further action to bring down prices.

HEDGE FUNDS PONDER NEW WAYS TO MAKE MONEY

Hedge funds, faced with falling profits and fading opportunities, are pondering fresh ways to make money, with one new strategy involving trading a company’s debt against its equity, analysts said. A very basic example would involve a hedge fund manager buying a corporate bond because he believed it was cheap and then selling the stock against it either as a hedge or because he thought it was overpriced.

Companies can issue many different types of bonds with different maturities, coupon and collateral, with many tranches. Alongside, voting or non-voting shares can often be listed on more than one exchange. If you toss into the pot share rights issues, bonds that can be converted to equity and derivatives, the complexity of securities linked to a company grows. That makes it difficult for markets to price all bonds and equity issued by a firm in a consistently fair way, and boosts the profit potential of those who take the time to work out how the pieces of the jigsaw fit. Hedge fund managers who can understand and analyze a company’s capital structure have been taking more money from investors who have recently seen returns slip at hedge funds where returns rely on market trends and volatility.

Some hedge funds have turned to Eastern Europe, where illiquid markets increase the chances of mispriced assets. But investors in these hedge funds are likely to be locked in for long periods, possibly a year, as managers cannot jump in and out of Eastern European markets as quickly as they can in New York or London. Hedge funds who trade commodities, especially crude oil which has risen to record highs on fears of disruptions to world supplies, have also become more popular this year.

Hedge funds who trade convertible bonds or their different components -- equity, bond and volatility -- have lost money this year because of low volatility, too much money chasing too few opportunities and a dearth of new issues, analysts said. Many of them are now focused on trading the bonds of firms who are in financial trouble, where prices have collapsed, but the chances of repayment are seen as high or there is a possibility that the debt could be converted into equity.

Recent changes in SEC’s regulation of investment advisers.

During the past 12 months, the U.S. SEC has significantly revised its regulation of investment advisers. These regulatory changes and their implications on registered investment advisers, as well as investment advisers to hedge funds who are currently exempt from the registration under the Investment Advisers Act of 1940 (Advisers Act) are highlighted below. The rule proposed by the SEC in July 2004, if adopted in its present form, will require many investment managers or advisers to unregistered “private funds” (i.e., hedge funds) to register with the SEC.

DEBT WAS BAD THEN, WORSE TODAY

Like cocaine, consumer credit comes in lines and is dangerously habit forming. It has been around a long time. Credit is now elevated to the status of a fundamental human right. It lifts up consumers with personal loans from the bank, credit cards through the mail, store-cards at the till, and on the back of any imagined increase in the value of overpriced homes. So important is credit to modernity that some western governments even create new banks to grant ever more of it to those unfortunates excluded by the prejudice of a wicked banking sector which reckons, not unreasonably, that it is daft to lend money to people who have no real prospect of paying anything back.

But although current consumer indebtedness is bigger than it has ever previously been it is still only the tip of the iceberg. Corporate consumption of credit is far worse. The numbers from the publications of the IMF and the Bank for International Settlements show the world bond market, i.e. debt which has been issued in the form of traded bonds, grew from $800 billion in 1970 to over $35,000 billion in 2001. This is 43 times. It is still growing rapidly, but even this colossus is of no consequence; because next to it is the world of derivatives. Our cleverest brains have for twenty years been constructing arrangements which allow giant corporations to get things which they cannot pay for. Not surprisingly in the minds of the investment bankers who earn fees from these derivatives every cent of the credit exposure is perfectly secure.

DEFICITS-R-US

Two years ago, I made fun of gold and those who held the precious metals at a conference in New Orleans. Since then, the price of gold has risen 25%. Not bad, I say, and better than most financial indexes. But I still think those who hold the metal in bullion form are playing with less than a full deck.

I am, however, all for holding proxies for precious metals in a portfolio. These proxies can be in the form of gold/precious metals shares or options. (I must admit, I am the furthest from a gold bug as far as investing goes, but do I do believe in the concept of a strong currency backed by strong fiscal and monetary policy.) Pretending to be a doomsayer would be too easy. Pretending to know when gold will reach that next magical plateau of $500, if ever, would be crazy. I am a pragmatist. What I do know is that the value of my currency, the dollar, is being eroded daily with no end in sight.

I could blame the politicians or the Federal Reserve for taking the dollar down the low road...but they are only doing what many of my countrymen are doing, borrowing today and hoping to pay back tomorrow. As long as we want handouts, the dollar will fall. As long as we are at war, the dollar will fall. As long as we mismanage our personal savings, the dollar will fall. So you see the strength of the dollar is in our control to a large extent. The multitrillion U.S. deficit may seem passé, but it is quite real. The continuous deficit spending that adds to that debt is real. Yet we sit back, like the proverbial deer in the headlights waiting to get slammed by a fast-moving semi that has a leaky hydraulic braking system.

As a country, we cannot let go of entitlements that were once reserved for the poorest and least fortunate in this country. We look to the government, an extension of ourselves, to bail out every failing institution. Yet the government only complies after being given permission by you and me. The borrowing, my friends, has just begun. This continuous bailout process will not end in my lifetime unless we (1) magically transform into a nation of savers, (2) magically transform into a nation of taxpayers with marginal rates of 50-70% or (3) come to our senses and realize that supporting government bailouts is the same as reducing our standard of living. I bet that none of the above will occur. When you are fat and lazy, even reaching for the remote is an ordeal.

