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PRAY FOR DEFICITS
One reason I am bullish is that the federal budget deficit is so high. Yes, you heard that right. If you prize prudence in financial matters, you may be surprised or offended to hear that federal deficits are associated, at least in the short term, with bull markets. But the historical pattern is unmistakable: When the federal deficit (as a percentage of GDP) spikes, stocks do well in the intermediate term. Budget surpluses generally have led to dour markets. Pray for more and bigger deficits.
Those who fear deficits also miss the fact that the fear itself, widely disseminated, is already priced into stock markets and has had a depressant effect. The aftermath of this depression must be bullish. Another reason to be bullish: Stock buybacks in 2004 are at the highest level in almost 20 years. In other words it has not escaped the attention of corporate treasurers that stocks are cheap. Whenever a stock’s “earnings yield” (the inverse of the price/earnings ratio) is high relative to borrowing costs, the corporation can increase earnings per share by buying in shares. That buying drives prices higher. You should buy before the treasurer buys more.Link here.
When once asked where I would live if not Chicago, my response was Baltimore. While the Second City is first with me, I have always liked Baltimore -- from its lively inner harbor to its small-town feel to its big-city conveniences. Most of all I like that Baltimore has a deep reverence for the past. Hence its nickname, Charm City. Perhaps this recognition of the past has produced an approach to doing business that has stood the test of time. As difficult as it is to generalize about a city’s commercial character, there is no doubt that some of my most profitable investments have been in Baltimore-area companies. Still a bustling seaport, Baltimore today hosts a bevy of industries ranging from heavy manufacturing to finance.
One home run for me was the Rouse Co., which has been a huge force in restoring grand urban locales, both in Baltimore and elsewhere. South Street Seaport in New York and Faneuil Hall in Boston were both brought back to their former glory under Rouse. While you no longer can own Rouse stock, you should take a look at another of my longtime Baltimore favorites, McCormick & Co. (37, MKC), the world’s largest spice vendor and a 115-year-old business that continues to show new pizzazz. Trouble is, the stock has doubled over the past three years, and is not cheap anymore at 25 times trailing earnings.
Founded in 1910, Black & Decker (85, BDK) has shown a similar yen for innovation through the decades. It introduced the first power drill back in 1916, a revolutionary development, and the Dustbuster vacuum cleaner in 1979. As the number one producer of power tools and accessories Black & Decker has held onto a daunting market share with a lineup that includes the DeWalt and Kwikset brands. B&D has solid financials with record earnings per share, enormous free cash flow and its lowest net debt in a decade. Management has done an impressive job controlling costs and reinvesting cash. Currently trading at 14 times earnings, B&D is at an 11.4% discount to my $96 private market value estimate.
An old favorite in our roster is T. Rowe Price Group (60, TROW), founded in 1937 as a portfolio manager and now the operator of a large mutual fund family. Fund tracker Morningstar awards 64% of the company's retail funds either four or five stars. Also selling at 21 times earnings, T. Rowe Price shares trade at a 13% discount to my $69 private market value estimate.Link here.
OPEN BAR FOR HEALTH COSTS
There is hope for medical cost control, but it will not be easy. Try telling someone with a deadly ailment that he should not use a promising but expensive remedy. Still, costs have skyrocketed because demand and supply are completely divorced from the discipline of the marketplace. Americans’ incentives to seek the most extensive and expensive care has risen as their share of the bill has nose-dived. In 1960 out-of-pocket payments covered 55% of total medical costs, but in 2001 only 17%.
To put it bluntly, a certain amount of what goes on is recreational medicine. A minor ache means a half-day off work and a battery of medical tests. Think of the demand when the postwar babies retire. Americans also insist on the latest, most expensive drugs, especially since the FDA permitted drugmakers to advertise to consumers. On the supply side, heavy government involvement via Medicare and Medicaid creates waste since government efficiency is an oxymoron. Estimates are that 15% to 30% can be cut from government medical outlays without reducing service. Hospitals are not run for patients but for physicians -- who have no financial responsibilities to the institutions, so they order unnecessary tests and services freely.
Still, the tide is moving toward lower-cost care. Bigger insurance deductibles and copayments are making consumers aware of costs. Health savings accounts are even more effective, because with them the patients’ own money is on the line. Medical centers are hiring “hospitalists”, doctors who follow patient needs from admission to discharge and do not have the perverse incentives that attending physicians do to order up unnecessary tests.
In the medical-cost-containment future, look for winners among pharmacy benefit managers, diagnostic testing labs and diagnostic equipment makers, outfits that provide home health care services and supplies and outpatient services and clinics. Also consider manufacturers of noninvasive diagnostic and surgical equipment, companies that provide health care information and services on and off the Internet and companies involved in doctor and hospital management information systems as well as market research services. HMOs may regain favor as consumers become better medical service shoppers, to the benefit of former Blue Cross-Blue Shield plans and other health care managers. And as the postwar babies age, do not forget the funeral business.
Avoid Medicare- and Medicaid-reimbursed nursing homes and long-term-care homes. Government limits on pricing may offset the future huge demand for them. Producers of expensive medical equipment (like exotic X-ray scanners) are vulnerable. Even though drugs are often cheaper than surgery, I would shun the big drug companies since their oversize costs will take years to work off. Generic drug providers are a better bet. The era of medical cost containment is at hand. Invest accordingly.Link here.
KEEFE BRUYETTE & WOODS IS BACK FROM THE ASHES, WITH SOME BANK STOCK BUYS AND SELLS
On a wall at Keefe Bruyette & Woods hangs an image of the American flag with Sept. 11 victims’ names making up the stripes. John Duffy knew the people on this grim roster, all Keefe Bruyette employees. Along with other Wall Street firms like Fred Alger Management and Cantor Fitzgerald, the World Trade Center attacks devastated Keefe Bruyette, killing 67 employees, almost everyone in equity sales, trading and research. The research wipeout was the most harmful. Research, particularly on banks, has been Keefe Bruyette’s beating heart since its 1962 founding. In the days when there were twice as many commercial banks as now, this proved to be a prosperous niche as institutional investors came looking for stock picking advice for the little-followed sector.
Keefe Bruyette enjoyed a shining reputation, marred only briefly by the 2000 insider trading conviction of its onetime chief, James McDermott, who gave tips to his porn-star mistress. The mess forced successor Duffy to spend five months on the road reassuring clients. Duffy faced a far more enormous task following the 2001 tragedy. The firm was on the 88th and 89th floors of the South Tower. Everyone on 88 got out but the researchers and traders on 89 were told to stay put. Duffy resolved to put the broken company back together. He did that, and then some. Three years later Duffy has relocated Keefe Bruyette to Midtown, doubled the staff to 410 from the level before Sept. 11. The travails of larger financial outfits have helped. Scandals over tainted research, which besmirched such august houses as Merrill Lynch and Salomon Brothers, did not touch Keefe Bruyette; memories of the McDermott imbroglio faded. Layoffs at the big firms furnished Keefe Bruyette with a lot of talent.
Above all, banks remain Keefe Bruyette’s strong suit. “No one can compete because they don’t know the players,” says lawyer Edward Herlihy, a Wachtell, Lipton, Rosen & Katz partner who has used the firm in valuing securities during bank mergers. The picture is not bad for banking. Duffy believes banks can continue to increase profitability from 8% to 10% yearly, despite interest-rate tightening. Banks typically suffer when rates rise because the cost of deposits tends to climb faster than the yield on loans. Industrywide, the net interest spread has shrunk modestly from 3.96 percentage points 18 months ago to 3.52 now. Lending spreads will tighten further. Under the circumstances, Duffy believes certain banks are undervalued and others overvalued. Basically, it is a matter of who is sizable enough to weather higher rates. Regional banks emphasizing customer service have done very well until now, though some are riding too high for their own good. Duffy is worth listening to. He, after all, knows how to take a financial firm apart -- since he has put one back together.Link here.
