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WHEN EARNINGS ARE CHEAP
Whenever you have doubts about the U.S. stock market, you should take a step back and look at the whole world. Markets elsewhere may give you some reassurance that the phenomenon you see at home is or is not a fluke. Foreign data help you check U.S. reality. One phenomenon I have in mind relates to earnings yields and bond yields. The earnings yield on a stock is the earnings divided by the share price. It is the flip side of the price/earnings ratio. General rule: When earnings yields are higher than bond yields, stocks are cheap.
It works here and it works abroad. Between 1974 and 1982 the earnings yield was steadily above the bond yield, a great long core period to buy stocks. The same was true inBritain and much of the Continent. Contrast that with what was going on five years ago, when the earnings yield on the S&P 500 was only 3.5%, while ten-year government bonds were yielding 7.6%. Not a good time to load up on equities. Tracking it through history, usually the current earnings yield is a little below government bond rates. Earnings yields at or above bond yields are exceptional. When you see that inversion of the normal relationship, you probably should be buying stocks.
Which means you should buy now. At a recent 1120, the S&P 500 is going for 16 times this year’s 2004 earnings (before nonrecurring items) of $70. Turn it around and you have an earnings yield of 6.2%. That is a terrific earnings yield, compared with the 4.2% you get on a ten-year Treasury. Now earnings yields are above bond yields all over the developed world -- in Japan, for the first time in modern history.
It gets better than this. The best time of all to own stocks is when the earnings yield is good, yet mainstream expert opinion says stocks are overpriced. You are buying, and you are betting against the crowd. When the crowd comes to its senses, it will bid up the prices of the shares you own. Here are four stocks that have earnings yields above the market’s 6.2% average.Link here.
BUGABOO BONDS THAT WILL PAY YOU WELL FOR DARING TO BUY THEM
You can purchase two types of municipal bonds that appear to dwell on the dark side but really do not. I am talking about tobacco bonds, whose revenue streams are imperiled by a hellish legal assault on cigarette companies, and private-purpose bonds, the ones that finance stadiums, industrial parks and airports. Private-purpose bonds are subject to the alternative minimum tax. If you are not paying the AMT, a stadium bond could be a very good deal. My confidence in the tobacco bonds is based on the fact that neither the federal government nor the states want the tobacco companies to go bust.Link here.
STOCKS FOR A WEAK MARKET
The stock market today would be familiar to Macbeth: full of sound and fury, signifying nothing. The bulls have fought the bears to a standoff. Certain factors in place will limit stock gains to a single-digit annual average for the rest of the decade. I am not being unduly negative here. There will be good years. You might even see a great year, but that will occur only if we have a very bad year first. Bull markets need a catalyst to get going, as shown in my firm’s recently completed 2,500-page study of financial cycles going back to 1962. Looking ahead, I see no such catalyst.
What is missing? No low valuations. No financial crisis to burn away excesses and fuel a powerful rebound. No structural innovations. Meanwhile, we have seen trends arise that undermine a bull market by making life difficult for the average investor, who is needed to get things moving. While accepting the reality that returns in this decade will not be anything like the returns in the previous one, you should identify good stocks and buy them. Here are four.Link here.
John Edwards says the U.S. is becoming two nations, one rich, one poor. Regardless of where you stand politically, you have to concede that the evidence supporting these income trends is strong. What the Democratic senator probably would not like to hear is that this polarizing of income presents an opportunity for investors. While it is not quite true that the poor are getting poorer, there is no doubt that the poor are getting squeezed -- by $2-a-gallon gasoline and by medical bills. That means they have less money to spend at Wal-Mart and Target. The average real (that is, inflation-adjusted) wage is falling, unusual for this stage of the business cycle. You should exit companies that sell to the masses and buy into businesses catering to the upper stratum.
A different trend is going on at the other end of the income scale. Executive pay continues to leap. Even chief executives dismissed in disgrace receive huge severance packages. The polarization of income is a long-term trend, and government can do little to reverse it. The economic squeeze extends even to parts of the upper-middle-income bracket. The middle- and lower-tier folks have maintained growth in spending by borrowing more and saving less. Rising delinquencies and bankruptcies suggest that consumers may not be able to keep borrowing much longer.
How should you respond to the two-Americas trend? Shun stocks in the producers of discretionary items for the middle-and lower-income classes. Deflation, if it arrives as I forecast, will aggravate the problem by leading to a self-feeding downward spiral of consumption. Avoid shares in automakers, which depend on rebates and zero-percent financing to move the metal. Appliance makers will also suffer if the housing bubble breaks, as I expect it will. Credit card issuers will be hurt as borrowers swear off. The well-heeled, though, will patronize the providers of luxury cars, yachts, high-end resorts and travel and other upscale goods and services. Invest in those companies’ stocks.Link here.
IS MERCK A GONER?
Merck pulled painkiller Vioxx from the market after a study showed it doubled the risk of heart attacks and stroke. Prominent doctors are calling for congressional investigations, and European regulators are scrutinizing the safety of similar drugs such as Pfizer’s Bextra and Celebrex. Merck will be lucky to survive a legal onslaught that easily could rival the $13.3 billion in damages paid out so far by Wyeth in a far smaller drug recall, the fen-phen fiasco. “This may be the biggest drug safety catastrophe in U.S. history,” says Vanderbilt epidemiologist Wayne Ray, who published a study linking high doses of Vioxx to heart attacks in 2002. “The potential liability is mind-boggling,” says drug industry analyst Hemant Shah. “Every person who took Vioxx and had a heart attack is a potential litigant.”Link here.
OILFIELD SERVICE COMPANIES ARE GETTING A BOOST FROM EXPENSIVE OIL AND FROM A CHEAPER PROSPECTING TOOL
$52 oil has a remarkable effect on petroleum engineers. It concentrates their minds. They come up with all sorts of new ways to find oil in the ground and remove it. The sharp run-up in oil prices has already had an impact on the shares of oil service companies, now looking forward to a new burst of exploration and development by oil companies. Schlumberger, Baker Hughes and Weatherford International have all seen their stocks climb at least 36% in the past year. There is reason to believe, nonetheless, that they have further to run. High oil prices are here to stay for a while. The December 2009 forward contract for crude is changing hands at $38. That price will cover a lot of drill pipe, deep-sea rigs and high-tech gear used for discovering oil lying miles down.
Traditional seismic work calls for penetrating the earth with sonic booms and then capturing and analyzing the reflected sound waves electronically. A new technology substitutes a low-frequency electromagnetic wave for the sonic boom -- more radar than sonar. It can be used before, or in conjunction with, traditional seismic analysis. The electromagnetic imaging is expensive at $200,000 per test but still a lot cheaper than a dry hole. ExxonMobil has already used it to find 13 deepwater successes in a row -- an unlikely streak with classic seismic work. The new technology will give wildcatters a high enough hit rate to justify a lot more spending in deepwater.
“The point is not that the technology itself will be a big revenue generator,” Morgan Stanley analyst Ole Slorer says. “It’s that the new wells found will generate perhaps another billion in revenues for oil services companies within the next two to three years.” The oil service leaders are trading at rich multiples. Somewhat cheaper is National Oilwell at 19 times its 2005 forecast, making it the cheapest U.S. company in the mix. National Oilwell makes land rigs as well as drilling systems for offshore rigs.Link here.
THE DOLLAR IS DEFYING BOTH EXPECTATIONS AND GRAVITY
The dollar is confounding investors again and nibbling into their returns from abroad. And some forecasters say that the currency will continue to hold its own and even rally into next year, creating another headache for investors with a taste for foreign stocks and bonds. The dollar’s strength is surprising, given the record deficit in the country’s trade and services with the rest of the world -- known as the current account. That deficit could easily become a major drag on the dollar if foreigners curtail the hundreds of billions they invest in the United States each year.