It is high time for those of us who realize this inevitable crisis to take some steps to act on a strategy that can counter a trend that is defined and gaining momentum. This does not mean selling all your stocks and hiding in a cave surrounded by dead presidents. It means taking the time to reevaluate your portfolio and engage in alternative investing. Alternative investments usually do not come cheap. They require education and cost you time. But the rewards from understanding strategies that could invigorate your portfolio are more important today than ever before. To me, alternative investing is not about buying a “weird” security, but adopting a mindset that allows me to invest in different sectors, using different strategies without feeling lost.

Do not look to your broker for this type of direction. The first step is figure out how much of a contra-dollar asset you need in your portfolio. I am not recommending euros or yen or Malaysian ringgits or even renminbis here. As far as I can tell, there are just as many deficits-in-waiting abroad as there are here. The answer is to accumulate shares in high-quality resource companies that will benefit from higher commodity prices. There will be ups and there will be downs, but in the end, the tangible asset will overcome losses from the asset is little more than faith and hot air.

BLUSTER AND DEBT FILL THE SAILS OF THE USS MACROECONOMY

As an economist I am forever struggling to reconcile the neat and tidy world of our models with the crazy hailstorm of contradictory data and impressions that flood the senses. As an avid reader of the financial press and government data I am alternatively shocked and left to wonder if the leading lights are reading what I read. How could they see the same numbers so differently? The conventional wisdom -- always important -- has become as transparent as New York harbor and the reigning consensus as wise as a swim in those troubled waters.

The economic models, presumptions and expectations that shape opinion and decision are all based on the notions that economies rise and fall on their productive efficiencies, job creation and innovation. None are therefore ready to handle -- deftly and accurately -- a national economy that lives on debt, wealth and bluster (the loudly proclaimed and widely followed notion that things are as they should be). I write to you today to announce that debt, bluster and wealth are the wind in the sails of the post new economy. I have chosen that name knowing that it is prima face absurd. Of course, as the models assume and history has brutally taught many times, an economy can not run on bluster, external debt and wealth sale. However, this is what drives the great ship these days and inspires so much confidence around our increasingly troubled world.

All of this matters supremely because debt must be carried and paid back. Bluster creates unsustainable expectations followed by anger, betrayal, loss of credibility and good will. Wealth sold is gone. He who lives by selling what he owns and claims on his future income is planning for a declining living standard and strife. Much of our national economy is now based on these imprudent, unsustainable and unrecognized actions. The massive sale of wealth and claims on future income to bond marketeers, foreign and domestic, signal steps down a slippery slope. How many times can you sell your wealth, your future income receipts? Not that many. How many times can you reassure folks at home and abroad with positive statements and robust forecasts? It is yet to be seen. From my widow’s watch it looks as though the keel is not functioning and the USS Macroeconomy is listing under the weight of severe imbalances. Shifts in her mighty load of imported freight, or the onset of even slight sea change, could increase the odds of capsizing.

SOUTH AFRICAN EXPATS EYE PROPERTY MARKET

In another sign that South Africans are playing a major role in fuelling the local property boom, South African estate agents report growing interest from expatriates at international property exhibitions. According to Cape Town-based Pam Golding Properties, over a third of serious enquiries about South African properties at an exhibition at the Property Investor Show in London this month have been from expatriate South Africans. This echoes comments made earlier this year by agency Seeff, which said there was growing interest from South Africans living abroad in acquiring properties back home in towns close to industry, like Benoni, as well as more scenic, holiday-type spots.

Of the 360 serious enquiries received at the London exhibition, at least 35% were from “mostly young professionals who have forged successful careers overseas” and are “either wanting to invest in South Africa or return home” in the near future, said Bev Bloch of Pam Golding International. Areas of interest for buyers included new developments in Cape Town’s city centre and surrounds, including Century City, and Johannesburg in general.

AS “DIVERGENCES” GO, THIS ONE IS ESPECIALLY LARGE

The major U.S. stock averages do not move in lock step together, yet they do tend to share the same general direction. So when the trend in one of these markets diverges from the others, it is worth taking note. Technical analysts call this a “non-confirmation” -- and an especially large divergence between certain of the stock averages is often followed by an especially large move when the average in question heads back in line with the others.

A “non-confirmation” is precisely what has developed between the Dow Transport Average and the other stock averages. Just last week the Transports reached new highs for 2004, and were up some 8% on the year; most other stock averages were flat or in negative territory. As non-confirmations go, this one is especially large -- the last one on this scale appeared during the mid-1970s. That divergence finally resolved itself with a 28% move that unfolded over many months. [If memory serves, the Dow Transports failed to confirm the early 1973 top and the December 1974 bottom in the Dow Industrials. Both non-confirmations were followed by major moves in the Industrials.] The past several days have offered several key pieces of evidence that the current divergence in the Dow Transports has now started to resolve itself.

IN THE FACE OF BAD NEWS, THE STOCK MARKET... DID WHAT?

Tuesday’s financial news offered a wealth of reasons for the stock market to decline. U.S. consumer confidence in September came in below the consensus estimate, registering its second consecutive monthly decline. The ICSC-UBS Chain Store Sales Index fell in the week ending Sept. 25, its second down week in a row. And oh -- did you hear? -- a barrel of crude traded above $50 for the first time, making nine straight sessions of higher prices for the November light sweet crude futures contract. Then of course came the usual suspects mentioned in recent days -- “uncertainty” about the U.S. presidential election, “worries” about corporate profits, Dan Rather’s approval ratings.

Thus, in the face of all this (and more) bad news, the stock market could not help but... Rally. The Dow Industrials fell in early trading, but climbed more than one percent from its morning low to its session high. It is silly to make too much of any one day in the markets, but it is not silly to make this simple point: News does not drive the stock indexes.

