Wealth International, Limited

Finance Digest for Week of December 20, 2004

Note:  This week’s Offshore News Digest may be found here.


The S.E.C.’s smackdown of Fannie Mae should upset not only the company and its arrogant executives. It should also embarrass the Wall Street analysts who reassured investors last September that the S.E.C. would probably take a friendlier view of the company’s accounting than did its other regulator, the Office of Federal Housing Enterprise Oversight. Instead, the S.E.C. said last week that Fannie Mae, the giant mortgage company, must restate its earnings for the past four years.

But because shame is simply not in the typical brokerage analyst’s DNA, investors were given further assurances that all remained fabulous in the house of Fannie. According to one of the shills, removing $9 billion in earnings from Fannie Mae’s results since 2001 (Fannie’s own estimate, by the way) would have “no economic significance”. Of course, these are the same people who have never met a corporate management team they did not like. And the steady stream of bounteous investment banking fees Fannie Mae provides to Wall Street probably does not hurt, either. In any case, the analysts’ utterances had the desired effect: Fannie’s stock fell only 0.5% by the end of the week.

A few analysts are not under Fannie Mae’s spell, however, and they take a different view. One such skeptic, Josh Rosner, an analyst at Medley Global Advisors in New York, said that while the company’s regulatory woes were the immediate problem, other forces out of Fannie’s control would put significant pressure on its business of buying and selling billions of dollars in mortgages. On the subject of Fannie Mae, Mr. Rosner is worth heeding. For a year, he has been warning clients about coming Fannie Mae woes; his has been a lonely voice of reason on the company’s prospects. Mr. Rosner said that even after Fannie Mae works out its differences with legislators who want to rein it in and with regulators who want more conservative accounting, its troubles are far from over. That is because the mortgage market is changing, and those shifts are sure to lessen the company’s dominance and, more important, cut into its income growth.

In making his case for why the landscape around Fannie Mae is forever changed, Mr. Rosner pointed to three major shifts. First is the fact that the 30-year fixed rate mortgage, the highly profitable loan that is Fannie Mae’s stock in trade, appears to be losing some appeal among homeowners. A second element that could undermine Fannie’s business in coming years relates to new capital requirements expected in 2006 from the Bank for International Settlements, which will significantly increase the economic incentives for banks to hold onto mortgages, especially those with the most predictable credit and cash-flow characteristics -- and cut into Fannie Mae’s growth. Another worry is the prospect for a decline in the fees that Fannie Mae earns from banks for guaranteeing loans, a big source of its income. Fannie Mae charges guarantee fees that are roughly double those assessed by the home loan banks. Mr. Rosner said that this could soon change, further pressuring Fannie Mae’s profit margins.

Mr. Rosner concedes that these may be longer-term concerns. More immediately, he fears a possible wave of mortgage defaults. After all, mortgage defaults typically occur from three to five years after the loans are written. The flood of refinancing in recent years means that a great majority of outstanding mortgage loans are less than three years old. Defaults could rise substantially. Why Fannie Mae shareholders are so unfazed by the company’s mounting problems is a mystery.

Sean Egan, president of Egan-Jones, an independent debt-rating firm that does not receive payments from companies it analyzes, said he was surprised by the denial at work among Fannie Mae’s investors and debt holders. “All big failures are built on false assumptions,” he said. “The tulips were always going to be in short supply, so prices were always going to go up. In the case of Fannie Mae and Freddie Mac, they have terrific assets -- mortgages that have historically been a low-default asset. And the federal government is going to stand behind them.” What if one or both assumptions are false? “If Fannie Mae gets into difficulty,” Mr. Egan said, “It’s highly likely that current investors are not going to get paid back in full and on time by the federal government.”

Link here.

Fannie Mae’s top executives leaving firm.

Franklin D. Raines has stepped down as chairman and chief executive of Fannie Mae, as the company’s directors ended days of tense and emotional deliberations and bowed to pressure from regulators who wanted him out. J. Timothy Howard, the company’s longtime chief financial officer, also is leaving. Raines’s departure was structured as an early retirement. Howard resigned. The departures come less than a week after the S.E.C. directed the giant mortgage-funding company to make accounting corrections that could erase $9 billion of past profit.

The housing finance company, which stands behind or owns a quarter of the nation’s mortgages, faces a criminal investigation by the Justice Department; a civil investigation by the S.E.C.; an ongoing probe of other accounting issues by its main regulator, the Office of Federal Housing Enterprise Oversight; and class-action lawsuits by investors. In addition, Fannie’s board has hired outside lawyers to investigate the regulators’ allegations.