A FALLING DOLLAR DOES NOT IMPLY YOU SHOULD INCREASE YOUR HOLDINGS IN FOREIGN STOCKS
During the past 20 years the value of the dollar has fallen 40% against a basket of foreign currencies. Yet someone who invested in 1984 in the S&P 500 Index would be 17% better off than someone who put his hard-earned bucks into the Morgan Stanley EAFE (an index of stocks from Europe, Asia and the Far East) and converted the result back into cheap dollars today. Some of those smug foreigners have hard currencies but soft economies.Link here.
THE FORBES 2005 COLLECTORS GUIDE ISSUE IS OUT
“Wonderful things,” said Howard Carter, asked what knickknacks he spied inside Tut’s tomb. That, too, describes the trove of goodies cast up by this year’s Collectors Guide: Meiji antiques, duck decoys, daguerreotypes, French art deco furniture, rare coins and Kurt Cobain’s drawings. Here you will find bargains and cautionary tales, plus a peek behind the curtain to see how dealers conspire to lift prices and how auctioneers learn the tricks of their trade.Link here.
Prices for contemporary art are stratospheric. Watch out for meteorites.
Scenes from a frenzy: Just two years after Italian artist and notorious prankster Maurizio Cattelan made “The Ninth Hour” in 1999, Geneva dealer Pierre Huber bought the life-size wax sculpture of Pope John Paul II being felled by a meteorite for $886,000. On Nov. 18 he flipped it at a Phillips auction in New York for $3 million.
In Sotheby’s first single-owner, living-artist sale, on Oct. 18 in London, British bad boy Damien Hirst -- known for works ranging from shocking sharks in formaldehyde to decorative dot paintings -- grossed $17 million for 50 or so items he designed for Pharmacy, his defunct London eatery and chic celebrity hangout. At the sale martini glasses estimated to sell for $90 to $125 brought $8,650. And a set of six Jasper Morrison dining chairs from the restaurant inspired one anxious buyer to call out “£10,000!” when bidding had only just reached £2,500. Talk about auction fever. In the November auctions big money burbled steadily from collectors’ pockets, as 56 separate works topped the $1 million mark, etching records for 20-plus artists.
“Is this healthy for the market?” muses veteran New York gallery owner Jack Tilton. “It’s insane,” says contemporary art collector Michael Hort. He was recently offered $600,000 for a Kai Althoff painting he bought for $10,000 three or four years ago. Bubble? Not everyone in the contemporary art world sees imminent danger, particularly sellers who are managing swelling client waiting lists and packed auction rooms. But you have to wonder.
Everyone agrees that contemporary art has been in a bull market ever since stocks crumbled in early 2000. There are more collectors, artists, dealers, fairs -- and hype -- than ever before, leading to a relentless upward march of prices. Driving those prices is a new breed of buyer, opines Brett Gorvy, international co-head of Christi’qs contemporary department: Wall Streeters in their forties who are looking in the cultural mirror and acquiring works of their own generation. More worrisome to the market is a breed of “professional” collectors -- who buy for themselves, but who also snap up extra works as investments -- and pure speculators, who acquire, store and then flip. And like sharks gravitating to blood, at least half a dozen art hedge funds are currently circling below the market surface.
The prevalence of speculators over long-term holders is perhaps a signal of trouble ahead. Just before the collapse in contemporary art that began in 1990, a large percentage of buyers were corporations and investors, says gallery owner Jeffrey Deitch, with the art stagnating in warehouses between sales. But as prices spiraled up, it turned into a game of hot potato, with many players getting seriously burned. From the passionate to the purely greedy, all contemporary collectors face the same challenges: price inflation, access to elite waiting lists and sorting out which artists will be kissed by posterity.
Bubble or no, there is no denying that art-making today is experiencing an explosion of grassroots energy and original expression -- in places like Germany, Mexico, Canada and Poland, as well as New York City. Sifting the keepers from mere ephemera, though, gets harder since art blurs the boundaries with fashion, music and advertising as never before. All the synergy is healthy, bringing art out of the exclusive province of bohemians, intellectuals and the superwealthy. But it also creates a lot of potentially expensive white noise. Serious collectors need to step out of the glare of the marketing hype. It would not hurt to take a deep breath before reaching for the checkbook. Ultimately, this bubble -- or whatever it is -- will burst. And time, as it always does, will sort out the winners.Link here.
Jim Halperin is the leading -- most controversial -- rare coin dealer in America.
“James Halperin is probably the most successful professional numismatist of all time.” So says his Web page. There is some truth to this self-assessment by the co-owner of Heritage Galleries & Auctioneer in Dallas, the world’s largest rare coin auction house. Heritage is on track to sell $300 million worth of coins, comics, sports cards and other collectibles this year, pocketing an estimated $60 million in commissions and netting some $5 million. Halperin has been in the forefront of this business for much longer, establishing new benchmarks for coin grading, sewing up the rights to auctions at leading shows, pioneering sales over the Internet and making headlines unloading the collections of celebrities.
Halperin, 52, is also probably the most controversial professional numismatist of all time. He has had brushes with postal inspectors, the Federal Trade Commission and coin dealers who have sued him for, among other things, sticking them with inflated prices. But then this is a profession that attracts controversy. With an estimated 130,000 U.S. collectors trading $5 billion worth of coins a year, the opportunity for mischief is considerable.Link here.
BORROWING TO BUY STOCKS COULD BE FISCAL SUICIDE
So you wanna bulk up your retirement nest egg? And make fast money on stocks? But you don’t have any extra cash? “Don’t worry,” some financial wise guy might tell you. “You’ve got that gorgeous home. Just take out a bigger mortgage, take some cash out and use that money to make even more money for you in the market.” Why not bet the ranch -- or the colonial?
Oh, brother. I cannot believe anyone would borrow money against the house -- the place that keeps the owner warm in the winter -- to buy something as risky as stocks, mutual funds or variable annuities. But regulators say more than enough people are getting taken on this dubious deal. Last week, the National Association of Securities Dealers, the industry regulatory agency, once again warned brokers to take extra steps to make sure customers understand the sizable risks of tapping into a home’s equity to buy stocks. One area of concern: The push of interest-only mortgages to free up money to buy stocks. The NASD calls it “Liquefied Home Equity”.
I call it fiscal suicide. But then I base that on words from one of my most respected advisers, my grandmother. Busia remembered the hardship faced by some people who lost their homes during the Great Depression.
Increasingly, investors are using their home equity to invest. A Federal Reserve Board study found that during 2001 through the first half of 2002, the most recent data it reviewed, about 11% of the money taken out of a home during refinancing was put into the stock market and financial investments. That is a nice jump from less than 2% from 1998 through the first half of 1999, the previous period studied.Link here.
A NEW WAY TO HEDGE YOUR HOME’S PAPER PROFIT
If you have owned a home for several years, you may be sitting on a sizable increase in equity. And if you are worried that the run-up in housing prices cannot last much longer, you may think the only choice is to call a broker, rent a moving van and head for the (less expensive) hills. But through an increasing number of new investments, you may be able to limit future erosion of your home’s value.
Macro Securities Research, a company affiliated with Robert J. Shiller, the Yale economist, has reached an agreement with the Chicago Mercantile Exchange to list pairs of derivative instruments that are essentially index funds linked to home prices in certain markets. One instrument in each pair will rise as its market index rises; the other will rise as the same index falls. That will let investors bet on the direction of housing prices. Similar, but less sensitive, vehicles are being offered by HedgeStreet, a firm in San Mateo, Calif., that offers small-scale derivatives speculation online.
While the options available to nervous homeowners are growing in number and sophistication, some advisers warn that they may provide minimal protection from the vicissitudes of the real estate market. But other, simpler strategies may help you prepare for a softening of the market, they add. One is to avoid variable-rate mortgages before any serious increase in interest rates -- an event regarded as a possible trigger for a reversal in home prices.Link here.
PADDLING THE SILVER BOAT INTO UNCHARTED WATERS... AGAIN
An interesting thing happened on the way to the 16% decline in silver prices that unfolded in early December: Large Speculators got even more bullish than they already were. Now, you may be thinking, “Well, isn’t that why they’re called ‘large speculators’?” Good point, but consider the following: This particular group of traders (mostly hedge funds) was already holding a record “net-long” position in silver. In other words, they paddled their boat even further out into uncharted waters.