COME ON, EVERYBODY’S DOING IT

Big shots at Fannie Mae must feel like the kid sent to the principal’s office for wearing baggy pants. What teenager does not wear obnoxious clothes? In fact, maybe it is the kids who are not wearing baggy pants that we ought to be watching. I mean, if everybody is doing it, why are they not doing it too? Likewise, regulators are accusing Fannie Mae of smoothing out earnings blips with help from the accounting department. Fannie’s regulator is accusing it of using off-balance sheet reserves to help keep earnings in line with Wall Street’s expectations.

John R. Grahama, Campbell R. Harvey, and Shiva Rajgopal are authors of a study called “The Economic Implications of Corporate Financial Reporting”, which is all about how far companies will go to “make the number”. This academic study is not about how companies fiddle around with accounts receivables and cookie jar reserves to improve the bottom line. Rather, it finds that companies actually make (or do not make) real-live spending decisions just to make earnings look better. The study, based on more than 300 surveys and 20 interviews, found that smooth earnings were so darned attractive that 78% of executives would “give up economic value in exchange for them”. And 55% of managers would avoid kicking off a potentially profitable project if related expenses could result in an earnings miss.

Here is what the authors mean: 80% of survey participants would cut discretionary spending on R&D, advertising and maintenance just to meet an earnings estimate. That is a degree of consensus usually found only when Congress votes itself a raise. While the authors found that managers were willing to alter the course of their businesses (at least in the short term) to make the Street’s numbers, they found that management was less likely to use accounting finagling to improve the bottom line. Maybe.

But there is still enough earnings managing going on for CFO.com to report that accounting issues still dominate securities class action cases, even though the number of such lawsuits has fallen. CFO.com also finds that because executives still have the ability to influence earnings, more companies are tying incentive pay to free-cash flow. So there must be something to this earnings management businessness. So with so many kids pushing the envelope, why send Fannie to the principal’s office? Because if Fannie gets in trouble, we are all in trouble.

WHITE ELEPHANTS

Poor P.T. Barnum. He had gone through all the trouble and expense of getting a real white elephant to the States, only to be upstaged by a phony competitor. The war of words began, of course, with Barnum angrily protesting his competitor, Adam Forepaugh’s, “swindling, cheating, false and fraudulent elephant, which he is now knowingly, willfully and criminally imposing upon the community.” The most galling part of it all was that the public vastly preferred the fake -- at least for a time.

Today’s American dollar is a lot like Forepaugh’s white elephant. It is, quite simply, a fake. For most of the dollar’s history, it was defined in terms that people from all nations and from all places understood. It was defined in terms of how much gold you could turn it in for, like redeeming chips for money at a casino. This amount was fixed. For a time, a dollar was 1/35 of an ounce of gold. If you had $35, you could exchange it for an ounce of gold. That is what a dollar was, and gold was an essential part of it. You could no more separate dollars and gold than you could separate 12 inches from a foot.

But they were separated. It was a long fight -- a long, tortured road through all sorts of political swindling and monetary mix-ups. The trend was always to try to free money from the shackles of gold. A gold-backed dollar was like a shackle because it helped prevent politicians from printing more dollars than they had gold to back it. Politicians, understandably, did not like this kind of restriction. After all, there were wars to be fought, elections to be won. Isn’t that always the way? We always want things that we cannot presently afford. The difference is that we cannot just go in our basement and turn on a printing press and spend the money the next day.

Quite often in history, this process gets way out of hand, and then you have hyperinflations -- like in Germany during the 1920s or in Argentina more recently. Today, we have a dollar that is only worth what people believe it might be worth. It is a system based on faith. But the strange thing was that despite all the lessons of history, the dollar still became the international currency of choice. The dollar, for many years, towered over its currency brethren, like a giant oak standing in a grove of saplings. Gold, which had provided able service as a medium of exchange for mankind over hundreds of years, was dismissed as a “barbarous relic”. Poor gold.

But there are limits, even today. Faith can be tested. Gold has risen and the dollar has weakened. The dollar’s long reign as the world’s favorite currency is no longer the cinch it once was. Yet one consequence of its long hold on foreigners is that foreigners have built up large exposures to the U.S. dollar.

BERGSTEN’S FIVE HORSEMEN OF THE APOCALYPSE

By popular consensus amongst today’s market pundits, there any number of factors, either in isolation or some combination, which could conspire to bring about economic calamity. Few have discussed these problems more succinctly than C. Fred Bergsten, director of the Institute for International Economics in Washington, DC, notes the Mineweb journalist, Barry Sergeant. Sergeant drew our attention to a recent edition of The Economist, in which Bergsten cited five major risks posed to the global economy today: the US fiscal deficit, China, the growing possibility of an oil shock, a growing US current account deficit and, related to this issue, rising trade protectionism.

Sergeant very cleverly likens these conditions to the five horsemen of a possible new economic apocalypse. He notes Bergsten’s observation that the global economy “faces a number of major risks that, especially in combination, could throw it back into rapid inflation, high interest rates, much slower growth or even recession, rising unemployment, currency conflict and protectionism. Even worse contingencies could of course be envisaged,” such as further terrorist attacks or a collapse in US productivity triggered by an oil shock. The good news from Bergsten is that “fortunately, policy initiatives are available that would avoid or minimise the costs of the most evident risks.”