So far, though, the unexpected rise of the dollar has hurt investors who bet it would fall for the third consecutive year. Instead, the dollar has gained 1.9% against the Japanese yen, although the Japanese in March stopped their extraordinary intervention in support of the dollar, and 1% against the euro so far in 2004. It is also up 2.9% against the Australian dollar and 2% against the Mexican peso. The big exception is Canada: There, a vibrant economy, a strong commodity base and a trade surplus with the United States has pushed the American dollar down 3.4%.
The current account deficit has to be covered by the inflow of funds from abroad into American assets, including Treasury securities, corporate bonds and stocks. Many economists suspected that this flow from abroad would begin to slow, setting off dollar selling as investors sought to beat a decline in the currency -- and a climb in interest rates. The current account has been worrisome enough that four top Federal Reserve officials have talked about it since September. Some said that the dollar could be pushed sharply lower if the deficit gets out of hand. But if the dollar’s strength persists, then foreign stocks and bonds will have to attract American investors on their own merits in coming months -- without the expectation of a boost from the dollar.Link here.
CAUTION IS STILL KING IN THE BUSINESS WORLD
While corporate spending and hiring have picked up over the past year, it is clear the economy is still suffering from the overinvestment of the late 1990s. What is more, concerns about terrorism, soaring energy prices and a rapid increase in health care and pension costs are adding to a sense of hesitancy and leaving many firms in a state of limbo. Over the past three months, additions to nonfarm payrolls have averaged just 103,000 per month, with more than half of those gains coming from either the government sector or temporary help services. Meanwhile, capital spending as a share of profits is sitting near a 30-year low.
A survey by the Philadelphia Federal Reserve found that just 23% of companies plan to increase capital expenditures significantly in 2005, compared with 33% that anticipate just a slight increase. About 30% expect no change, and 15% said spending would actually be lower. This reluctance to spend has come as a surprise to some because companies are seemingly awash in cash. Cash liquid assets in relation to short-term liabilities rose to a 40-year high of 41.2% in the second quarter, according to Morgan Stanley.
In addition, companies have been showered with incentives to invest. Corporate tax rates have been lowered sharply and a federal depreciation benefit has allowed buyers of new equipment to write off an extra 50% of the cost of equipment bought before the end of the year. Mark Zandi, chief economist of Economy.com, said this benefit has recently been extended for small businesses. Still, many companies are not taking advantage of the special allowance.
Analysts and economists say tax breaks have been relatively ineffective because the economy is still working through the excess capacity built up in the 1990s. Once the crash came and demand fell off, many of these firms found themselves with more inventory and more workers than they needed. Barry Ritholtz, market strategist at Maxim Group, said the effects of the bubble continue to hang over the market four years later. “We’re still putting on band-aids from the crash,” he said. “These guys are still the walking wounded from the NASDAQ collapse.”Link here.
WHEN YOUR NEIGHBOR IS IN FORECLOSURE, YOU CAN LOSE, TOO
As much as I have written about adjustable-rate mortgages, I may have missed the proverbial forest for the trees. What if the armies of new buyers taking out these risky loans never have any intention of meeting their maker? After all, with no equity in a home and the closing costs rolled into the mortgage, there is no risk whatsoever to owning. Heck, I have even heard that some buyers are not escrowing their property taxes, because they do not have the cash to pay it every month.
Critically, owning under these circumstances is cheaper than renting a comparable home, especially when you factor in the mortgage-interest tax deduction. When something goes wrong, all the buyer need do is pick up their possessions, along with anything they can detach from the home, and walk away, leaving the lender in the lurch. I have no sympathy for the mortgage holders who continue to buy these packaged loans from the originators. There is no way they have missed the extreme deterioration in lending standards. What saddens me is who gets hurt the most -- tradition-minded folk who saved up that 20% down payment and took out as short a fixed-rate mortgage as possible. Call us the foreclosed-house-next-door’s neighbor.
Under scenarios in which there is no downside to walking out of your home, real estate prices do not fall steadily, they plummet. It is true that banks are savvier today than they were in the 1980s. There are no fire sales on foreclosed homes any more, because banks retain real estate brokers just as any seller would. But foreclosures are close to record levels nationally. What about a few years down the road, when the records have been shattered, when big Wall Street investment banks cannot get an appraiser to vouch for the value of the homes sitting on their balance sheets? That is called a write-off where I come from. I remain unconvinced that the fire sale will not be resurrected after all.Link here.
ACCOUNTING ANALYSTS PONDER FANNIE MAE REPORTING DELAY
Fannie Mae’s decision to delay its third-quarter earnings results has weakened the U.S. mortgage finance company’s strident defence of its financial accounting practices, heightening concerns it may restate earnings, some analysts say. “It raises more questions,” said Edwin Groshans, equity analyst at Fox-Pitt, Kelton. “If Fannie did nothing wrong, why can’t it file?”
Fannie typically reports third-quarter earnings by mid-October, but said last week that it would not release its results until it filed its quarterly report with the Securities and Exchange Commission. The company said it would “actively seek” to file by the SEC’s deadline on November 15, leaving open the possibility it may file later. Some analysts believe that Fannie is refraining from reporting earnings until it receives word from the SEC on whether its accounting practices comply with US accounting rules.Link here.
ACCOUNTING, ACCOUNTABILITY, AND LIARS
We are living in memorable times, indeed, even though whether these are times in Eden is open for debate. The New York Times reported last week that the Financial Accounting Standards Board (FASB) granted American companies a six-month reprieve on the deadline to start deducting the value of stock options granted to executives and other employees from their profits. The move will delay the reduction in reported profits for many companies, and may give them more time to lobby Congress to stop the rule from taking effect at all. To whom is FASB accountable?
Thanks to the monetary policies of the Federal Reserve and the fiscal policies of the government we are now facing an accumulated federal debt of $7.429 Trillion dollars, an increase of $1.755 trillion or 31% over the past four years. The total debt amounts to more than $25,000 for every adult and child in the country. This could lead to one or more of the following -- significantly higher interest rates, a significantly lower dollar, and a significant drop in US personal incomes. Who is held accountable if such a disastrous scenario unfolds? Elected administration officials, Senators and Representatives might not win when they run for reelection, but they can turn around and get those high paying lobbying positions.
This leads me to make a proposal that not only solves the above accountability issue, but also takes care of the unemployment problem at the same time. Let us expand the Senate and House so that every American is a member of one of the two houses. This immediately solves the unemployment problem. Every citizen can take home a cool $158,100 this year, with cost-of-living-adjustment increases every year. Everyone gets the same healthcare options, and the same retirement benefits. If this increases the deficit some more, what of it? This way everyone gets to join in the fun while it lasts.
On October 7 the House and Senate showered extraordinary “early Christmas” gifts to corporations via a new tax bill. What is really galling is that this abomination is titled “American Jobs Creation Act” in the House and “Jumpstart Our Business Strength (JOBS) Act” in the Senate. The President, instead of threatening to veto it, was busy calling Senator Kerry a “Massachusetts Liberal”. Let us demand no more usage of the words “job creation”, “conservative”, “liberal”, etc. unless they are defined and proven. It is high time the citizenry of the country demanded an honest LIARS (Label Investigation and Approval Regulatory Services) Department. Among other things this department would be tasked with ensuring that the labels used by politicians are accurate and complete, similar to the role of the “FDA” in regulating the pill business.Link here.