And it is worth remembering this group’s previous “uncharted” voyage, which came in March of this year, when silver had climbed even higher... and just before it plummeted even further than prices did just recently. It is not just Large Speculators who hold an extreme position in silver; Commercial Hedgers do as well, except on the other side of the trade. A chart including silver prices, and the positions these two groups have taken, going back to 1996, does not need much examination to understand what usually happens.Link here.
The socionomics behind cocoa prices.
Analyst Jeffrey Kennedy spoke about the connection between Cocoa prices and social mood in Ivory Coast, the African nation that produces 40% of the world’s Cocoa. “Socionomics is a young field of social science that challenges basic sociological and economic assumptions, by arguing that mood governs events. Because social mood is reflected by price fluctuation in speculative markets, the [Elliott] Wave Principle is uniquely suited to recognizing extremes in social mood, which in turn produce the best opportunities in markets. ...
“The civil war in Ivory Coast formally began in July 2003 and has been going on with more or less intensity since then. It’s no coincidence that the only times you read about the conflict are when Cocoa makes a notable move. Cocoa is Ivory Coast’s preeminent speculative market, so we should expect both the best and worst expressions of national social mood to accompany the commodity’s price extremes.”Link here.
Coffee news is a load of... crop.
According to a December 14 Wall Street Journal article, coffee bulls “threw in the towel yesterday” when prices plunged to a two-week low. The joke of a reason the fundamental experts served up to explain the collapse in coffee prices? The recent release of Brazil’s 2005-2006 Crop Estimate report -- which was “slightly larger than some trader’s expected” -- caused the dent in market sentiment. To put it delicately, this logic is a load of crop. And here is why: The report hit the presses on Friday, December 10, BUT coffee prices had been falling long before that -- to be exact, since December 2.Link here.
PRINCELY FINANCE AND TAXATION
One would have hoped that financial rip-offs committed by medieval princes would have been permanently shelved when liberal enlightenment ended the divine right of kings. Recent imperious announcements by Messrs. Greenspan and Bernanke to use the “printing press” to inflate anything they can should be considered startling only in the resort to honesty. Euphemisms for currency depreciations started with the original promoters of the Fed and the tout was that a “more flexible” currency would prevent serious financial contractions.
Regrettably, since 1914 there have been many financial crises and the dollar has lost 90% of its purchasing power. This is particularly ironical as the key regular ones have not been prevented. These would be the 1920-1921 and 1990-1991 examples that ended a long period of vigorous economic expansion and the post-1929 and post-2000 crises that ended, in such a costly fashion, a “perfectly” managed new financial era. Recall the “Goldilocks” pitch. 19th Century liberals, so rational and principled in their views, could not have imagined the greedy craft developed by many modern governments in confiscating private savings earned by productively working citizens. Are we seeing medieval financial tyranny replicated by today’s proponents of the divine right of bureaucrats? A look at history provides perspective.
No matter how imaginative or despotic princely financing was, it cannot compare with the long-running compulsion to spend other people’s money by today’s bureaucrats and politicians, virtually unrestrained by the checks and balances of constitution or mainstream media. But before expanding this point, consideration should be given to the other event that formally ended the old world, which was the beginning of modern finance with the incorporation of the Bank of England in 1694. As history shows, central banking is fine when disciplined by a convertible currency and, when not, it becomes a tool of state ambition to confiscate wealth though currency depreciation. That the dollar has lost 90% of its purchasing power in only 50 years exceeds most princely devaluations and, like those, has been no accident. Indeed, Fed announcements to “print money” could be considered as an attempt to go for the final 10%.
Today, princely cunning really comes together with Washington’s finesse in running the currency down and moving everyone up the confiscation ladder of “progressive” taxation. Without desperately needed constraint, the combination of currency depreciation and bracket creep with eventually force those below the “poverty line” into unconscionable tax rates. Fortunately, history provides some antidotes to such governmental abuse of the productive sector. Short of rebellion, the most effective of course has been to force government and its financial agencies to be accountable to the taxpayer. As for those who have wrecked the currency, Dante, in his Inferno, reserves a special place in hell for “false moneyers”.Link here.
There is nothing so paltry or coincidental that people do not find something in it to flatter themselves. One man takes pride in the way his hair waves. For another, pride is found in a victory of the hometown football team. Is it any wonder we feel like geniuses when our property goes up? A bull market creates geniuses, we recall, and the boom in Delray, Florida real estate has created a whole town full of them. “[Y]es, the prices do seem absurd,” said our friend. “But people keep coming. And they seem willing to buy even at these higher prices.” And why not? They can buy a little bit of paradise and get rich doing it. A $750,000 condo rising in value at 20% per year adds $150,000 in extra “wealth” each year.
The longer the boom goes on, the more confident the buyers become. They have been warned that the market could collapse at any time. But no matter how thin the ice is supposed to be, it never seems to give way. Instead, they skate to profits -- getting rich while the worrywarts make nothing. Is there any better proof of true genius?
“The higher prices go, the more sure people are that they’ll go higher. You begin to believe that there is something special about this situation that separates it from other examples of boom-bust markets. You begin to think that the boom will last forever. Or, even if there is a bust, it is likely to be modest. After all, people really do want to move here. And there are reasons to think this could catch no nationally -- like Sausalito or South Beach. It’s a pretty little town and a quick walk to the ocean. Why shouldn’t condos be worth $1 million?”Link here.
THE PARADOX OF TRADE
The macro conclusions from various trends are inescapable: A sharply diminished U.S. industrial base places major constraints on the potential upside of any trade-induced multiplier effects that may arise from a depreciation of the dollar. This erosion has been a constant trend evident over most of the post-World War II era. But it is particularly important to scale the size of the U.S. manufacturing base relative to that of the mid-1980s -- a point in time when the major countries of the world endorsed the so-called Plaza Accord, which was aimed at pushing the dollar sharply lower. Back then, the ensuing currency adjustment did provide some unmistakable benefits to the U.S. -- namely, a marked pick-up in export growth and a related narrowing of the trade and current account deficits. U.S. exports increased at an 11% average annual rate over the 1986 to 1990 period and the trade deficit narrowed enough to push the current account actually into surplus briefly in 1991. But, today, with America’s manufacturing base about 40% smaller than it was in the mid-1980s -- measured both by jobs and labor income generation -- its potential for sparking a revival in aggregate economic activity is likely to be commensurately smaller.
Consequently, a weaker dollar is hardly the final answer to America’s macro conundrum. It does, however, have the potential to be an important trigger for a series of related adjustments that would go a long way in addressing the basic problems of a saving-short U.S. economy. The key is the link between the dollar and interest rates -- and the likelihood that dollar depreciation triggers a rise in real U.S. interest rates. That, in fact, is a time-honored characteristic of a classic current account adjustment. In my opinion, it is especially likely in the present climate, as America’s creditors -- heavily overweight dollars -- ultimately demand compensation for taking sustained currency risk. In the end, higher real interest rates may well be the only means to restrain the excesses of U.S. domestic demand. But that is exactly what it will take to bring all the pieces of the U.S. rebalancing puzzle into play -- reduced imports, a narrowing of gaping trade- and current-account deficits, and an improvement in domestic saving.
There is a certain irony in the adjustments that now lie ahead for the U.S. The excess consumption of the Asset Economy is heavily dependent on the interest-rate subsidy provided by America’s foreign creditors. Dollar depreciation challenges the sustainability of that subsidy. It also puts pressure on the underpinnings of asset markets that are so heavily dependent on interest rates. However, a weaker dollar is unlikely to spur a trade-induced renaissance of U.S. industrial activity that might otherwise compensate for a shortfall in domestic demand. Therein lies the ultimate paradox of trade: Courtesy of a strong dollar and cut-rate foreign financing, America has been living beyond its means for almost a decade. As the dollar now weakens, that movie is about to run in reverse.Link here.