It is here that we tend to part company with Bergsten. Taken in isolation, there may indeed be available initiatives which could alleviate each individual threat outlined by Bergsten. The difficulty, however, is that the embrace of a solution to one invariably seems to exacerbate the problems of another. No wonder our political leaders remain conspicuously silent on these issues; there are really no easy answers with which one can comfort the electorate. To achieve a less than catastrophic outcome imminently, current policy remains wedded to a horrible status quo -- the economic equivalent of sweeping more and more dirt under the rug. This in reality means no genuine solution at all. It is a polite way of saying that policy checkmate is upon us.

WHAT THE INTERNET BUBBLE GOT RIGHT

I had a front row seat for the Internet Bubble, because I worked at Yahoo during 1998 and 1999. One day, when the stock was trading around $200, I sat down and calculated what I thought the price should be. The answer I got was $12. I went to the next cubicle and told my friend Trevor. “Twelve!” he said. He tried to sound indignant, but he did not quite manage it. He knew as well as I did that our valuation was crazy.

Yahoo was a special case. It was not just our price to earnings ratio that was bogus. Half our earnings were too. Not in the Enron way, of course. The finance guys seemed scrupulous about reporting earnings. What made our earnings bogus was that Yahoo was, in effect, the center of a pyramid scheme. Investors looked at Yahoo’s earnings and said to themselves, here is proof that Internet companies can make money. So they invested in new startups that promised to be the next Yahoo. And as soon as these startups got the money, what did they do with it? Buy millions of dollars worth of advertising on Yahoo to promote their brand. What made it not a pyramid scheme was that it was unintentional. At least, I think it was.

A year later the game was up. Starting in January 2000, Yahoo’s stock price began to crash, ultimately losing 95% of its value. Notice, though, that even with all the fat trimmed off its market cap, Yahoo was still worth a lot. The fact is, despite all the nonsense we heard during the Bubble about the “new economy”, there was a core of truth. You need that to get a really big bubble: you need to have something solid at the center, so that even smart people are sucked in. (Isaac Newton and Jonathan Swift both lost money in the South Sea Bubble of 1720.)

Now the pendulum has swung the other way. Now anything that became fashionable during the Bubble is ipso facto unfashionable. But that is a mistake -- an even bigger mistake than believing what everyone was saying in 1999. Over the long term, what the Bubble got right will be more important than what it got wrong.

ECONOMIC WARFARE

This week began with continuing evidence that the bull markets in energy, raw materials, and China are stronger and more durable that your average cyclical bull market. That is because they are not your average cyclical bull market. In fact, they are quite the opposite. In a recent meeting with colleagues back in Baltimore I noticed how often the word “war” kept coming up. Of course, I was the one who kept using it. A war over oil. A war over water. A trade war over food and grains. You are starting to see the economic equivalent of war (total economic warfare, as I have called it) for one simple reason: more than ever before, people are competing for the same scarce resources.

This competition is what drives bull markets across the board in commodities, in emerging markets, and in Asia. Holding true with the spirit of any competition is the end result of winners and losers. And if the winners are the investors who identify the right themes, the losers are the investors who stick with the old themes. Everyone is probably tired of hearing that point by now; however, it is relevant enough to stress again, even if it just to prevent itchy fingers from calling a broker and saying “buy”. American stocks are in a long-term bear market. You can chase the rallies, although I recommend doing so through options on index and exchange traded funds and only if you can afford to lose the money.

I previously mentioned a deep-seated bull market in energy. Energy stocks keep rising because energy is both in great demand and tight supply. The demand, despite what some pundits are saying, is still being driven by China. China is consuming raw materials at a ferocious rate. And, after all, it takes energy to keep factories running and construction sites humming. A recent Goldman Sachs report states that iron ore prices may increase to $28.53 a ton due to rising Chinese demand.

This all continues to validate our strategy of China profits without the China risk, namely, buying the Western companies doing business with China and taking a pass at speculating on U.S. listed shares of Chinese companies. Why? Cherry-picking the winning Chinese companies on U.S. markets is a gamble. Although you can make money, you can also get burned when white-hot speculative demand gives way to misplaced skepticism, as it did earlier this year.

China faces an enormous test, the likes of which is new in history. They must transition hundreds of millions of people from subsistence-level, labor-intensive farming, and move them to cities that already have 15 million inhabitants, and have these rural farmers undertake labor-intensive manufacturing. It is a mass migration no government could possible conduct. However, one way or another, the market will have to manage it. The market is not a school-crossing officer or social worker. It does not wait to make sure every last person keeps up. In other words, China’s transition is likely be volatile. Their native institutions of social organization may help it through what would otherwise be a demographic catastrophe.

GOLD WILL GO THROUGH THE ROOF AND TO THE MOON, SAYS DOUG CASEY

There is an old saying to the effect that a person’s views on the economy tell you more about their mind-set than they do about the direction of the economy. Long-time readers know I am of two minds on the subject. For the long term, it is a near certainty that the longest trend in existence, the Ascent of Man, will not only continue, but also likely accelerate. Over the next century, the poorest regions on Earth will have standards of living better than that of the average American today, just as the average American has a standard of living far superior to the wealthiest royalty of only a couple centuries ago. As nanotechnology becomes a practical reality over the next couple of generations, the nature of life itself will change totally and almost unrecognizably. Things will not only be better than you might imagine, but probably better than you can imagine.

The bad news is that something called the business cycle still exists, which evidences itself in periodic booms and busts. We have had a tremendous boom from 1982 on. Must it result in a serious bust? In a word, yes. Especially in that the latest boom has been accelerated by currency inflation giving false signals to the market. The distortions and misallocations of capital it causes must be liquidated, through bankruptcies and unemployment.