REMARKS BY CHAIRMAN OF THE FEDERAL RESERVE, CA. 25 YEARS IN THE FUTURE
On October 7, 2004, the Federal Reserve Bank of St. Louis held a “Conference on Reflections on Monetary Policy 25 Years after October 1979”. Alan Greenspan, Chairman of the Federal Reserve, addressed the conference with a speech that recalled those hard days compared to the job he was handed in 1987. In his speech Greenspan cites testimony he gave to Congress on November 5, 1979: “We are here…to evaluate the moves of Chairman Volcker and his colleagues last month, implying that some alternate policies were feasible at that time. However, given the state of the world financial markets, had the Fed not opted to initiate a sharp interest rate increase in this country, the market would have done it for us.”
Today, a scant 25 years from October 1979, we are near a similar moment in financial history. The markets belying their usual prescience are to be unpleasantly surprised by a margin call of gigantic proportions. The Federal Reserve will be powerless to stop the rate increases that follow. By my analysis, what will follow is deflation, stagnation and policy paralysis. Having addicted ourselves to the nectar of asset price appreciation, easy money, debt and profligate pandering politicians, there is no end to this episode than a bad one.
I have re-written Greenspan’s speech to this conference (which should be read before my rewritten version), substituting some new words and ideas. In re-writing this speech, I anticipate some Federal Reserve Chairman in 20XX will view the years between 1994 and 2004 in the same way that the current chairman viewed the years leading up to October 1979. Greenspan’s speech was written from the perspective of a nation inured to inflationary excesses and unsound currency management leading to a decline in purchasing power. My re-write of Greenspan’s speech is written from the perspective that our long addiction to debt and asset price appreciation will require as strong medicine as was rendered to the country/economy in October 1979.Link here.
FIVE SAMURAI STOCKS ... AND TWO OIL TIPS
Five analysts share their ideas and strategies vis a vis Japan, in an interesting roundtable discussion. The opening question is, “The Japanese market had a great run in 2003, but the rally seems to have stalled in recent months. Is it over?” A followup question asks for specific company ideas.Link here.
HOW HIGH WILL OIL PRICES CLIMB??
Since its last major low in 1998 at $12 (when the Economist published a very bearish piece about oil), crude oil prices have climbed to around $50 at present. The question, therefore, arises whether oil prices are headed for a sharp fall, as most analysts seem to think, or whether far higher prices could become reality in the years to come.
I do agree that near term oil prices might succumb to some profit taking. Bullish consensus runs above 80% and oil has become a popular topic of discussion in the media and at every investment conference I attend. Moreover, the U.S. administration could decide to sell oil from its strategic reserve, which currently exceeds 630 million barrels. Thus to sell daily 2 million barrels into the market amounting in total to 120 million barrels over a two months period would be an option if prices continued to soar. Also, since Chinese oil imports were up so far in 2004 by more than 40%, I suspect that some inventory accumulation also occurred in the Middle Kingdom. Therefore, if the Chinese suddenly decided to curtail their oil imports the same way they stopped buying soybeans in March 2004 -- an event which led to an almost 50% decline in prices -- prices could come under some near term violent pressure! Still, I maintain the view that we may see sometime in future far higher prices than anybody envisions.
If I am right that in future oil prices could rise much further than is generally expected, geopolitical tension would likely increase dramatically, as countries such as the US and China would increasingly become concerned about adequate supplies. And, in the case that oil prices were to rise in real terms to their 1980s highs -- well over $100 -- then the foundation for World War III would be laid and most certainly begin to weight heavily on equity prices for which I cannot share the prevailing widespread optimism anyway. Financial stocks have begun to weaken and this is an indication that something is not quite right!Link here.
What comes after oil?
Unlike the run-up in oil prices in 1973-80, the rise in 2004 appears to have been very largely driven by demand. Traditionally, Saudi Arabia and other OPEC producers kept a reserve of about 5 million barrels per day in unused capacity, which could be brought on stream to meet any short term shortages. However, the rapid industrialization of China and to a lesser extent India is increasing demand for petroleum products to such an extent that this buffer is more or less gone. Moreover, while the Saudi fields appear good for another century or more at their present pumping rate, by some calculations it is unlikely that we will find new reserves quickly enough to replace those lesser producers whose fields finally begin to run out.
If oil prices are due for a prolonged period in the $50-60 per barrel range or even higher, then the energy market will have to adapt a new pattern of energy sourcing and usage. Sources of energy that have been hopelessly uneconomic at $25 per barrel become far more interesting at $60 per barrel. A survey of these possible sources follows.Link here.
Although oil prices will not decline in the near future, the outlook is not necessarily dire.
Crude oil prices have soared this year for many reasons: Global demand is rising at an estimated 2.4% annual rate, well above the past decade’s average of 1.7%, while worldwide excess capacity has almost disappeared. Terrorist threats in Iraq and elsewhere have added a premium to oil prices that some estimate in the $5-10 per barrel range. And as with many markets in recent years, hedge funds and other speculators are exerting strong, if not dominant, influences that may account for $3-9 per barrel of crude oil’s current price.
Given the current U.S. crude oil consumption rate, each dollar per barrel costs the American economy about $7.5 billion per year. So if prices are, say, $20 per barrel above the ex-terrorism, ex-speculation equilibrium, that amounts to an extra tax of $150 billion annually, or 1.4% of GDP. Considering the markups, as crude oil is converted into various products and sold to final users, the increased cost is closer to 2% of GDP.
In addition to fearing that the recent oil price leap will sink the economic ship, some fear that expensive energy will persist indefinitely, while others believe that worldwide production will top out in the next decade or so. I believe this is far too pessimistic of an outlook. Continual technological improvements make the discovery of big new fields, and increased production from existing ones, likely. Nonpetroleum energy is also sure to be exploited. The declining importance of energy in GDP production in the United States and most other countries means that the current crude oil price leap is less significant than previous spikes and should do less damage to the economy. Furthermore, petroleum’s share of U.S. energy consumption has fallen since the late 1970s.
On balance, the recent spike in crude oil prices is not nearly as devastating to the world as were earlier oil shocks, especially those in the 1970s. Nevertheless, given the basic weakness in the U.S. economy and China’s determination to cool excessive investment, the “tax” that energy-exporting countries are collecting from American energy users may be big enough to precipitate a recession in the United States that will spread globally, especially if China has a hard landing. That would be the 6th consecutive time that a jump in crude oil prices provoked an American business downturn.Link here (scroll down to piece by Gary Shilling).
Show me the oil!
Tecently, Deutsche Bank’s oil strategist, Adam Sieminski, said that oil prices may temporarily rally “toward $100 a barrel”, if an accident, disaster or sabotage reduces supplies from two major oil-producing countries at the same time. He is right. But the scary thing is that the oil price will move higher, even without any disaster or sabotage. Even in a perfect world of uninterrupted supplies, the booming global demand for oil will push its price toward $50 a barrel, and eventually to $100.
OPEC is pumping at its highest level since 1979 and has said it will raise production to 30.5 million barrels per day next month. And yet, prices still rise. The world needs more oil capacity, pronto! So many wishful thinkers are hoping, praying and betting on the idea that Saudi Arabia will come to the rescue. They think the world’s top exporter should be able to boost capacity enough to bring U.S. oil prices below $40. Sorry, it ain’t gonna happen, folks. OPEC producers are already pumping near 25-year highs. Simply put, the well is running dry. Cartel production is near its highest since December 1979, just below the 29.76 million it pumped in November 2000. Demand is simply swamping available capacity, and that means high oil prices are here to stay.