SURFING THE WAVE OF CHANGE
We are at one of those unique moments in history when, to borrow a phrase, “everything old is swept away as in the twinkling of an eye.” Tomorrow’s world will be unimaginably different and those who understand it -- anticipate it even -- shall inherit the earth. Sounds preposterous, doesn’t it? It is not. And in retrospect -- like everything in this world -- it will all seem so obvious. “If only I’d bought $100 of Microsoft stock twenty years ago,” they still lament, “I’d be rich.”
I tell those types to stop whining. The opportunities presenting themselves now are many times as lucrative ... and you do not need any special tools to pick them. All you have to do is open your eyes! Change Drivers -- the power behind this juggernaut -- are already turning whole economies upside down. But a century from now? Forget about it. The world will be entirely unrecognizable. Those who surf this wave will make fabulous profits ... some are already doing so. Those who ignore it will be crushed beneath it.
Every technological advance rests on the foundation of a series of advances that came before it. That is obvious. What is not so obvious is that many of these advances are not just freestanding, they are catalytic -- they transform how other fields of technology can progress. In certain fields, the catalytic effects are going to be especially great. Included among these are future energy, nanotechnology and space development. Each of these is a Change Driver. Computers are another, with offshoots in artificial intelligence, robotics, and virtual reality, to name a few.
Raymond Kurzweil-the keynote speaker at the World Future Society’s last annual meeting, and founder of six leading technology companies-has researched the progress of technology. He has established that in every measurable area the rate of progress has been doubling every two years-and is accelerating. Today’s supercomputers -- if they can be said to be intelligent -- rival a rat’s capabilities. The next few decades will see the arrival of computers that first match, and then greatly surpass human intelligence.
Some still argue that computers will never “really be intelligent”. They are missing the point. Remember the old saw, “If it walks like a duck, quacks like a duck and flies like a duck, it’s a duck?” For all practical purposes, a computer that can perform an activity better than all but the best human practitioners can be said to be intelligent, at least in that area. Consider that people are generally less reliable, cannot work 24 hours a day, and expect to be paid on a regular basis; as the power of computers continues to double every year or so, the economics will shift in their favor.
As computer capabilities continue to surpass humans in more and more areas, whole professions will disappear in the blink of an eye. Already, service professions are starting to disappear. Consider the automated checkout line at your grocery store. Soon we will start seeing automated fast food restaurants. Then automated mechanics. The so-called professions will hardly be immune. Those who ignore this do so at their peril. You have no assurance that your profession of today will still pay well-or even exist-in 2020. The Luddites of yesteryear got crushed, and the ostriches of today will get eaten.
We are living in an age of science fiction made real. But unlike the potboilers of yesteryear, where a single advance was worked into an otherwise normal world, we are seeing advances in diverse fields all rushing forward together, intersecting and tumbling into one another, cross-fertilizing into all kinds of bizarre and wondrous things. Computers. Genetics. Robotics. Artificial intelligence. Outer space development. Nanotechnology. Future energy. Virtual reality. The key to making a fortune from this technological tidal wave is understanding that tomorrow’s IBMs and Microsofts will be those companies that surf the wave, leading progress in some area crucial to human progress. Microsoft went from nothing to one of the world’s biggest companies in just 20 years! Others will do the same in diverse fields as other change driver technologies leap ahead. Those who invest early in these companies will make staggering fortunes.Link here (scroll down to piece by Jonathan Kolber).
FED’S MOST IMPORTANT STEP WAS NOT RATE INCREASE
The most important step Federal Reserve officials took yesterday was not raising their target for the overnight lending rate by a quarter point. It was the decision to release the minutes of each Federal Open Market Committee session three weeks after it occurs instead of waiting until a day or two after the next meeting. Earlier release of minutes will give financial markets more timely information about Fed thinking before the subsequent policymaking session. Thus, when the minutes of yesterday’s meeting are published on Jan. 4, the world will have much more knowledge about what went on in the Fed boardroom than could possibly been conveyed in the FOMC’s brief statement issued after the meeting.
More than a decade ago, Fed Chairman Alan Greenspan and his colleagues decided it would make the conduct of monetary policy easier if they shared more information about their decision with the public. In other words, to become more transparent. The increased transparency is a key reason the Fed has unprecedented credibility as it pursues its goal of price stability. That credibility, in turn, has given the central bank the luxury of being able to wait for economic developments to unfold before taking actions that might have turned out to be premature.
Actually, that is the case today. After holding the overnight rate target at 1 percent for a year to ward off a possible episode of deflation, the Fed began raising it at the end of June at a “measured” pace, which so far has proved to be a quarter-point per meeting. Over the past six months, prices of oil and numerous other commodities soared with only a small adverse impact on inflation expectations regarding the next two or three years. As the Federal Open Market Committee statement put it, “Inflation and longer-term inflation expectations remain well contained.”
Perhaps the best example of that is that yields on 10-year U.S. Treasury notes yesterday stood at 4.12%, almost a half-percentage point lower than when the Fed first raised the overnight rate target on June 30. That is, the target has gone up by 125 basis points while the 10-year yield has dropped by 50 basis points. That has got to be largely the result of Fed credibility as an inflation fighter.Link here.
Treading water with the Fed.
When the Federal Reserve’s Open Market Committee meets every six weeks or so, the financial markets wait with bated breath -- even when they have already factored in what they think the Fed will do. This time was no different. Starting at noon, the markets treaded water until the announcement at 2:15 p.m. that the Fed was indeed going to raise rates for the fifth time this year by a quarter point to 2.25%. Then the charts of the major stock markets briefly looked like a heart patient’s EKG right after an electric shock, before they calmed down again.
In fact, according to a Reuters report just after noon, everyone already knew what the Fed would do: “Everybody knows it is going to be a quarter point increase, but the more important thing will be (Federal Reserve Chairman Alan) Greenspan’s outlook for the dollar and inflation and the market will dissect that information,” said Mike O’Hare, head of listed trading at Lehman Brothers. Well, there was not much to dissect: The Fed said that “inflation and longer-term inflation expectations remain well contained.” Well, you can say that again. Because, to us, it looks so well contained that maybe the Fed ought to be talking about what we are really looking at: deflation.
Prices are down for everything from computer hardware operating systems, digital cameras, automobiles, movie rentals and brokerage firm services. The market for flat screen TVs reflects how tenuous inflation’s grasp is right now. Producers are doing everything they can to keep prices up through Christmas. Meanwhile, lenders are finding it harder to give away credit, since many Americans are overstretched. Except for one growth industry -- payday lending. In 2003, more than 13% of all U.S. households used a payday loan to make it to their next paycheck. They paid an average of 400% for the privilege, compared with the more typical 18% credit card cash advance. And what makes this information more telling is that four out of the 10 largest U.S. banks are going after this market [!].
Think about that as you contemplate the new 5.25% prime rate and how it is going to affect your business dealings. We think about all kinds of data like this as we analyze the price charts of stocks, bonds, and commodities, to name just a few. What we see is not exactly what Greenspan & Co. see. Maybe you are skeptical, too. If so, then come read some refreshing analysis of what is going on in the real world -- not the one inhabited by monetary policymakers.Link here.
FIDDLING WHILE ROME BURNS
Everyone recognizes that this week’s White House Economic Summit here in Washington is political theater. It is a chance for the White House to showcase its second term economic agenda, and get lots of mostly favorable press for it. Still it is an important event, as much for what it leaves out as what it includes. The U.S. faces a very uncertain economic future. Our economy, public and private, is borrowing 6 percent of our income from abroad. Although the Japanese, Chinese, and other central banks have been kind enough to finance this borrowing by purchasing U.S. Treasury obligations, we cannot expect their generosity to continue indefinitely.
These central banks have already lost hundreds of billions of dollars over the last three years by holding U.S. dollars instead of Euros. It would be nice if that were the end of the story, but the dollar has only fallen about 17% against a basket of foreign currencies that is representative of our trade. So it still has quite a way to fall before our record trade deficit, and hence our foreign borrowing, can reach a sustainable level. Should the U.S. try to arrange an orderly decline of the dollar, co-ordinated with other countries, as we did between 1985 and 1987? This question does not appear to be on the agenda of the economic summit.