What I expect is a depression: a period of time when most people’s standard of living drops significantly. It will occur for the same reasons as the unpleasantness of the 1930s, but not necessarily in the same way. For one thing, it is likely to be inflationary, not deflationary, because the government has far more power today than it did in the 1930s. And the amount of debt at all levels of society is much greater, which means there is political advantage in making it disappear through inflation.

Inflation is an excellent way of getting rid of the liability represented by a couple trillion dollars held offshore by foreigners. Inflation is also an excellent way for the government to generate revenue for itself, which it will increasingly need to do, with its deficits running $500 billion a year and, I suspect, headed much higher. The next economic episode -- an episode I think will someday be called the Greater Depression -- will feature plunging stock prices and dwindling profits. But while stocks plummet, commodities will flourish.

Contrary to popular opinion, however, commodities are not very volatile. They are far less volatile than stocks, whose prices can drop to zero or multiply hundreds of times: Either extreme is an impossibility for commodities. Commodity prices are generally limited on the downside by the production costs of the most efficient producer, and on the upside by substitution from other commodities and new production. Since 20-1 leverage is available in commodities futures, people usually wind up using it -- and that tends to turn the commodities pits into gambling casinos, where 95% of the players walk away losers.

The best approach with commodities -- as with any market -- is to treat them like a ball game with no called strikes. You just wait for the market to get tired and lob a real meatball over the plate. Although the long-term trend (and here, I mean since the beginning of recorded history) for commodities is to head down, I am generally a bull at the moment. Oil is definitely in a new equilibrium range, over $40, and is probably headed over $100 in the next few years. Natural gas and unleaded gasoline are likely to do even better, relatively. The meat complex is in midrange, therefore uninteresting. Corn at $2, wheat at $3 and beans at $6 are all excellent buys. The real bargains are in the tropicals: Cocoa at $1,600, coffee at 65 cents, OJ at 62 cents and sugar at 8 cents are all below production cost, and have been for years now.

I think someone who buys a bunch of them on very low margin is going to make a killing. Such a person might even do as well as someone who buys the precious metals. Gold has risen only about in step with the world currency markets; so far, we have not really seen a bull market in gold so much as a collapse of the dollar. In fact, gold has been a laggard among the metals. Right now and for the foreseeable future, precious metals are both the safest and the highest potential place to be. The real action will be in gold. In a world beset by huge instabilities in every area, it is going to become the asset of choice. The price of gold is not just going through the roof; it is going to the moon. The timing of this occurrence is, of course, problematical. I think we will see gold prices surpass $3,000 before this decade is over. I know that price point is hard to imagine, but history is littered with sweeping economic dislocations of far greater magnitude.

“ELEMENTARY” KNOWLEDGE, OBLIVIOUS BEHAVIOR?

What is the most elementary truth about the stock market? Taking the question at face value, my reply is: To own a share of stock is to own part of a company. From this comes other basic truths: To purchase shares in a company is to assign value to that company; and, the share value should grow as the company grows.

But even though this may read like Finance 101, you could never glean these truths from the way investors behave today. The number of U.S. mutual funds surpassed the number of publicly traded stocks in 2001, and in fact the number of publicly traded stocks has been shrinking since 1997. At the same time, what has not been shrinking is the variety of exotic financial vehicles that are linked to the stock market -- futures, options, hedges, swaps, all manner of derivatives, etc.

My point is simple: U.S. stock market investors have never been so utterly disconnected from the share values of what they supposedly own. What is more, this historic “disconnect” is measurable in several reliable ways. Consider dividend yields, for example. We have data going back more than 80 years for the dividend yield in the Dow Jones Industrial Average: at long-term market lows, dividend yields typically paid 7% or higher; at long-term highs, yields typically fell to about 3.5%.

These historic norms changed dramatically in the 1990s, with the dividend yields falling to lows that remain extreme to this day; right now the yield stands at 2.1%, so it needs to rise 50% to reach the level where a TOP would normally be! It is not only that investors are detached from value; the evidence makes clear that they are detached from stock market history. Thus we believe the question is not “if” history will assert itself, but “when”.

GAMBLING CRAZE: IN THE CARDS FOR SOCIAL MOOD

If I knew growing up that one day there would be a World Series of Poker with a take-home first prize of $5 million, I would have asked my parents for Texas Hold ‘Em lessons rather than tap-dancing classes. According to a September 17 Sports Illustrated article, “Pokermania has become pandemic” in American society.

No bluffing. The piece deals out the following details: 1.) Currently, an estimated 60-70 million people play poker, and the number is growing; and 2.) “Internet poker sites are reproducing like crazed rabbits -- 210 and counting up from barely 50 a year ago. Nearly $110 million is wagered daily on online poker games, up from $20 million last year.” The article wagers that “television has catapulted poker into the mainstream,” as today’s channel surfer has a steady stream of programs to choose from devoted to the, um, “sport”. As one source put it: “Poker has proven to be effective programming. It doesn’t matter if it’s paint drying. If it gets ratings, it stays.” And ratings it rakes in all right. In the words of one ex-gambler: “This is a real phenomenon! This is a real explosion. TV poker players are as famous as baseball and football players.”

But the real phenomenon is this: Cable is NOT the cause of the current gambling craze; a turn in social mood is. In a nutshell: As social mood turns down, the amount of effort people want to expend to earn money falls. An overall interest in “Lady Luck” to grant them a million dollars NOW rises, and all bets are on gambling to get rich quick.

OIL: THE BEGINNING OF THE END?