Remember that film Jerry Maguire and how oft-repeated line “Show me the money”? Well, I say, “Show me the oil”.
According to Merrill Lynch, each 1-cent rise in gas prices sucks about $14 billion a year from consumer spending. Since 9/11, higher oil prices have taken more than $400 billion out of consumers’ wallets. That is keeping consumers from purchasing automobiles, clothes and countless other consumer goods. And we are trading at over $50 a barrel. Imagine what things will be like when oil hits $75 or $100 a barrel. The possibility is turning into reality, and it may be here sooner than you think.Link here.
Record prices for jet fuel prompt air carriers to raise prices again.
A round-trip ticket from most major airlines has just gone up another $10, marking the third increase in a month by major carriers to cover record fuel prices. As usual with airline fares, there are exceptions. The increases appear widespread, although they will not be implemented by most airlines on some competitive routes with strong discounters such as Southwest Airlines. The latest fare increase on domestic routes by the airlines comes as many of them are awash in losses for the third quarter, which normally would be a strong period because of summer travel.
The fare increases also point out just how badly the high price of jet fuel is hammering the industry. Earlier this year, repeated attempts to raise fares failed because not all of the carriers would match. Fuel costs have jumped from 88.9 cents per gallon at the beginning of the year to more than $1.56 per gallon now, said Tom Parsons, chief executive of Bestfares.com. Fare increases also have been put in place on international flights, Parsons said.Link here.
Get the straight story on oil, inflation and recession.
For the second time in as many weeks, CNNMoney has run a headline that asks, “Oil Shocked into Recession?” Both versions of the story begin the same way: “Economists say record oil is already taking a bite out of growth; some fear recession will follow.” Let us get something straight: If we go into a “recession”, it will not be on account of soaring Crude Oil prices, despite the deafening echo of similar news stories.
All the back and forth between pessimists and optimists is just noise. Why? The question that they are answering should not have been asked in the first place. Oil prices are not foreshadowing an inflationary economic decline a la the 1970s. That scenario looks like a fantasy once you see the facts. In reality, a deflationary decline has been in force for months already. The rise in Oil prices is likely just a lagging beneficiary of the credit reflation that began in 2001. Liquidity is everything now. Do not be on the bandwagon that rolls off the cliff just because mainstream financial media, independent economists, and the folks at the Federal Reserve happen to be aboard.Link here.
AS FOREIGN INVESTMENT SHOWS DECLINE, ECONOMISTS KEEP WATCH
On Sept. 9, as it must frequently do, the U.S. government turned to Wall Street to raise a little cash. But at 1 p.m., as the auction opened, foreign investors, who had been voraciously buying Treasury bonds, failed to show up. Bond prices cascaded downward, interest rates rose. “It’s amazing,” Paul Calvetti, , the head of Treasury trading at Barclays Capital, gasped, after the Treasury Department announced that Wall Street traders, not foreigners, had been left to buy virtually the entire auction. “I don’t think I’ve ever seen this before.”
The most recent auction of 10-year Treasury notes may have been a fluke, a momentary downturn in one aspect of the massive world market for U.S. government and private-sector bonds, stocks and other securities -- a market so large and diverse that it has long been the world’s safe haven. But a rash of new data, including Treasury Department figures released yesterday showing a net sell-off by foreigners of U.S. bonds in August, has stoked debate over whether overseas investors -- private individuals, institutions and government central banks -- are growing dangerously bearish on the U.S. economy.
It is a portentous issue. Foreign governments and individuals hold about half of the $3.7 trillion in outstanding U.S. Treasury bonds, for example, and the government has been heavily dependent on continued overseas bond purchases to finance the roughly $1 billion a day it has to borrow to pay its bills. Foreign lending and investment are also needed to finance the country’s roughly $50 billion monthly trade deficit, while foreign capital has been a key prop to U.S. stock prices. A turn in overseas attitudes toward the United States could ripple deeply through the economy, depressing the market, raising interest rates and pushing down the value of the dollar.Link here.
(This is Part II of an essay by Marc Faber. Part I can be found in the bottom half of the page here.)
Investors should never forget the lessons of the South Sea Bubble and John Law’s experiment with paper money. The Mississippi Scheme in particular is relevant to the current situation in the United States; in fact, there are several lessons contemporary investors can learn from John Law’s rise and ultimate demise. It is true that Law’s policies were initially a great success, boosting the French economy considerably. In fact, at his peak in 1719, Law was one of the most admired personalities in continental Europe. But the Mississippi Scheme failed, and Law fell from grace because the Banque Royale held for too long the firm belief that it could solve every problem simply by increasing the supply of paper money. When Law finally realized that the enemy was a loss in confidence in paper money and accelerating inflation, the damage had already been done.
There will surely be a time when the present “chain letter” type of fiat money operation practiced by the U.S. Federal Reserve Board will similarly no longer work and lead to a sharp depreciation of the U.S. dollar. The other possibility, of course, is that the dollar begins to depreciate, not compared to foreign currencies, but -- as was also the case at the time of John Law -- against commodities and real assets.
Concerning real estate, it is very common for prices to continue to rise for some time after a stock market bubble has burst, for two reasons. Once speculators realize that stocks have hit a peak, they shift their funds to another object of speculation. In other words, when the world is engulfed in a wave of speculation, the wave does not end abruptly, but tends to carry on for a while and spreads to assets other than equities, such as real estate, commodities, art, etc. Thus, real estate prices continued to rise in Japan throughout 1990, for example, although the stock market had already topped out on Dec. 29, 1989. And in the case of Australia, real estate prices continued to rise for another two years after its stock market peaked out in the summer of 1987. But eventually, real estate prices eventually also succumb to the forces of demand and supply and then follow the declining trend of equity prices.
The Mississippi Scheme and the South Sea Bubble are also interesting from another point of view. The wave of speculation in the period of 1717-1720 spread across the entire European continent, and the subsequent crisis was international in scope. The shares of the Mississippi Company began to collapse in January 1720, but in London, the shares of the South Sea Company had only begun to take off. In other words, British and international investors were in no way perturbed by the collapse of Law’s scheme. Then in the summer of 1720, just as the South Sea stock peaked out, speculators moved funds from England to Holland and Hamburg in order to speculate on continental European insurance companies.
For today’s investor, however, the most interesting effect of excess liquidity creation is perhaps found in commodity prices. In the future, just as during the Mississippi Scheme, a bull market in commodities is a distinct possibility and could exceed investors’ expectations. In particular, I want to emphasize that commodity prices can increase sharply under any economic scenario, provided that there is excessive money and credit creation and that investors’ confidence in financial assets is shaken. Take the early 1970s, when commodity prices soared, even as the global economy headed for the worst recession since the 1930s. If the global economy does not improve dramatically, it is likely that commodity prices will be boosted, because of further liquidity injections by the monetary authorities as well as expansionary fiscal policies.
Now consider this: Investors have little faith in either the euro or the yen. Therefore, if in the future international investors lose confidence in U.S. dollar assets, where will they go with their liquidity?Link here (scroll down to piece by Marc Faber).
HOUSING STARTS SLIDE NOT A SURPRISE TO GOLDMAN SACHS
At least one house on Wall Street was not shocked at the week’s news that housing starts fell 6% in September. Economists at brokerage house Goldman Sachs had predicted starts would slide by 5%, double what the rest of the Street had predicted. Certainly, a 1.9 million annualized pace is historically high. Year-to-date, starts are still 5% ahead of 2003’s pace and the strongest since 1978.