Ss foreign central banks lose their appetite for U.S. treasuries, the interest rate that we have to pay on them will go up. That means mortgage rates will also go up. This could spell very serious trouble for the U.S. economy: our economic growth since the recession of 2001 has been fueled overwhelmingly through the housing market. Not only has demand for housing been unusually strong, but as millions of people took advantage of record-low interest rates to refinance their mortgages, they also borrowed literally trillions of dollars. And spent it. Hence our incredibly low personal savings rate (0.2% in October), and heavily indebted consumers.
The result has been a big bubble in the housing market, which began nine years ago as a spillover from the stock market bubble. In the past nine years housing prices nationally have increased 40% more than the overall rate of inflation; for the four decades prior, house prices increased at the same rate as inflation. When the housing bubble breaks, it will almost certainly cause a recession. How will the federal government respond, with our public debt (65% of GDP) already at 50-year records, and the federal budget deficit at near-record levels -- again, as a percentage of our economy, including borrowing from Social Security and Medicare? And will the Federal Reserve continue to raise interest rates as the economy slows? More tough questions for an economic summit, but it does not look like anyone will be asking them.Link here.
HOW QUICKLY THEY FORGET DEPARTMENT: MERGERS SURGE
The holiday season arrives clothed in optimism, freely spreading hope for a brighter future. It seems only fitting that a slew of corporate giants are arm in arm negotiating mergers, spreading cheer amongst shareholders with rhetorical bonbons like “synergy” and “efficient consolidation”. Just since the beginning of this December, mergers real and rumored have multiplied with the exuberance of last-minute gift ideas. Today, the phenomenon made the front page of The Wall Street Journal in an article that cites over half a dozen deals. What is so much better about fewer companies getting bigger?
Well, the Journal suggests that, “At the least, the surge in big deals persuades some investors that the U.S. stock market retains value even after two years of reasonably strong profits.” Hence the willingness of shareholders to approve deals that pay out an average premium of 28% over market value for shares of targeted companies, a 6% increase from last year’s average.
Does all this enthusiasm make you wonder if shareholders have actually forgotten recent history, or did they simply choose to suspend the disbelief that offers “something for nothing”? Either way, you do not have to look back very far to learn the lesson these folks apparently do not have in mind. As late as February of this year, The Elliott Wave Financial Forecast remarked on the similarities between last winter’s similar flurry of merger news and the M&A “frenzy” that the AOL-Time Warner deal punctuated:
“Memory loss is the No. 1 contributor to stock market loss. That’s why we write this stuff down and compare what’s happening to what was going on at past market tops. The striking of so many of the same sentiment chords that were hit in the first quarter of 2000 can only mean one thing: the bear market is about to make a more lasting impression.” By March, most of the major indexes had topped and begun months-long declines.Elliott Wave International Dec. 14 lead article.
Will merger mania extend to 2005?
While we are not witnessing the delirious flurry of mega-transactions of the late 1990s, the volume of mergers and acquisitions is on the rise. So far this year, there have been 9,837 deals, up more than 15% from the total of 8,525 at this time last year, reported Mergerstat. The dollar value of deals so far this year stands at $789 billion, 43% higher than the $552 billion at this time last year, added the research company. No surprise, then, that this revival is boosting Wall Street’s fortunes. Will this momentum continue into 2005?
It all depends. If the economy continues to strengthen and the stock market continues to rise, then you can certainly expect increased merger activity next year. At PricewaterhouseCoopers, the transaction services group is calling for a “moderate pick-up in 2005” in M&A. “While corporate acquirers continue to approach mergers and acquisitions with caution, pressures to demonstrate growth coupled with abundant financing and cash reserves should raise the levels of corporate M&A next year,” wrote PwC in a new report. “At the same time, cash-laden private equity buyers are already seizing many deal opportunities and will continue to compete with strategic buyers for middle market deals over the next 12 months.”
The firm pointed out that companies will be more active across the board because they have a lot of cash and there is a lot of debt financing available. As proof, in a little less than a year, financing sources have moved from financing acquisitions at 2.25 times EBITDA to 5-plus times EBITDA. PwC’s Bob Filek noted that as M&A financing sources chase yields and try to beat their benchmarks, they have been willing to go into lower-quality issues and take on longer maturities.Link here.
THE WORLD’S WORKSHOP
“When customers start demanding things, you know it’s going to start topping out,” says Arnold Van Den Berg, the 64-year-old founder of the eponymous money management firm that has soundly beaten the market averages since 1974. The investment business “is the only business where the customer could be wrong.” Investors have been clamoring for Chinese stocks like children pining for more dessert. But unlike dutiful parents, the market is giving them what they want -- even though some of these companies are not quite ready for life as publicly traded companies.
Recently, I have written about how China was the “Big Story” and cautioned that China, as an emerging market, was likely to suffer some gut-wrenching peaks and valleys. It did not take long for the market to provide a fresh example in the plight of China Aviation Oil (CAO), the monopoly provider of jet fuel to China. China Aviation Oil collapsed after disclosing losses of $550 million stemming from oil derivatives trading. It was the biggest scandal to hit the Singapore exchange since rogue trader Nick Leeson felled the venerable Barings Bank. Is CAO a portent of things to come or just an aberration? On the one hand, say some officials, this is something that could have happened anywhere. Indeed, it could have. But when the CAO event happens in a larger pattern of fraud and deception, one has to wonder if CAO’s problems are not isolated, but endemic. Particularly galling for investors was the fact that CAO was widely regarded as exemplary of good governance.
Popularity is like arsenic to healthy investment returns. In the case of China, its popularity is unquestioned, as foreigners have been pouring billions into Chinese state enterprises. But new research from China Economic Quarterly sheds some light on who is making money in China so far. CEQ editor-in-chief Joe Studwell looks to answer the question of how individual companies are faring in the frontier of Chinese capitalism. To preview his conclusion, his answer is “not that great”. The main point of the CEQ is that yes, profits from U.S. affiliates in China have been rising, but they are not very impressive when put in perspective.
The steadiest earners among U.S. companies in China have been American automakers and fast food chains. Together, these two sectors accounted for nearly one-third of total U.S earnings in China. Moreover, these companies are achieving profit margins no better than their global averages. While this indicates a number of things, it is obvious that it is harder to make money in China than widely believed. The cost of doing business there is perhaps higher than advertised. By all accounts, China is still heavily regulated and deeply bureaucratic.
For all this, there is no denying that China is the workshop of the world -- the cheapest manufacturer of many things on the planet. China as supplier is an instant money saver. Plus, China as a heavy consumer of commodities is undeniable. China holds more potential than perhaps any other market in the investment universe. Reality says something different -- at least today. There will be more scandals and more disappointments, but there is a prize to be won in China. It simply may not be in buying Chinese stocks, and the profits may come more slowly than commonly thought. The emergence of China as an economic power is not preordained. There is still much that has to happen before that becomes a reality.Link here.
HEDGE FUNDS: HEALTHY RISK?
By head count alone, it looks like investors on Wall Street have come to the following conclusion: Living on the h-EDGE fund is, indeed, a safe bet. A recent Wall Street Journal column says that in the first 10 months of 2004, $106.6 billion flowed into hedge funds vs. $72.2 billion in all of 2003. Assets in hedge funds have grown by 260% over the past five years to reach a combined asset figure of $1 trillion.
With this many zeros, it is natural to think that superior performance in hedge funds must account for the rapid growth. Think again. Hedge funds gained 19.6% in 2003 vs. 7.1% year-to-date through November 2004. Not to mention the fact that one in ten hedge funds go under each year, according to the Journal of Investment Management. Oh, and another thing: hedge funds are not subject to government regulation, meaning information on performance is provided voluntarily. We could go on listing the potential hazards of the hedge fund industry (high fees, inflated returns, etc.) but the fact is, the fire of “one of the hottest investment vehicles” is only getting hotter.