To Colin Campbell, a 73-year-old retired oil-industry geologist who lives in a coastal Irish village, the news that the price of crude oil was shooting up was sweet vindication. It meant that the “moment” he had been predicting for about 15 years -- the beginning of the end of the age of oil -- might finally be at hand. Campbell is at the center of a small but suddenly influential band of contrarians known as the peak-oil movement. They see cause for alarm in the fact that since the early 1980s the world has been pumping more oil out of the ground than it has been finding. By as early as next year, they say, humanity will have reached a point of reckoning: It will have extracted half the oil it will ever get. Once that “peak” is reached, Campbell says, global oil production will start falling, never to rise again.

The peak would mark the end of cheap oil. Although people would probably keep using oil for another century or so, prices would steadily rise. To maintain economic growth, the world would have to become radically more energy-efficient, shifting quickly to alternatives such as solar and nuclear power. If the switch is not fast enough the global economy would screech to a halt. “The perception of this decline changes the entire world we know,” says Campbell, whose wife affectionately calls him Mr. Doomsday. “Up till now we’ve been living in a world with the assumption of growth driven by oil. Now we have to face the other side of the mountain.”

People have been incorrectly predicting oil’s demise since the industry’s early days, and the peak-oil movement has yet to make a serious dent in the energy policies of the United States and other developed nations. But the debate is flaring up with new intensity because of some powerful forces changing the geopolitics of oil, among them the rise of an oil-guzzling China and persistent instability in the Middle East and Russia.

The oil industry calls Campbell a crackpot. Since he began writing about a looming peak, the industry notes, he has progressively postponed his predicted date, from 1995 to 2005. This roughness of the numbers, the industry says, points to a more fundamental problem with the peak-oil theory: It underestimates the power of technology to find more oil -- indeed, to broaden the concept of oil itself. That this debate can occur points to a striking fact: Nobody really knows how much oil exists. More to the point, nobody knows how much can be gotten out of the ground.

“We’re running out, but not in any important way. We’re running out so slowly it does’qt matter,” says Michael Lynch, an oil-industry consultant who has emerged as a leading critic of the peak-oil theorists. At some point, the world will shift from oil to other energy sources, Lynch agrees. But he says there is plenty of oil to ensure that transition will happen smoothly -- long before the world hits the last drop. Critics such as Lynch contend that the decline in discoveries since the 1960s is not an inexorable trend but an artifact of economic forces. Today’s supply crunch, by pushing up oil prices, should give the industry an incentive to figure out how to extract more of the oil still in the ground. Campbell calls Lynch “the high priest of the flat-earth economists.” Meanwhile, the industry is bullish that future improvements in its technology will enable it to extract enough fossil fuel to stay ahead of demand.

Getting a grip on slippery logic about oil.

Every day this week, headlines have explained the rise in Crude Oil prices with cause-and-effect logic that only seems plausible. E.g., “Supply Worries Lift Oil Near $50 US (Toronto Star, October 1)”. If this sounds right to you, it is probably because you have heard similar stories over and over. The fact is, explanations like this one are misleading, even if they do jibe with conventional wisdom. So what is the best alternative? Try turning this headline around: “Oil Near $50 US Lifts Supply Worries”.

Just by flipping a few words, the explanation changes completely for the better. The prevailing perceptions about supply and demand tightness do not cause Crude Oil prices to surge. Rather, fluctuations in the price of Crude actually cause perceptions about Oil supplies to change. Prices drive fundamentals. The news itself reflects what has already happened in the market -- in other words, it is a lagging indicator.

OIL PERFORANCE IN A WORLDWIDE DEPRESSION

In a previous article called “China’s Great Depression”, I postulated that China must necessarily fall into a depression, probably comparable to the American one from the 1930s, which in turn will spread to become a worldwide depression. In response, many readers asked whether in such a depressionary environment the price of oil would go up or down. The straightforward answer is that in an inflationary bust, the price of oil will go up, and in a deflationary bust, down. Of course, the response is evasive, provides no analysis, and answers an ill-defined question. Therefore, the goal of this article is to explain the importance of the question, to define its scope properly, to answer it with sound economic analysis, and to summarize our results.

Over the next decade, oil fundamentals may be characterized as 10+. Oil supply is at or near its “Hubbard’s” peak, and oil is currently pumped at close to 100% capacity. Therefore, growth of oil supply is rapidly slowing down and is expected to decrease in the coming years. On the other hand, China’s and India’s industrialization will continue to drive oil demand at growth rates higher than the growth rates of oil supply, and as a consequence, the price oil has to go much higher in order to ration the relative scarcity of oil supply. In this environment of strong fundamentals for oil, a booming worldwide economy will guarantee much higher oil prices; however, in a worldwide recession, the issue becomes whether the strong oil fundamentals will nonetheless outweigh a slowdown in oil demand. Precisely this issue motivates our present analysis.

The proper definition of the problem requires investigation of the price of oil (1) relative to the U.S. dollar, (2) relative to strong fiat currencies, (3) relative to gold and silver, and (4) relative to a basket of commodities. Below, we investigate each in turn, although I would like to respectfully acknowledge Marc Faber’s seminal contribution in (1) and (2).

The U.S. dollar is fundamentally unsound. A depressionary environment will exacerbate the dollar’s problems and the dollar is likely to fall a lot more than oil due to its inherent vulnerability. As a result, in a depression, the price of oil is likely to go up in U.S. dollars. In terms of strong foreign currencies (e.g., Swiss Franc), I believe that in a depression the price of oil will actually fall.