In “Trouble Brewing in the Housing Market”, Goldman economist Jan Hatzius explains why the firm has modified its long-held belief that the housing market is sound. At current levels, the report says, housing is 10% overvalued. The coasts are overvalued by 12% to 14%, vs. about 7% in our neck of the woods [Houston]. We have never seen an outright, national decline in prices. Goldman is making a big call.
Though low interest rates certainly have contributed to the froth, they are not one of the three factors that pushed Goldman to change its stance. The factors are unjustifiably high prices, excess supply and speculation. A bubble mentality seems to have set in. Turnover troughed at 4% at the bottom of the housing recession in the 1980s but typically runs at about 6%. Today, it is at 9% as homeowners flip houses like burgers at a cookout with the expectation of wolfing down double-digit returns.
The bottom line: Goldman views the housing market “as the key downside risk to our baseline forecast that U.S. growth will ... escape a full-blown recession in the near term.” Given Alan Greenspan’s blasé take on the housing news, I would have to venture he is not on Goldman’s distribution list.Link here.
U.K. house-price change index falls to lowest in 9 years.
An index of U.K. house prices fell to its lowest in 9 years in the 3 months through September, an industry group said, suggesting potential buyers are shunning the property market after five interest-rate increases since November. The seasonally adjusted net balance of property appraisers reporting an increase in house prices from a year ago, minus those identifying a drop, fell to minus 30% from minus 12% in the August period, the Royal Institution of Chartered Surveyors said. That is the lowest reading since June 1995.
“This raises concerns that the housing market will slow more abruptly than expected,” said George Buckley, an economist at Deutsche Bank AG, which expects no more interest-rate increases. “The risks are to the downside on the housing market, but I don’t think there will be a crash.”
House prices have doubled since 1999, underpinning growth in consumer spending and helping the U.K. record its longest period of uninterrupted growth in more than 200 years. A drop in property prices would damp household spending that makes up more than two thirds of the economy. The pound fell to its weakest since January against the euro on the report.Link here.
Fed’s Olson: “Ignore that bubble behind the curtain.”
There is no housing price “bubble” in the United States because the national market is too large, though home-price rises in some areas seem irrational, Federal Reserve Governor Mark Olson said. “In order for there to be a true bubble, there has to be a single market,” Olson said in response to a question following an address on banking at Widener University.
“There are clearly markets where the prices of housing has exceeded any economic rationale ... and so the likelihood in those markets is that we will see a decline in value,” Olson said, without identifying any particular regions. “That is different from an equity bubble where there is in fact a single market,” Olson said. There are some countries where it is possible to identify a “bubble” in prices nationally, but not the United States, he suggested. “England for example is clearly in a bubble situation in housing.”Link here.
A Florida land boom of an earlier era.
Miami had 25,000 realtors, the price of a beach lot was $800,000 (in today’s inflation-adjusted dollars), and a summer issue of The Miami Herald was over 500 pages. What year was it? Believe it or not, it was the summer of 1925.
South Florida’s real estate boom in the 1920s ended very badly. In the fall of 1926, two hurricanes came. On September 18, 1926, 400 people died and many thousands were injured, as the hurricane ripped roofs off of houses and tossed elegant yachts into the streets of Miami. Oceanfront lots probably did not hit $800,000 in today’s dollars in south Florida again until the 1980s.
“On my island here in Florida, whenever you ask well-off folks around here what they do, they all say the same thing: ‘I’m in real estate.’”, a colleague writes. “The truth is nobody’s talking stocks anymore. If you’re not ‘in’ real estate, you’re supporting the real estate business around here...contractors, banks, architects, builders, etc. Outside of tourism, there is no other business here. Just like Miami in the 1920s.”Link here.
Is the Las Vegas housing boom over?
When homebuilder Pulte Homes publicly announced that it was cutting the price of its homes in Las Vegas from 5 to 25%, Wall Street and the financial press immediately began sounding the death knell for the Las Vegas housing market. Greg Gieber, an analyst with A.G Edwards & Sons, Inc., typifies the view in the investment community. Gieber penned a research report contending that Las Vegas homebuyers have decided to “run and hide”. Gieber decided to come to Vegas and visit a dozen or so new home communities just after the Pulte announcement to see first hand what was happening and was “somewhat astonished to say the least by the dearth of interest in purchasing a home [that] weekend.”
Gieber admits in his report that Pulte had been too aggressive with its pricing and was $60 to $80 per square foot above competing product. Unlike many other Las Vegas builders Pulte was slow to restrict investor home sales and now is paying the price with numerous freshly built, never occupied homes lining the streets available for sale and competing against the company’s new releases.
Additionally, the company has reportedly fielded 500 lawsuits for having the audacity to lower prices. Ross King, a Denver investor, closed on a 1,900 square foot Pulte home on September 24th at a price of $498,000. After King closed escrow, Pulte lowered the price of that same model to $382,990. King will be receiving $1,600 per month in rental income from the home, only covering three-quarters of his $2,200 mortgage payment, and none of his homeowners association dues. “I feel like the biggest idiot. I feel like I was absolutely taken,” King told the Las Vegas Review Journal. “I am a smart guy. That’s what makes it even worse.” Las Vegas loves guys like Mr. King who have an unshakable belief in how smart they are yet seem to be horribly challenged in the math department.
The Las Vegas housing market has gone from less than a month’s supply of available homes to a five or six month supply according to Lee Barrett, President of the Greater Las Vegas Association of Realtors -- an inventory level that is similar to other markets. So the price system works. High prices send the signal that more of a product is needed and suppliers come to the rescue with more of that product and prices fall. So what was a sellers’ market is now a buyers’ market. However, at least one Las Vegas housing expert does not believe the buyers’ market will last much longer. Stephen Bottfeld, executive vice president of consumer research firm Marketing Solutions, told a capacity crowd at his quarterly Market Perspective seminar that Las Vegas is “not on a bubble, but on the edge of a boom.”
The Las Vegas housing market is far from dead. But will it roar ahead after this brief hiccup as Stephen Bottfeld predicts? Is demographics Vegas’s destiny? Who knows? But, one may recall that Harry Dent, Jr. used demographic studies to predict that the Dow Jones Industrial Average would reach 40,000 by 2007.Link here.
A time-honored privilege falls to black magic.
Nothing defines the “American Dream” better than homeownership. If you want to put up quiet curtains or hang obnoxious wallpaper, nobody (spouses excepted) gets to tell you otherwise. And beyond the decorating liberties lay more substantial financial benefits, of a kind that most families could not otherwise afford: Owning a home allows you to build equity in an asset that typically appreciates over time.
So it is disturbing indeed to watch this time-honored privilege increasingly taken over by the black magic of “creative financing” and “debt consolidation”. The New York Times recently ran a long article under a headline that got it just right: “Erase Debt Now. (Lose Your House Later.)”
The story rightly notes that millions of Americans have taken out second mortgages at low interest rates, to pay off credit card debt with high rates. Sometimes this has been a wise step, but not always. In fact, 25% of homeowners who refinanced took out LARGER mortgages than what they already had, just to pay down credit card and other types of debt. It goes on to say that, “each year, tens of thousands of people -- not just the poor -- lose their homes after trying to cope with their debts this way... and their heart-rending tales” run the gamut of misfortune, from complete financial loss to suicide.
If anything, the evidence suggests that this unhappy trend may still be in its early stages: “Last month, the Federal Bureau of Investigation warned of a looming ‘epidemic’ in mortgage fraud involving loan brokers, appraisers and lending officers.” The shysters begin to flock in when the conventional lending sources dry up. This is implicit in when the October Elliott Wave Theorist said a “debt implosion” is “already underway. Lending to corporations is down. Venture capital is way down. Only real estate lending has continued strong, but that trend is ending.”Link here.