The government-sponsored company has been on the defensive since September, when OFHEO alleged that Fannie had systematically manipulated accounting estimates, ignored accounting requirements it had lobbied unsuccessfully against and operated with weak internal controls that helped obscure the other problems. The report said Fannie Mae delayed booking $200 million of expenses in 1998, which allowed Raines and other top executives to receive millions of dollars in bonuses linked to Fannie’s profit. A source with knowledge of the board’s recent deliberations described a sometimes painful debate. Raines, the source said, at times argued passionately that he had done nothing wrong.

Link here. Fannie Mae’s accounting crisis timeline -- link.


One-half of Americans say they worry about the money they owe, and many say they worry most of the time about their overall debts, an Associated Press poll found. Those debts can come from home and car loans as well as credit cards -- even more so with December buying sprees. Three-fourths in the poll said they have credit cards. Four in 10 of those with credit cards said they will use plastic to help pay for their holiday spending this year. Most of those who are using credit cards said they would pay off their holiday expenses when their next bill arrives. About one-fourth of those with cards said they use credit for purchases when they do not have the cash.

Most with credit cards said they carefully manage the debts on those cards, which often have high finance charges on unpaid balances. A sizable minority of them admitted to having serious problems with credit cards. Some 16% of those with credit cards said they do not trust themselves to manage their own credit card debts. For many, their debts cause stress; 20% of all adults in the poll said they worry about their debts most of the time. Experiencing the highest levels of stress from debts were people at their credit card spending limit; those who are unmarried and have children; those without jobs; and minorities. Those with the lowest levels of stress from debt were retirees, Republicans, married people, college graduates and people between age 30 and 49. Those groups’ stress levels were measured based on their responses to a series of questions asked of 1,000 adults about debt and stress.

The total amount of revolving credit debts, such as that caused by credit cards, was just over $600 billion five years ago and is almost $800 billion now, according to the Federal Reserve. In the survey, about 10% of those with credit cards said they have missed making their minimum payment during the past six months. Economists say people are missing fewer credit card payments by juggling their debts and getting new credit cards. One-fourth of those in the poll said they have no credit cards.

Links here and here.

Internet lenders combine high fees with anonymity.

Sharon Jackson repaid one debt from an Internet lender but was soon borrowing again. This time it was harder to repay the loan on top of other bills, and she found herself borrowing from other online lenders. By September, online lenders were withdrawing about half of her paycheck from her bank account to cover loan fees. A 36-year-old accounting assistant at a law firm fell into the familiar debt trap of payday loans, this time with a new and potentially riskier twist: Internet payday lending. These loans come over from faceless people in other states or countries who gain access to borrowers’ bank accounts to assure repayment and fall outside easy reach of state regulators.

Payday loans are small cash advances, usually $500 or less, on the borrower’s next paycheck. Web sites advertising these short-term loans charge as much as $30 per $100 borrowed, or an annual percentage rate of about 780% on a two-week loan, according to the Consumer Federation of America, which recently released a survey on Internet payday lenders. Payday lenders sprang up in storefront operations in the 1990s. With these operations, borrowers get a cash advance and, in return, give a postdated personal check for the advance and finance charge that the lender can cash after their payday. But with the Internet, borrowers fill out an application online, print it and send it to the lender. Instead of using a check, borrowers give online lenders permission to debit their bank accounts. Borrowers often can renew the loans and pay only the finance charges.

When problems arise, borrowers and regulators often have trouble tracking down lenders. And giving lenders access to bank accounts can backfire. “It makes it possible for a lender to ding your account over and over,” Consumer Federation’s Jean Ann Fox said. “It’s hard to turn it off. You can’t find them.” To qualify for these loans, borrowers generally must be 18 or older with a checking account and monthly income of at least $1,200, or $800 for those on Social Security. Fifteen states prohibit payday loans. Payday Connection posts examples of its loan terms online that range from an annual rate of 521% for $100 borrowed for three weeks to 1,564% for a $500 one-week loan.

Link here.

Not the whole story, but a great “outline”.

Statistics rarely tell “the whole story”, yet they can often help you understand the plot. The whole story of they way consumers use credit today would no doubt fill a book, requiring several chapters just on credit cards. But my space here is limited, thus my use of the statistics in the table below. The data comes from a recent New York Times article, though I calculated the percentage increases.