In a depression demand for gold as a commodity collapses, but its demand as the only safe money skyrockets; the latter dramatically overcompensates the former, and total demand for gold increases substantially. As a result, gold (and silver) is likely to rise against all currencies, weak or strong. However vital for human civilization, in a depression, oil is no match for gold, and is certain to fall in terms of gold. In a strong economy, oil prices generally rise relative to commodity prices, and in a weak economy they fall relative to commodity prices. Therefore, one may expect that in a depression, the oil price will most likely fall in terms of a commodity index, such as the CRB, provided that there are no oil disruptions. It follows that the appropriate investment strategy for investors should involve the accumulation of gold, silver, strong foreign currencies, and government bonds denominated in those currencies.

SOME HOME OWNERS STRUGGLE AS REAL ESTATE MARKET BOOMS

It is an ugly downside of the soaring real estate market: Many of those who put a toe in the housing water are finding themselves unable to afford more than the basic necessities, unless they try to survive with a credit card lifestyle. “Americans are in over their heads when it comes to debt,” said economist A. Gary Shilling. “The value of real estate assets has zoomed, but people are borrowing more and more against their homes.” A brief layoff or other job interruption can be enough to push many young home buyers over the financial edge to insolvency.

Huge house payments are a direct reason for sky-high levels of bankruptcy and foreclosures. In some parts of the country, notably in California, the cost of housing can consume 60% of a household’s budget. For some people, the problem may not be housing prices but spending habits. The availability of credit often exceeds their ability to use it wisely. But the odds are against even some financially responsible home buyers affording their dream home. Real estate costs are outstripping what families are earning, making homes increasingly less affordable. Yet the boom in prices is unrelenting.

In the four years ended June 30, median home prices rose 33%, while per-capita personal income climbed just 10.4%. Nationwide, mortgage delinquencies rose last quarter for the first time in a year. At the same time, foreclosures fell to the lowest level since 2000, according to the Mortgage Bankers Association. Analysts said the foreclosure rate is held down by mortgage lenders who counsel borrowers on ways they can avoid losing their homes. To keep the housing market rolling, economist Shilling said, the government is encouraging mortgage loans with zero percent down payments. In many cases, Americans can buy a home with no money down even if they have filed for bankruptcy or gone through a previous foreclosure.

Fannie Mae’s woes may cost home buyers.

US home buyers may see a slight rise in mortgage rates if housing finance company Fannie Mae, which is mired in an accounting scandal, slows purchases of bonds backed by home loans in response to new rules imposed by regulators. This purchase of securities that pool monthly mortgage payments has been a key ingredient to Fannie Mae’s growth. But an agreement with its regulator requiring the company to set aside more cash may curtail these purchases.

FINDING GOLD IN PLAYED-OUT MINING TOWNS

In the gold and silver rushes of the19th century, sleepy settlements changed overnight into teeming boomtowns. But after the mines played out and people left, what became of these one-time capitals of capital? Some turned into ghost towns. A handful, like Aspen and Park City, capitalized on their scenery to spawn leisure-time hot spots.

Excluding the fortunate few that went chi-chi, one attribute many played-out mining towns possess in abundance is housing. The exodus of former residents left behind an inventory of well-constructed buildings for newcomers to snap up. Often, they cost a fraction of what they would fetch in faster growing areas. One factor that many mining towns have in common is that they suffered from disastrous fires in their early days, when wood was the main building material for their houses and stores. Consequently, near the peaks of their prosperity many rebuilt their infrastructures of brick and stone. These constructions, for the most part, survive until the present day.

COLLISION COURSE

The world economy is on a collision course. The United States -- long the main engine of global growth and finance -- has squandered its domestic saving and is now drawing freely on the rest of the world’s saving pool. East Asian central banks -- especially those in Japan and China -- have become America’s financiers of last resort. But in doing so, they are subjecting their own economies to mounting strains and increasingly serious risk. Breaking points are always tough to pinpoint with any precision. Most serious students of international finance know that these trends are unsustainable. But like any trend that has gone to excess, a group of “new paradigmers” has emerged with a compelling argument as to why these imbalances can persist in perpetuity. That is usually the sign that the denial is about to crack -- possibly sooner rather than later.

The short of it is that America is no longer using surplus foreign saving to support “good” growth. Instead, it is currently absorbing about 80% of the world’s surplus saving in order to finance open-ended government budget deficits and the excess spending of American consumers. The international financial implications of America’s mounting imbalances are equally astonishing. It was not all that long ago that the United States was the world’s largest creditor. Unless the US quickly addresses its current-account deficit problem, foreign debt is set to rise for as far as the eye can see. But for every debtor there is always a creditor. Contrary to widespread belief, it is not an open-ended “buy America” campaign by enthusiastic private investors from abroad. Instead, it is increasingly a policy decision by foreign officials with very different motives.

There is no deep secret as to the identity of the Great Enabler -- Asian central banks. The rationale is clear: Lacking in domestic demand, Asia needs cheap currencies in order to subsidize its export-led economies. A new-paradigm crowd now argues that these trends are a manifestation of a new world order. They argue that it is in Asia’s best interest to keep funding America’s current account imbalance. To do otherwise would run the risk of Asian currency appreciation -- tantamount to economic suicide for these export-led economies. The huge flaw in this so-called miracle, in my view, is that just as America is putting itself in grave danger by squandering its national saving, America’s Asian financiers are running equally reckless policies in providing open-ended funding for these imbalances. In the end, sustainability will probably be challenged by the unintended consequences of this new arrangement. The stresses and strains of an unbalanced world are growing worse by the moment. China is probably the weakest link in this chain. I now suspect that China will flinch sooner rather than later.

China agrees to move “firmly and steadily” toward flexible currency.