INSURANCE BID-RIGGING PROBE WIDENS AS INVESTORS FLEE
The probe into insurance bid-rigging by New York attorney general Eliot Spitzer has widened to health insurers, unnerving investors worried that more revelations of wrongdoing and lower profits lie ahead. Insurers and HMOs suffered most of the biggest declines on the New York Stock Exchange, as it became evident the AG is examining life and medical insurers, as well as property and casualty insurers and brokers. Shares of health insurers Aetna and Cigna fell 11.8% and 10.3%, respectively.
“It is scaring to death anyone invested in the sector,” said Tim Ghriskey, chief investment officer of Solaris Asset Management. “It intimates that brokerage fees could potentially become transparent to consumers, and that will increase competition. As a result, brokerage fees might decrease. Consumers will benefit, but it will squeeze the companies.”
At least three states -- California, Connecticut and Pennsylvania -- are studying Spitzer’s lawsuit last week against New York insurance broker Marsh & McLennan Cos. for allegedly rigging bids and inflating client costs. Spitzer’s probe centers on the “contingent commissions” that insurers offer brokers in exchange for steering insurance business their way. He is also examining potentially fictitious bids made at the expense of corporate and municipal clients.Link here.
A very smelly scandal.
Hold your breath, because another “very smelly scandal” has emerged out of the cracks on Wall Street. This time, the stench is coming from the insurance industry. According to the mainstream press, the insurance broker debacle sent the insurance sector to a two-week low and initiated a steep decline in the Financial Select Sector. An October 15 Reuters column explains, “[Insurance] has been a magnet for bad news, and this is yet another blow for market sentiment.”
Excuse our French, but “P.U.” See, the real stinker here is backwards logic. The scandal is not a “magnet” for the downtrend in the financial services industry. It is a byproduct of the wave pattern unfolding in the Financial Select Sector, one whose “personality” typically produces “blow ups” of this nature. Back in April 2004, the Elliott Wave Financial Forecast prepared readers for a spree that would despoil the reputation of financial firms across the nation: Their “strategies” to stay afloat were about to “backfire”, we noted, and the “repercussions would be widespread.”(Link no longer available.)
EUROPE’S WATCHDOGS MAY FORCE MARKET PLAYERS TO EXPOSE BOND-PRICE SECRETS
It is a truth universally acknowledged that a market in possession of a good size must be in want of regulation. Well, acknowledged by regulators anyway. And in Europe, the guardians of financial probity are realizing the bond market is still mostly virgin territory for them. An obvious first target would be the lack of price transparency for corporate bonds. Unlike equities, where myriad electronic screens tell you exactly what a share is worth at any given moment, the value of a secondhand bond comes down to whatever you can get for it at sale time. What is more, the U.S. bond market provides a handy remedy for this shortcoming.
Over the years, bond market participants have resisted attempts to shift from self-regulation to a more formal system of controls. They have argued successfully that bond buyers are mostly institutions able to look after themselves, unlike the widows and orphans at risk of being ripped off in the equity market.
That argument is wearing thin. When the U.K. Financial Services Authority introduced new rules earlier this year to stop analysts touting investments they do not really believe in, it said “our requirements recognize that conflicts can affect investment research on products beyond equity securities and include fixed income.” No special exemption for bonds, then. And now, a European Parliament initiative called the Markets in Financial Instruments Directive threatens to force dealers to start posting public prices for bonds, mirroring a system introduced in the U.S. market in July 2002.Link here.
A GLOBAL GROWTH INFLECTION POINT?
We have long argued that the underlying dynamic generating global “economic growth” was an unhealthy symbiotic dance of death between the US and China. The massive dollar support operations of the Asian central banks, particularly the Bank of China, have until recently preserved low long-term U.S. rates, thereby perpetuating a credit bubble which has enabled American consumers to continue to purchase goods they can ill afford any longer, whilst concomitantly enabling China to overproduce already saturated manufacturing markets. But a changing global backdrop points to increasing signs that this dynamic may be entering its death throes.
When policy steroids are removed from economies whose underlying financial structures are built on Ponzi-type financing, and an oil price spike is thrown in the mix, it should come as no surprise that economic momentum tends to peak and decay. The mighty twin peaks of growth, the US and China, are both increasingly manifesting increasing signs of economic exhaustion, as policy stimulus diminishes and monetary tightening has commenced. Many of the more troubling signs signaling slowdown have been obscured by, in the case of America, the ever increasing drama of a too-close-to-call Presidential election and, in regard to China, the ambiguous nature of the government’s own “hot and cold” pronouncements on the economy. But if one steps back from the endless array of AP, Gallop, and Zogby polls, and peers at the most recent constellation of economic data in both countries, it is becoming increasingly evident that an important inflexion point may have been reached.
Just as nobody rings the bell at the top of a market cycle, so too economies in the final throes of a credit bubble blow-off seldom provide a definitive “event” or characteristic to indicate that the game is over. Certainly, so long as Alan Greenspan remains chairman of the Fed, we can be sure to expect yet more soothing rhetoric to alleviate investors’ frayed nerves, much as he did in his guise as Apostle of the New Economy in late 1999. And no doubt China’s policy makers will endeavour to produce statistics validating their hopes for a soft landing, as opposed to a precipitous crash. But reality is beginning to emerge from behind the curtain and last week’s troublesome action in the dollar and base metals market might be providing a microcosm of what lies in store for the rest of us in the months ahead.Link here.
EURO GAINS TO 8-MONTH HIGH; MINISTERS FAVOR STRONGER CURRENCY
The euro rose to an eight-month high against the dollar after European finance ministers said they favor a stronger currency amid rising commodity prices. Gains in the currency will ease the impact of the record price of oil, which is denominated in U.S. dollars, said Dutch Finance Minister Gerrit Zalm. French Finance Minister Nicolas Sarkozy said “a strong currency is better when commodity prices are high,” after a meeting of European ministers in Luxembourg.
The yen also rose to the highest in almost four months against the dollar after a government report showed Japanese exports surged to a record. The 12.5% gain in shipments abroad boosted speculation the country’s economy may extend a five-quarter expansion. So far this week, the dollar is down 1.4% against the euro and 1.7% versus the yen amid concern about waning demand from foreign investors for U.S. financial assets.Link here.
UNDERSTANDING INTEREST RATES IN THE AGE OF PAPER MONEY
Three months ago, the yield on 10 year US treasury bonds was 4.9% and market participants were nearly unanimous in expecting it to go considerably higher. They were spectacularly mistaken. The yield fell below 4% in late September. The world’s central banks are creating too much paper money to allow interest rates to rise. In this new age of fiat money, the rules have changed. From now on, the supply of money will be at least as important as the demand for money in determining interest rates.
Once upon a time -- before the breakdown of the Bretton Woods System -- interest rates were determined by the supply and demand for money. That is still true today. There is one very important difference, however. Then, there was a limited amount of money and governments did not have the power to create it at will. Today, governments can create as much money as they want. This convenience makes global economic management very much easier. Then, if governments spent more than their tax revenues, government borrowing pushed up interest rates and crowded out the private sector. Today, that is no longer true … at least not for the United States government. Today, the interest rate on the US 10 year Treasury bond is determined primarily by the relationship between the demand for money from the U.S. Federal Government and Government Sponsored Enterprises (like Fannie Mae) and the amount of paper money created by the United States’ trading partners, which, in turn, is generally (but not always) determined by the size of their trade surplus with the United States. Capital markets were stunned in recent months by the sharp drop in 10 year treasury bond yields. The explanation for the unexpected decline is simply that more paper money is currently being created as a result of the rapidly expanding US current account deficit than is needed to fund the budget deficit and the GSEs’ demand for credit. This surfeit of money also explains why the interest rate spread on corporate bonds over treasuries is at multi-year lows.