                                          Avg. revolving
          Cardholders     Charge volume       balance          Fee revenue   Pretax profit
1990       82 million    $338.4 billion        $2,549         $6.2 billion    $6.4 billion
2004      144 million  $1,524.6 billion        $7,519        $21.5 billion   $29.8 billion
% increase    76%            351%                195%             250%           306%

Two points are especially worth mentioning. First is the “average revolving balance”, because it comes only from the 60% of credit card customers who carry a balance. They subsidize the monthly interest-free loans enjoyed by the 40% of customers who pay in full each 30 days. Second are the percentage increases. It is not unusual for the number of cardholders to grow by 76% in 13 years, but note the disproportionate way they use their cards; the average balance and charge volume have exploded, with an immense transfer of wealth into the coffers of lenders.

None of this is to suggest inappropriate business practices on the part of credit card companies; the terms of use are in the spelled out in those small-print booklets that nobody reads, which arrive in the same envelope as the new credit card. As for the wisdom in using credit cards this way, well, that is a whole ‘nother question. Then there is the matter of how much longer it can continue. Problems like this one develop slowly -- 13 years slowly -- and do not appear to be a problem at all, because no one wants to draw attention to it. Consumers want their credit, and what the card issuers want speaks for itself. You do not have to be anywhere near the train wreck. Safety begins with seeing the danger before the herd does, and getting out of the way.

Link here.


Dozens of countries, mainly in the Middle East and the Americas, define the value of their currencies through a fixed exchange rate with the dollar. Many others, especially in Asia, keep their currencies tightly linked to the U.S. currency. In these regions, the dollar’s dive on world markets has been a watershed event, since it has taken their currencies with it. In the past, countries like Argentina and Mexico devalued their currencies as a last resort to stave off or escape from financial crises, often long after economists and investors had started calling for such action. So could this gradual devaluation, imposed from outside, be giving some countries just what they needed?

A few years ago, the answer might have been a resounding “yes” from countries around the world that struggle to compete in export markets. But for some, the growing importance of the euro has made today’s reality more complex. Lebanon, for example, maintains a strong link between its currency and the dollar, but its position as a gateway between the Middle East and Europe has tied its fortunes to the euro as well. “The short answer is that the dollar’s depreciation is neither a clear-cut boon nor an unmitigated bane to Lebanon,” Adnan Kassar, a banker who recently became Lebanon’s minister of economy and trade, e-mailed in response to questions.

Before the euro, a falling dollar might have helped Lebanon close its trade gap by making Lebanese exports cheaper and imports more expensive. It might also have eased repayment of some of the government’s debts, to the extent that revenue in other currencies could be used to pay interest on dollar-denominated loans. At the moment, however, these effects range from uncertain to impossible to tell. “To the extent that the pound is linked to the dollar, this does imply a depreciation of the Lebanese pound in real terms,” said Samir Makdisi, a former minister of economy and director of the Institute of Financial Economics at the American University of Beirut. “At the same time, it is not known to what extent the depreciation of the pound will serve as a corrective mechanism in terms of improving the trade balance of Lebanon.”

Other countries in the Middle East may look glumly upon the dollar’s decline for a different reason. They run big trade surpluses because of their oil exports, and, if anything, their currencies might gain value if left to float freely on global markets. But for now, a weaker dollar means their consumers must pay more for European imports like sports cars and designer clothing. Outside the Middle East, the weakening dollar certainly has benefited some countries. “If you talk about winners and losers, definitely a winner is a place like Ecuador,” said Alberto Ramos, senior economist for Latin America at Goldman Sachs. Ecuador has no currency of its own. Instead, it simply uses dollars that are already in circulation. As a result, prices that foreigners pay for Ecuadorean exports can change because of factors that have much more to do with the American economy than with Ecuador’s.

Link here.


Investments in Asian hedge funds have nearly doubled this year, reflecting a growing influx of U.S. capital after years of reduced exposure to the region. Total assets have jumped to about $60bn in mid-December from $34 billion at the end of 2003, according to Eurekahedge, the Singapore-based consultancy. AsiaHedge, its London-based rival, believes assets will have climbed to more than $70 billionby the end of this year.