And it is not just the wealthy (investing in hedge funds typically requires a minimum net worth of $1 million) who are hopping in. The WSJ piece reveals: “Hedge fund investors include one in five pension funds,” and many large institutions such as JP Morgan. In the words of one chief strategist, “The low hanging fruit has been picked over by swarming hedge fund investor locusts.”
Think about it -- if the hedge fund “fruit” turns out to be rotten, who will suffer the most now? The already rich investor OR the average JOE or JANE who entrusted their children’s educational future, savings, mortgage, and retirement in the pension funds and banks that also ate of that fruit? But hey, as one investment advisor observes, “Hedge funds are more likely to do well when stocks fare poorly ... They are a way to not only garner double-digit returns but also to reduce the overall volatility of an individual’s portfolio.” Well, when the stakes are this high, it is important to get the story straight.Elliott Wave International Dec. 15 lead article.
ALL THE SUCCESS, INTELLIGENCE, EXPERIENCE, AND STREET SMARTS ON EARTH...
Tom Wolfe’s Bonfire of the Vanities is the best treatment I have ever read of what it is like to be at the center of a media frenzy: People you cannot control seize control of who the world thinks you are. Your identity is extinguished. This may be how Mr. Bernard Kerik feels after the past several days, not that I am trying to solicit sympathy for the man. Nominated on Dec. 3 to be homeland security secretary, Kerik withdrew his name a week later, apparently because he employed a nanny “who may have been in the country illegally and whose taxes he had not paid.”
Yet this was just the iceberg’s proverbial tip. The press in New York (and elsewhere) has followed up with story after story of his scandalous behavior -- and if even a few of the allegations are true, he really is a rogue. With one mistress in his pocket and his wife pregnant, Kerik reportedly had an affair with Judith Regan, the most powerful book agent in the publishing business. The lady is known for a temperament and persona that could match Kerik’s own toughness.
So, why is this vulgar political soap opera on a page devoted to financial topics? Because it illustrates a basic truth about the human condition, one we would all prefer not to see in ourselves. We would rather look at this story and chuckle over sordid details and think that that is all there is to it. But the question that begs to be asked is, How could such intelligent people behave so ... irrationally? Bernard Kerik knew full well that he would face the FBI’s ruthlessly thorough background check, never mind the media’s scrutiny; yet he concluded that the allegations would not become public.
In this case, arrogance led to the irrational choices. In financial markets, rational thinking is overcome by greed and fear. Either way -- all the success, intelligence, experience, and street smarts on earth do not immunize people from bouts of extraordinarily irrational behavior. How do you protect yourself from yourself? There is no substitute for personal discipline, but it surely helps to have a method that you can rely on.Link here.
FANNIE MAE MAY HAVE TO RESTATE EARNINGS BY $9 BILLION
Fannie Mae, the biggest source of money for U.S. home mortgages, may have to restate earnings by as much as $9 billion after the SEC said it broke accounting rules. The amount is what Fannie Mae last month estimated would be the cumulative after-tax loss of the last three years if the SEC determined it erred in recording financial contracts designed to cushion against shifts in interests rates. The SEC’s ruling may be a setback to gains Fannie Mae and Chief Executive Officer Franklin Raines have made in recovering investor confidence after its federal regulator first accused the company of accounting errors in September. It may also strengthen efforts in Congress to create a stricter regulator for the company and the smaller Freddie Mac.Link here.
The latest chapter in Fannie Mae’s scandal saga.
When a government-sponsored agency pays its 21 top executives more than $1 million annually -- including $20 million for its CEO -- well, that will produce a story or two in the financial news pages, and some folks might even bother to read it. But when an SEC audit of this same agency finds accounting violations, and demands a restatement of earnings in order to recognize $9 billion in losses -- well, then you are talking real money, on a scale that will earn a front-page story in The Wall Street Journal two days in a row. Such was the case with mortgage behemoth Fannie Mae, and page one of the WSJ on December 16 & 17.
This chapter in Fannie’s scandal saga actually began in September, when the Office of Federal Housing Enterprise Oversight (OFHEO) issued a 211-page report that detailed “Fannie Mae’s dysfunctional accounting policy”. This dysfunction runs in the family: a similar scandal enveloped Freddie Mac in 2003, which likewise included an embarrassing audit, allegations of cooking the books for personal gain, a Congressional hearing, and a criminal investigation. Yet several particulars in this year’s scandal are even more sordid. The OFHEO report alleged that Fannie Mae sought to maintain the appearance of steady earnings growth at all costs, including sound accounting practices.
Why? Well, steady earnings growth keeps investors attracted to Fannie Mae’s stock, and helps with certain other trivial concerns -- such as the size of the bonus that executives receive. The OFHEO report explained that, during one year, Fannie Mae ensured the appearance of earnings growth by recording only half of a $400 million expense, which coincidentally also meant $27 million extra in bonuses went to its top managers. There is more to tell -- lots more -- though in brief, it is fair to say that the question is not “if” there will be a ripple effect. “How large” is more like it. Fannie Mae and Freddie Mac own or control nearly half of all U.S. home mortgages, some $600 billion; they hold a debt and derivatives portfolio to the tune of $1.7 trillion. More audits and investigations are sure to come. Wall Street and the investing public still have yet to see this story for what it really is -- never mind for what it could become.Link here.
STARBUCKS OPTIONS PLAN PUTS DILUTION ON MENU
When it comes to stock options, Starbucks (SBUX) is asking shareholders for one last refill. The coffee chain wants to pour in millions of new shares into the cup of options that it can hand out to employees and managers. If approved by investors, the plan, which the company laid out in its proxy filed last week, would push options-related dilution at the company to greater than 19% of outstanding shares -- far above the level at which many institutional investors might be expected to balk. By some measures, the plan would essentially double the company’s options dilution, noted Kent Hughes, managing director of Egan-Jones Proxy Services, an advisory firm. “This just seems like it’s excessive potential dilution,” he said.
As might be expected, Starbucks’s board argued that shareholders should approve the plan at the company’s annual meeting on Feb. 9. “The board has long believed that employee ownership in the company serves the best interest of all shareholders, by promoting a focus on long-term increase in shareholder value,” the directors said in the proxy. But investors could find themselves in a quandary about how to vote.
On one hand, the company has been a top financial and stock performer -- the most important issue for the many growth investors who hold the stock. On the other hand, its options practices seem to run against prevailing investor opinion on the issue -- and could pose both short-term and long-term problems for the company. For instance, accounting regulators are expected to issue a rule that would require companies such as Starbucks to start recognizing the cost of options in their income statements next June, which could immediately hit the company’s reported earnings. According to a footnote in Starbucks’s annual report, its earnings would have been 11.5% lower in its just-completed fiscal year if it had expensed options.Link here.
Stock options must be expensed.
After years of heated debate between high-tech companies and accountants, the head accounting rule-setting body declared all companies must subtract the cost of stock options from their earnings starting in mid-2005. It is a massive blow for companies, mainly in Silicon Valley, which had been doling out lucrative stock options to employees and executives for decades but not counting them as a cost. It also requires investors to rethink how they value companies: The new rule will affect everything from price-earnings ratios to earnings estimates. Accountants, thinking companies had been enjoying a loophole that understated their costs, applauded the decision. The new rule will have “a big impact, but it’s the right move,” says Ed Nusbaum, CEO of accounting firm Grant Thornton.
High-tech firms are not pleased. “We remain opposed to expensing and will continue to work with the Congress, the administration and the SEC to come to an accurate, auditable, transparent solution,” says Cisco Systems’ spokesman John Earnhardt. Sen. Peter Fitzgerald, R-Illinois, one of the rule’s champions, says he fears companies will wait for his retirement this year and try to derail the rule before it kicks in June 15. Silicon Valley companies “will stop at nothing to stop this (rule) from going into effect,” he says.Link here.