Classical economic theory taught that changes in the demand for money determined the level of interest rates since the supply of money was fixed. Today, that is no longer true. Keep an eye on the supply. It’s exploding!Link here.
“TO BE IGNORANT OF WHAT HAPPENED BEFORE YOU WERE BORN IS TO BE EVER A CHILD” (CICERO)
George Peabody may not be a name familiar to you, but surely, you have heard of J.P. Morgan. Well, there may never have been a Morgan if not for George Peabody. What follows is a bit of his story, a small study in the creation of wealth in 19th-century America. The opportunity for Peabody emerged in the aftermath of the Panic of 1837. The Panic of 1837 itself is a great tale, not only because of its useful parallels with today’s markets, but also because it gives us an example of the great truth about financial crises -- they are midwives of opportunity.
Generally, the study of the bubbles and busts of the past should be a staple in every investor’s diet, because speculative manias and panics are bound to be a part of every investor’s experience. There is much to be learned in mining these old experiences. The more we know (so we hope), the better prepared and less surprised we will be when things start to break. Panics always have their beginnings in the boom that precedes them. Just as all hurricanes first develop over warm waters from pre-existing conditions, financial storms are spawned by surging growth in money, debt and speculation -- the tres hombres of financial upheaval, if you will.
From the perspective of European investors, 1830s America was a booming emerging market full of promise and potential, a lure for hungry European capital. The cotton industry was thriving, as the United States was a major global exporter of cotton. Cotton prices were probably as important as the price of oil is today for Middle Eastern countries like Saudi Arabia. There was also the great surge in canal construction. The Erie Canal was completed in 1824 and made a big impact on trade. As Marc Faber reports in his excellent book Tomorrow’s Gold, the Erie cut travel expenses by 90% on some routes. The canal was like any of our recent technological marvels, in that it cut costs and improved productivity.
In any event, the success of New York’s canals helped make the state the financial and commercial center of the young republic. It also inspired numerous imitators, as other towns and cities sought to copy its successes. New bubbles need a crowd of support to wreak havoc, just as politicians need votes to get started. The canal mania also stimulated rampant speculation in land as speculators tried to position themselves to profit from the growing canal boom. Land prices soared, and properties were flipped like Internet stocks.
Much of this expansion -- the cotton boom, the canal construction and the speculation in land -- was financed on credit. The banking business, too, was a growth industry. The Second Bank of the United States (an embryonic Federal Reserve, which was disbanded in 1836 after Andrew Jackson vetoed the bill to renew its charter) and its coterie of state banks fueled a credit binge that would have made Greenspan proud. Austrian business cycle theory, as crafted by economists Ludwig von Mises and Murray Rothbard, dictates that any bank credit inflation leads to the boom-bust cycle. The 1830s boom would be no exception.
The immediate causes of the bust were numerous, and all happened in 1837, precipitating a period of tighter money in which the house of cards began to collapse on itself. But the immediate causes of the Panic are not important. What is important to remember is that massive borrowing and speculation put the economy on the inevitable path of all bubbles. It also important to note that as prosperous as America was to become, it was plagued in its early stages with regular economic crises -- in 1819, 1837, 1857, 1873, 1884 and 1893. Emerging market investors of today take note.
During the ensuing depression, cotton prices would fall 70%, bankrupting a number of speculators and plantation owners who had paid inflated prices for their land. U.S. banks, facing the withdrawal of foreign credit, began to shut their doors, unable to meet the redemption demands of their depositors. U.S. bank shares fell to small fractions of their previous highs. Many of the investments made in canal construction were based on unrealistic high-growth assumptions and caused great losses for investors. Many projects, starved for capital after the Panic, were never finished and became worthless.
It was in this maelstrom that George Peabody would build the fortune that founded the House of Morgan. Peabody actually saw what was coming, and in anticipation, he began to curtail some of his operations, collecting debts he was due, selling stock and getting into cash-building a kitty that would see his business through the Panic and give Peabody some dry powder to take advantage of inevitable new opportunities once the air finally came out of the balloon.
Peabody bought depreciated state bonds when they were trading for pennies on the dollar. When these bonds paid interest again, in the late 1840s, Peabody reaped a fortune. By 1848, American securities had come to be seen as something of a safe haven as Europe was engulfed in the flames of revolution. The American railroad boom was going strong too, and gold was soon discovered in California. The promise of America once again won the hearts (and investment dollars) of Europe’s moneyed elite. Proof once again that investors of all times and places have short memories. By the 1850s, he had amassed a fortune of some $20 million and had an annual income exceeding $300,000.
Peabody, though, was careful with his money. “My capital is ample,” he wrote, “but I have passed too many money panics not to have seen how often large capitals are swept away and that even with my own I must use caution.”
Taking the lesson of past crashes and heeding the warnings about rampant debt creation and widespread speculation, let us look at today’s market for areas that might be potential panic spots for 2005 and beyond. It is hard to look at today’s market and not see housing as a potential panic spot. The housing market has all the makings of a bubble -- lots of debt (mortgages), artificial government stimulation, incredible price increases and a belief that housing is always a good investment. Will we soon be able to add housing to the long list of great bubbles in American history -- along with canals, railroads and all the rest?
Take this story to heart and become more knowledgeable about risks, and learn to appreciate the timeless qualities of financial cycles. Like Peabody, let’s heed the warnings and keep our capital safe.Link here (scroll down to piece by Chris Mayer).
IRAN’S NUCLEAR LEVERAGE IN THE EVENT OF A CONFLICT
The Iranians have admitted to having a nuclear program. Who can blame them for pursuing technology that would defend them from America? After all, directly to the east are Americans in Afghanistan. Directly to the west are Americans in Iraq. Whether this was part of the Bush administration’s grand strategy or not, it has had the effect of putting the Iranians on the defensive. Perversely, it may have also accelerated their development of a nuclear weapon with which to forestall any U.S. action -- a lesson they must have surely learned from the North Koreans. The Iranians are suddenly sounding like they have some nuclear leverage.
Massoud Jazaeri, a spokesman for Iran’s Revolutionary Guard, recently said, “Our response to any invasive measure will be massive.” That sounds ominous enough. But it also sounds primarily DE-fensive, not OF-fensive. That is, until you read what Max Boot reports in the Los Angeles Times. Boot quotes Hassan Abasi, another senior member of the Revolutionary Guards, as having boasted that Iran has “a strategy drawn up for the destruction of Anglo-Saxon civilization.”
It would be impressive bluster if it was just bluster. But there is an awful lot at stake in the region. The Middle East is home to nearly 70% of the world’s proved oil reserves. The United States imports 20% of its oil from the Middle East. Nearly all of the oil that comes from the Persian Gulf must pass through the Strait of Hormuz, which Iran possesses a commanding view of. Without drawing up a strategic battle plan, it is pretty clear how a war with Iran might unfold. Iran could deal a devastating blow to the United States economically -- without touching Israel or even fomenting chaos in Iraq (although it is capable of doing both). With supplies in the United States already so tight... what would a deliberate Iranian attack on oil tankers in the Strait of Hormuz do?