The Bush administration, struggling to show progress in attacking this country’s soaring trade deficits, won a commitment today from China that it would move “firmly and steadily” to a flexible, market-based currency. However, the Chinese offered no firm timetable for how long the transition will take. Changing China’s currency system has been a key demand of the beleaguered manufacturing sector in the United States. Companies believe China’s current policy of linking its currency at a fixed rate to the U.S. dollar has undervalued the Chinese yuan by as much as 40%, giving the country a tremendous competitive advantage over U.S. products.

The Bush administration has been pushing China for more than a year to allow the value of its currency to be set by financial markets. However, the Chinese insist this cannot be done until the country puts in place a number of economic reforms designed to bolster China’s weak banking system and protect it from the volatility that would occur with a floating currency. China’s new commitment came in advance of its first-ever meeting with the Group of Seven major industrial countries, which was to occur over dinner tonight. The G-7 has been calling for China to adopt a more flexible currency system.

A group of eight senators and 22 House members said on Thursday that China should be forced to immediately stop manipulating its currency to gain trade advantages. They called on the administration to bring a case against China before the World Trade Organization, which could lead to trade sanctions against Chinese goods. Sen. Charles Schumer, D-N.Y., said the administration’s diplomatic efforts have been a failure and tougher action is required.

GOLDILOCKS DOESN’T LIVE HERE ANYMORE

With the core consumer price index rising at a 1.7% rate over the past year and the yield on the 10-year Treasury note under 4%, inflation appears quite subdued. Then again, oil prices have doubled, other raw materials costs have gained 35% and even Starbucks is raising prices. What to make of these seemingly conflicting signals? Inflation optimists see a weak economy that cannot generate enough punch to support price hikes. Pessimists see a return to 1970s-style stagflation as higher oil simultaneously feeds inflation and curtails demand. And the real worrywarts in the crowd believe falling prices, even a Japanese-style deflationary spiral, are the primary threat and driver of monetary policy.

Indeed, when it comes to the issue of cost pressures, this is either a golden age for theorists of all stripes, or an incredibly murky, hard-to-define period. It all depends on your perspective. Interestingly, almost whomever you believe about inflation, the picture is not bright for stocks. If inflation remains low when companies cannot pass on higher materials costs, profits will be increasingly squeezed. Low inflation from a weak economy is not good for stocks either.

And if inflation starts taking off, expect the Fed to get more aggressive about raising short-term rates while the bond market takes a nose dive. That would drive up long-term rates, removing one of the greatest sources of strength in today’s economy. Greenspan is expected to retire as Fed chairman on Jan. 31, 2006, when his separate 14-year term as a Fed board member ends. His replacement can expect a short honeymoon.

Where’s the beef? Milk? Eggs? Smaller supply boosts prices.

Over the past several months, the cost of food for consumers has risen at a faster clip than has been seen since 1990. Last week’s CPI indicated that the trend eased a bit in August, but overall food costs still are climbing steadily. From shoppers to restaurant owners to school lunch managers, many are feeling the hit. According to economists, the nation has just come through an unusual stretch in which at least a half-dozen major commodities -- eggs, milk, beef, poultry, corn and soybeans -- have shown sizable price increases due to factors ranging from the weather to the low-carbohydrate diet craze. People wanted beef, chicken, eggs and cheese like never before. And how they have paid for it.

HOW REIGNING IN FANNIE COULD REIGN IN THE BUBBLE ECONOMY

Yes, investors are beating Fannie Mae about the head and shoulders over the accounting problems outlined in the mega-report produced by the Office of Federal Housing Enterprise Oversight (OFHEO). It seems that a quasi-central bank running complex derivative strategies to hedge its mega-portfolio may not have delivered earnings as smooth as its lobbyists after all. So investors are shocked -- shocked! -- that such a thing could occur in the New Financial Era.

But the real shocker will come if the GSE’s high powered credit-creating machine is forced to operate on fewer cyclinders. It could happen. Fannie has already said it would boost its capital, and after further review, regulators may want more even capital kicked in. If that is the case, would that not limit Fannie’s ability to buy mortgage loan after mortgage loan to shove in its portfolio, the very act that frees up mortgage companies to make even more mortgage loans which they will also sell to Fannie? With less leverage at its disposal it is hard to believe that Fannie’s ability to fuel the mortgage financial bubble would not be affected as well. That would be a big deal. This chart provides just one implication of the Great Mortgage Bubble: inflated transaction values. In other words, the amount of money involved in home purchases nationwide has exploded in the last few years. Usually when a sector is given virtually unlimited access to credit, an asset bubble ensues. Hmmm.

Here is another angle on the mortgage finance bubble. According to the Fed’s numbers, from 1997 through 2000, the ratio of home mortgage borrowing to business borrowing was in the 52-66% range. This was below the average (of about 100%) over the 1970-1995 period, partly because businesses were going bonkers over the telecom. But as the mortgage finance bubble took the credit reigns from 2001 through 2003, the ratio of mortgage borrowing to business came in at 120%, 331% and 250% respectively. How big of a deal is mortgage debt? Household mortgage debt is now about 60% as large as GDP, compared to 43% as recently as 2000. This would have been impossible without Fannie and its fellow GSEs.

Now there are some optimists out there who think that the magic of immigration and The Great American Realization that renting is for suckers and that home ownership is the key to riches and smooth skin, have created a permanently high plateau for housing demand. These same people think that all this credit creation has been confined to the housing market. However, there are several sophisticated academic studies that prove that the mortgage finance bubble, as credit bubbles are prone to do, has distorted the economy. In the old days, credit bubbles ended when the central bank raised rates. What if this one ends because the fake central bank was forced to become prudent?