EUROPEAN CENTRAL BANK’S PADOA-SCHIOPPA SEES U.S. DEFICITS WEIGHING ON WORLD ECONOMY
ECB board member Tommaso Padoa-Schioppa said the U.S.’s large current account and public sector deficits are likely to weigh on the development of the world economy for years. In an interview in La Repubblica, Padoa-Schioppa said the high oil price, caused by strong demand from China and India, will be another factor affecting growth in the long-term. On the wide U.S. current account deficit, he said, “We see the phenomenon of the richest country in the world taking a loan, not so as to invest but in order to fuel consumption. The process of correction of this phenomenon will take years.” The U.S. current account deficit goes against traditional economic theory that rich countries export their capital to poorer economies, he said.
“It is unthinkable that the rebalancing comes only via changes in the exchange rate. The process has to include a correction in the U.S. public deficit and from more savings by U.S. individuals,” he said. The dollar has already weakened significantly in the last two and a half years because of the deficit, he noted. On the oil price, Padoa-Schioppa said the rise in price is due not so much to a shortage of production, but because of refining capacity. “It will take years to reestablish an equilibrium,” he said, adding that energy resources are not sufficient for rich countries’ levels of consumption to be extended worldwide.Link here.
WHO CAN AFFORD TO RUN CURRENT ACCOUNT DEFICITS NOWADAYS?
The prevailing rationale proffered for the greenback’s ongoing weakness is that the U.S. has an unsustainable current account deficit; therefore the dollar must fall. True, as far as it goes, but how does one explain the following: Last week, John Howard, Australian prime minister, said the country’s currency strength was becoming a threat to the booming economy. A 1.8% fall in exports widened the deficit in goods and services to A$2.24 billion in October.
It is not just America that suffers from the disease of chronic external imbalances: Australia had already reported a record current account deficit in its 3rd quarter of 6.5% of GDP. Even worrying from the perspective of the so-called “Lucky Country” is that the trade deterioration has come at a time of robust commodities demand, and the A-dollar has largely appreciated on the perception that it was a leveraged beneficiary of the global reflationary boom in commodities. The current commodities boom has often been likened to the period of the 1970s, yet during that time Australia ran a persistent current account surplus, which validated the strength of the A-dollar during that period. Perversely, Australia along with New Zealand and the U.K. had had amongst the strongest performing currencies against the dollar in spite of manifesting many of the illnesses that have recently laid low the greenback.
This tells us something else about current account deficits -- namely, that they do not merely reflect differentials in so-called purchasing power parity (PPP), but also reflect different savings propensities and correspondingly different central banking approaches as to how one approaches these varying propensities. In general, the “Anglo-Saxon” world over the past 10 years has been characterized by a dissipation in savings and a corresponding reluctance to curb the rampant credit excesses which accommodated this savings destruction. Debt also has been growing rapidly because its government and consumers have been spending more and more relative to their incomes. Other countries have been growing more slowly because their governments are fiscally constrained and their consumers are cautious and are trying to save more in response to such caution (which is the way American consumers used to behave in previous cycles).
Viewed from this perspective, substantial current account imbalances exist in many nations of the English speaking world because they are the profligates in the world, spending tomorrow’s money today with debt, with virtually no net national savings, whereas Europe and Japan, the supposedly slow, sclerotic economic blocs reluctant to embrace “supply side-driven reforms” have significant net national savings. Examining the world within this framework may help to elucidate in part why Euroland and Japan have had persistently strong currencies over the past few years, but the problematic strength of sterling, the Kiwi dollar and the A-dollar clearly suggest that this does not present the whole picture. Just as the actions of a gambling addict at the casino seldom stem from purely rational motives, so too global markets rampant with credit speculation seldom provide easy, pat explanations for why things occur as they do.
In many instances, countries with house price booms -- the U.S., Australia, New Zealand, and the U.K. -- probably have household sectors that are deficit spending. In most cases, these are also countries with large fiscal deficits as a share of GDP and large trade deficits as a share of GDP. The humbling reality is that across three decades, only one economic event has been guaranteed to produce balanced trade in the English-speaking nations: a recession. When the economy is contracting, people naturally buy less of everything, including imports.
No one appears ready to bite the bullet, which means that the endgame will be much worse even for those who have sought to conduct their monetary affairs in a responsible manner, such as the Bank of England. The current global financial fragility is unlikely to be saved by mere dollar devaluation; it is solved when the respecting offending nations restraining their respective profligate tendencies and implement policies designed to restore national savings to their historic norms. Of course, if all the offending nations do this together without any countervailing stimulus from Euroland or Asia, we will see a massive global contraction.
The Bank of England and IMF may see this checkmate position coming. They may be concerned they will see a global income depression on their watch if housing bubbles burst. They may accordingly be warning global monetary authorities 1.) not let the housing bubbles run any further, but perhaps more importantly, 2.) not pop these bubbles in anything other than a careful, deliberate, and incremental fashion. That would be nice, but history shows us that there is a reason why we rarely see bubbles popping gently.Link here.
PENNIES FROM HEAVEN
As it turns out, investing in penny stocks -- specifically stocks that trade on the Nasdaq Bulletin Board (OTCBB) and Pink Sheets -- has quite a few advantages. Lots of naysayers. If you are a contrarian, the more the better. From Wall Street to Main Street, no group of stocks is more reviled. But both Barry Diller and Warren Buffett, two guys who know a thing or two about making a buck or two, have been generous Bulletin Board suitors over the years. Two years ago, Mr. Diller fell head-over-heels for online dating service uDate.com, now owned by Diller’s IAC/Interactive. Mr. Buffett has had multiple Bulletin Board partners, including Benjamin Moore, the famed paint manufacturer, and Fruit of the Loom, the famed Atomic-Wedgie provider.
There are rules, of course. Buffett and Diller do not buy indiscriminately and neither do champions of penny investing. Happily, these are rules most living investors already know, rules that are part of other living investing strategies. As with all their investments, penny investors diversify across a broad spectrum of industries, identifying and overweighting “hot” industries when appropriate, but never chasing. Because trading costs are the primary eroder of profits, penny investors limit their number of transactions. They are selective, demanding such performance drivers as robust top-line growth, a solid balance sheet, reasonable valuation, and technological advantage. Indeed, penny investors demand the same things of Bulletin Board stocks as they do of the Wal-Marts and Mercks of the world -- except for the slave wages/destroying small business thing and the killer drugs/impending legal action thing ... penny investors try to avoid those. Penny investing is nothing more than a contrarian strategy that targets the most maligned group of stocks -- as any good contrarian strategy would.Link here (scroll down to piece by Carl Waynberg).
A BEGINNER’S GUIDE TO THE “MULTI-CURRENCY SANDWICH”
There is a powerful investment strategy I call the “multi-currency sandwich” that not only dramatically increases profit potential but can also add safety to your portfolio. This tactic is almost unknown in the U.S., but is time tested and very popular in other countries. I first learned and cashed in on this strategy in the early 1980s when the U.S. was being ravaged by inflation. The U.S. dollar had dropped strongly versus the Swiss franc. It was possible to earn 18% on U.S. dollar CDs. When my Swiss banker told me that I could use U.S. dollar CDs as collateral to borrow Swiss francs at 3% and reinvest at 18%, I was hooked!
At that time, for each US$50,000 CD I held, I could borrow the Swiss franc equivalent of US$200,000 at 3%. I could then convert these francs back to dollars and put them on deposit at 18%. Assuming the Swiss franc-U.S. dollar exchange rate remained at parity, this strategy increased the return on my US$50,000 investment from 18% to 78%. Yet the investment became even better! The dollar then recovered about half the value it had lost against the Swiss franc, so when it came time to pay off the loan there was a huge foreign exchange profit as well. My total profit was well over 100%.
Since I first discovered this strategy, I have used it in many different currencies to make gains of 30% or more annually, with relatively low risks given the profit potential. And today, conditions in the currency markets make it attractive again -- in particular, low interest rates for loans in the Japanese yen, versus much higher interest rates available in Eastern Europe. For over a decade, I have used the yen as a funding currency for multi-currency sandwiches. I have been able to borrow yen at rates as low as 1.6% and reinvest the loan in investments that have yielded up to 25%, sometimes making over 100% per annum.Link here.