If all this is sounding tremendously bullish for oil prices, it should. Call buyers should look at XOI (AMEX oil index), OIX (CBOE oil index), MGO (CBOE oil services index), and our old favorite, OIH (Oil Service Holders Trust). If there were a petroleum conflagration in the Middle East, there would certainly be a lot of work out there for service companies afterward.Link here.
WILL “RANGE BOUND” DESCRIBE 2005?
The Dow Industrials fell to its closing price low for the year on Friday, and, with this week’s performance in the S&P 500, all three major averages are back in the red on a year-to-date basis. The U.S. stock market is now 10 Fridays away from declines during four of the past five years. Obviously, the declines thus far in 2004 are not as impulsive as what we saw in 2000-2002; prices have hovered at or below break-even for most of the year. That said, several identifiable price turns did unfold this year -- “identifiable”, this is, if you followed the Fibonacci turn window indicator that gave the date range for the turn beforehand.
The indicator proved itself by anticipating reversals in February, June, August, and most recently in the first week of this month. In a relatively range-bound market, this is as good as it gets. As for what the coming year holds, well, we do not expect that “range bound” will be prove to be an accurate description for the trend in 2005.Link here.
SLOWDOWN SIGNALS ACCELERATE
Signs of an economic slowdown are becoming harder to ignore. Whether it is a fourth straight decline in the Conference Board’s leading economic indicators, a yield of just 3.98% on the 10-year Treasury note, a 500-point drop in the Dow since mid-September or commentary from some of the nation’s largest industrial companies, evidence of a deceleration in growth is mounting.Link here.
MOVE OVER, MR. NASDAQ
The latest day-trading fad? The Wall Street Journal reports that U.S.-based day traders, whose number swelled to over 100,000 in the late 1990s and then rapidly collapsed with the onset of the bear market, have been looking for “the next great thing”. And lo and behold, they found it: The German DAX futures. These trading vehicles have been available in the U.S. since the late 1990s via Eurex, a Frankfurt-based exchange. They did not get much attention at first because back then, most speculators were trading tech stocks. But things have changed -- American regulators have tightened the screws on day trading, plus the volatility of U.S. indexes, including the once-popular E-minis, has been dismal.
But the DAX still has it all: volatility, liquidity, no excessive regulation, plus something that U.S. markets simply cannot offer -- “convenient” trading hours (2 a.m. to 3 p.m. EST) that allow many traders to keep their day jobs. And, because you can open a trading account with as little as $2000, trading the DAX appears ever more peachy. For many U.S. day traders, this has become “the latest hope for financial independence”. Accounts in the U.S. fund 25% of the daily DAX futures contract sales, up from 5% in 2001.
“Trading the DAX is Like Trading the NASDAQ in the Late ‘90s!” claims an ad for a DAX-trading tutorial, one of many that are being offered all over the U.S., some costing as much as $4,500. Um, no -- trading the DAX is nothing of the kind. Trading NASDAQ five years ago was easy, probably too easy: All you had to do was open a brokerage account, buy a tech stock and watch it go up. Trading the DAX futures is anything but easy -- ask any day trader who has tried their luck in it.Link here.
NEW BOOK REVEALS NAKED TRUTH: MODERN INVESTMENT THEORIES ARE “NONSENSE”
The financial world was undressed recently. A new book by Benoit Mandelbrot and Richard Hudson, The (Mis)behavior of Markets: A Fractal View of Risk, Ruin and Reward, revealed the naked and revolting truth: Modern investment theories are “nonsense”. Mandelbrot is a mathematician at Yale who has popularized the idea of fractals -- elaborate and unpredictable natural patterns, such as frost on a windowpane. Fractal patterns have been thought to describe patterns of market prices.
Several Nobel laureates owe their prizes, their prestige and their incomes to what is known as the Efficient Market Hypothesis (EMH), or simply the Random Walk. No idea about finance ever enjoyed greater acceptance or recognition, and none ever sucked so much money out of the lumpen. But the EMH is really nothing more than an elegant subterfuge, based on propositions everyone knows are false. The basic idea is that the market is smarter than any investor. No matter how hard you try, you cannot beat the market... because at any given moment all that is known about a share price is reflected in the share price itself. The price -- no matter how absurd -- is thought to be “perfect”. No better price can be imagined. Yet a different price tomorrow is almost a certainty. Mr. Market is always right; he just changes his mind.
Since an investor cannot have a better idea of what a share is worth than the market itself, he cannot do better than buy at the market price, whatever it is. The actual performance will be random. He might as well throw a dart at pages of The Wall Street Journal. Or buy the index. He will get the same return. A corollary of the EMH was the idea that prices and rates of return were distributed evenly, according to what is known as the bell curve. This was the idea that led Long-Term Capital Management, for instance, to invest billions of dollars in Russian bonds on the proposition that if prices fell in a range outside of the norm, you could calculate the odds of how likely prices were to come back. In 1995, the fund made 42% on its money. In 1996, the rate of return was 40%. But in 1998, Russia defaulted on its bonds.
But the bell curve, or the standard distribution, applied to finance is “nonsense”, says Mandelbrot. It may be nonsense applied to many other naturally occurring phenomena, too. The seas in Holland, e.g., hit once-every-10,000-year levels in 1570 and 1953. There was something wrong with the calculation. The world was a riskier place than people thought. It came as a shock to Myron Scholes and Robert Merton. The two Nobel Prize winners at LTCM had staked their careers, reputations and money on the perfectly logical idea that bond prices followed a bell curve pattern... and that if they reached the kind of extremes LTCM was seeing in 1998, it was a not a defect in their logic, but a huge buying opportunity. And yet bond prices went further out of whack. Traders at other companies knew what was happening.
The old-timers knew the Random Walk theory was nonsense. There is always a lot of random noise in markets -- as in life itself. But there are patterns, too. The trouble is, the patterns -- like fractals -- are variable and largely unpredictable. Markets movements are not only mostly unforeseeable, but perverse; they move in tandem with the broad strokes of human sentiment. As people become more comfortable, more sure of themselves and the future... more confident and expansive... they tend to bid up prices. A house that was worth only $100,000 when they expected nothing but shelter from it rises to twice as much when they expect it to finance their retirement. But investors only expect such a result after a long experience of pleasure returns. The mood of the crowd reflects what has just happened, not what will happen next.
Mandelbrot points out that when you actually look at market prices, you find patterns that differ greatly from those predicted by mainstream financial theories. “Outlier events” -- those that are supposed to happen only once in a blue moon -- actually happen all the time. Citigroup looked at daily changes in the yen/dollar exchange rate, for example. It found that moves of five standard deviations were not uncommon, even though they should only happen, according to the theory, about once every 100 years. And on Octoeber 19, 1987 the Dow Jones Industrials fell 29.2% -- an event that registered 22 on the standard deviation scale.
Not only do the markets produce events that should never happen, they also act in other ways that intuition might predict, but existing theories cannot fathom. According to EMH, prices -- like dice -- have no memory. It is nonsense because human beings use recent prices as points of reference. Periods of intense volatility cluster together; bad news piles up in what is known as “positive short-term serial correlation”. Markets do not really just bounce around randomly, in other words, but there are periods when things go well and periods when they do not. There are bull markets and bear markets.
Investing is not rocket science. In fact, it is not any kind of science. Instead, it is a human study, like poetry or prize fighting. And as in all the human studies, the problems one confronts are not bounded engineering problems but unbounded, infinitely complex ironies. It is easier to send a spaceship to the moon, in other words, than it is to win an argument with your spouse or figure out which way stocks are headed. And if you are going to follow advice, an old-timer’s intuition is probably a better guide than modern portfolio theory.Link here.
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