WILL THE FEDERAL GOVERNMENT NOW DO SOMETHING ABOUT THE COST OF ITS BORROWING?
Unlike most of George Bush’s White House team, for whom economics is a slave to politics, Gregory Mankiw, head of the White House’s Council of Economic Advisers, labors hard to square the president’s economic policies with sound economic theory. “When I wrote my first economics textbook,” he said in a speech earlier this month, “I told students to keep an eye on three indicators of economic performance: gross domestic product, inflation and the unemployment rate.” By these standards, he pointed out, the American economy is doing admirably. The Federal Reserve seems largely to agree. On Tuesday December 14th, it raised interest rates by another quarter of a percentage point to 2.25%, its fifth rate hike this year. Output has kept up its “moderate pace”, it said, despite recent rises in energy prices. Inflation remains “well-contained”, and the jobs market continues to improve, albeit gradually. The Fed thus saw no reason to break its measured stride towards a more neutral rate of interest.
But Mr. Mankiw’s better students know that high growth and low inflation -- what economists used to call “internal balance” -- are not the be all and end all of macroeconomics. Later chapters of their textbooks introduce them to “external balance”, telling them also to keep an eye on the economy’s balance of payments with the rest of the world. By this standard, America’s economy has a real problem. Mr. Mankiw neglected to mention the trade deficit in his speech, and the Fed’s rate-setting committee never mentions it in its statements. But it is on the minds of the committee’s members
As the Fed’s chairman, Alan Greenspan, said in a speech in Frankfurt last month, America’s lack of external balance -- its need to borrow huge sums from foreigners -- reflects a lack of national savings. He bears no small responsibility for this dearth: tempting households to abjure thrift and embrace debt was part of his strategy for rescuing America from its recession. But, as he was anxious to point out, the most effective way to “augment” domestic saving is for America’s federal government to curb its borrowing. How likely is that? Budget deficits, as Mr. Mankiw has pointed out, “are a mechanism whereby one generation of taxpayers passes the buck for its spending on to future generations.” That is why they are so insidious economically, and so attractive politically.
Mr. Mankiw and his boss in the White House no longer have to worry about facing the voters. Thus the president’s budget proposal for this fiscal year showed somewhat tighter fists. Goldman Sachs warns that Medicare will start shelling out for seniors’ prescription drugs starting 2006. Defence spending may not stop at 4% of GDP, as the government’s forecasters predict, but head up towards Reagan-era levels of 5-6%. And America’s politicians are unlikely to allow the Alternative Minimum Tax, which was meant to apply only to the highest earners, to ensnare ever greater numbers of taxpayers. Besides, though Mr. Bush does not have to face the voters again, his allies in Congress do. Thus the fists may soon start to loosen on domestic spending.
According to William Gale and Peter Orszag of the Brookings Institution, a think-tank, America’s budget deficits are likely to average about 3.5% of GDP for the remainder of the decade. As the government continues to gobble up America’s scanty savings, it will crowd out the investment on which America’s prosperity depends. By 2014, reckon Messrs Gale and Orszag, the deficits will have reduced America’s wealth by roughly 20-30% of GDP. That is no good in anyone’s textbook.Link here.
WEAK DOLLAR SENDING MORE U.S. INVESTORS ABROAD
Americans have been stepping up their purchases of foreign stocks and bonds as the dollar’s decline has accelerated and foreigners have slowed their buying of securities in the United States. Such a shift overseas may bring American investors better returns. But the sending of dollars abroad to buy foreign stocks and bonds, combined with the declining interest of foreigners in the U.S., promises to put further pressure on the American currency. As of the end of October, Americans have bought $51.9 billion of foreign stocks and bonds, compared with $36.2 billion in all of 2003, according to Treasury data released yesterday. With two months to go, that is the largest foray into foreign markets by Americans since 1997.
With the dollar falling, returns on foreign investments are enhanced -- or losses are reduced -- when they are translated back into a weaker American currency. For example, Germany’s benchmark DAX index of 30 blue-chip stocks has risen 6.3% this year. But it is up 13.1% when it is translated back into dollars. Indeed, some American money managers have been moving a lot of money into foreign stocks and bonds since the dollar began to decline almost three years ago. But the recent fall in the dollar, which has amounted to 6.3% against a broad index of foreign currencies since August, is intensifying the focus on investing abroad.
The U.S. Treasury market, however, continues to remain relatively immune from the weak dollar. The price of the 10-year Treasury note rose Wednesday, sending its yield, which moves in the opposite direction, down to 4.07% from 4.12% on Tuesday. The desire of Americans to invest abroad is being fueled by more than just the weak dollar. Analysts argue that in countries like Britain, Americans can also earn about twice the interest rate on shorter-term British bonds than on comparable Treasury securities. In addition, analysts say that many foreign stock markets are less expensive in terms of valuation, compared with the American stock market.
Several analysts warned yesterday, however, that investors should be cautious when buying foreign stocks based on the assumption that the dollar will fall further. They believe that the dollar can decline further from here. But they also agree that a lot of the dollar’s drop may have already occurred, so that gains from dollar weakness in the future may not be as good as in the last three years.
There seem to be some indications that while many investors were flocking abroad, some hedge funds may have been selling foreign stocks and bonds. The October data for the Caribbean, which includes countries that are the headquarters for a lot of hedge funds, shows that there was net selling of foreign stocks and bonds totaling $4.3 billion.Link here.
HOUSES ON STEROIDS?
Housing and home equity have been the performance-enhancing drug that pumped up the U.S. economy for several years now. Most conventional economists have said that “consumer spending” played this role, but you do not have to dig very deeply to see the facts. Nearly $400 billion in home equity was “cashed out” -- converted into debt -- and homeowners in turn put it into the stock market or spent at the mall.
Likewise housing starts and GDP growth. In Q2 of 2004, for example, GDP grew at a 3.3% rate. Yet if you remove the “residential home construction” component from that figure, the number falls to 2.44% -- and this no exception. Home construction played this role in quarterly GDP growth for several years, but a strong hint of trouble in paradise did appear in the Q3 data; GDP growth came in at 3.9%, and would only have fallen to 3.8% without home construction.
This brings us to today’s housing starts figure, which in November showed the largest one-month drop since 1994. What does it mean? We have long covered the housing bubble, especially this year. The November issue of The Elliott Wave Financial Forecast discussed the trend that is unfolding even now, with a trail of evidence running from New England to Detroit to Las Vegas to Southern California. Home prices are either flat or falling fast, accelerated by the growing inventory of unsold properties. What is more, this trend has a context that is much larger even than the real estate market itself. Our analysis provides that context, in a way that you can use.Link here.
THE LESS IT COSTS, THE LESS THEY BUY?
Four years ago, foreign investors loved to buy British assets -- stocks, mostly. In 2000, direct foreign investment in the UK totaled £78.5 billion. That was a very good year. But then the bottom fell out. In 2001, as the FTSE began its deep correction, direct foreign investment in Britain was cut in half. In 2002, it collapsed to only £16 billion. And in 2003, Britain got even less, only £12.4 billion. But is it not curious that as British stocks were getting progressively cheaper year after year, foreign investors wanted to buy fewer and fewer shares?
The law of supply and demand says that the opposite should have happened. As the price of goods works its way to the “right” level the demand for goods should be increasing. So when British stocks were falling in 2000-2003, the demand for them should have been getting stronger, not weaker. But it did not happen. Why? Because the law of supply and demand works differently when it comes to financial assets. At a retail store, lower prices usually mean higher sales. At a stock exchange, it is usually the other way around. Prices for stocks do not act like prices for shoes and bread.
We all know how “unreasonable” investors can get -- just remember the dot-com bubble. But still, there must be some logic, some mechanism that governs investors’ mass psychology. What is it? It is the Wave Principle. Traditional economic theory does not offer a useful model of finance. The Wave Principle does.Link here.
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