While global hedge fund returns have fallen sharply this year, Asian hedge funds have continued to outperform their more mature rivals in the U.S. and Europe. Some industry experts point to the fact that Asian financial markets tend to be less heavily researched than their more developed counterparts, creating market inefficiencies that hedge funds seek to exploit. This has not been lost on the big U.S. hedge fund groups, many of which cut their exposure to the region following the 1997-98 Asian financial crisis. At the time some Asian politicians accused hedge funds of making speculative trades on the rise and fall of the region’s currencies, contributing to their collapse.

Some industry experts warned that U.S. funds of hedge funds might find it increasingly difficult to invest in Asian hedge funds, because the latter may not want to be exposed to U.S. regulatory scrutiny. Meanwhile, overseas investors have been benefiting from the growing breadth of Asian hedge fund strategies. “We might see the launch up to 140 new hedge funds over the next 12 months,” said Paul Storey, at AsiaHedge. “But if the Asian financial markets perform poorly, many of these funds won’t get beyond the planning stage.”

Link here.


As President Bush prepares to disclose the details of his plan to funnel hundreds of billions of dollars of future Social Security funds into privately held investment accounts, Wall Street has begun a muted lobbying campaign, chastened by bolder forays that failed in years past. So far, the chief executives of most financial firms have refused to take a public stand in support of private accounts, wary of being seen as too eager to embrace a potential new revenue stream. At last week’s White House economic meeting in Washington, they were conspicuous in their absence from the Social Security panel. Even in direct meetings with President Bush, who actively campaigned on the issue of Social Security, executives have shied away.

There are signs, however, that the industry is becoming a little more aggressive in pushing for private accounts, through a loose assemblage of trade associations, business coalitions and conservative research centers. These groups have lately begun trying to raise money from business interests and to marshal support on Capitol Hill, while also seeking to deflect criticism that Wall Street is behind the move simply to reap rich rewards for administering the accounts.

Opponents of personal accounts, led by labor unions and some state pension funds, accuse the groups supporting private accounts of acting as a stalking horse for the financial industry. “Our sense is there is a lot of activity behind the curtain,” said Bill Patterson, the director of the office of investment at the A.F.L.-C.I.O. “There is a dangerous confluence between the industry and the ideologues of the right. These groups can’t do it by themselves -- they need the covert and overt support of the financial services industry.”

Link here.


Some of the most painful errors in economic policy resulted from the belief monetary problems were not monetary but fiscal -- caused by budget deficits. Blinded by such fiscal fundamentalism, President Hoover persuaded Congress to triple income tax rates in 1932, President Lyndon Johnson proposed a surtax as a counterproductive alternative to Federal Reserve tightening in 1968-69. A series of Japanese governments imagined wasteful public works schemes and new taxes on consumers and investors would somehow undo the Bank of Japan’s prolonged deflation. Over the past two decades, the U.S. dollar has often gone up and sometimes down. Although these ups and downs were transparently unrelated to budget deficits or surpluses, apostles of the quaint Keynesian faith have nonetheless misspent two decades alternating between predictions that budget deficits must push the dollar up or down.

The real reason U.S. imports grew faster than exports during the long economic expansions after the recessions of 1981-82 and 1990-91 is that the U.S. economy was growing faster than those of its biggest export markets. That is still the reason. For the year ending in the third quarter, economic growth was 1.8% in the euro area, 2.6% in Japan and 4% in the United States. Any proposal to “fix” the current account deficit by imposing brutal European or Japanese tax policies on the United States simply aims to weaken the U.S. economy and thus reduce demand in general, including demand for imports. It “works” only in the same sense recessions have always cut our need for imported industrial materials, components and equipment, and our ability to pay for them.

Today, as in the 1980s, the U.S. is again said to be at grave risk if foreigners suddenly decide to sell their U.S. stocks and bonds. This is often said to threaten the dollar, but that too confuses fiscal policy with monetary policy. The $1.9 trillion in daily trades on the foreign exchange market, mainly involving dollars, is settled with cash, not Treasury bills. You cannot offer to trade dollars for euros unless you either have the dollars in a checkable fund or are willing and able to sell something quickly to get the cash. Selling U.S. Treasury bills or bonds is one way to get dollars, but selling labor (wages) or goods (exports) are much bigger ways of acquiring dollar cash. Neither buying nor selling Treasury bills can add to the world’s supply of dollar cash. The world supply of dollar cash is unaffected unless our own Fed buys those Treasury bills, paying for them with new bank reserves and thus allowing banks to create new money by making loans or buying securities.

Another reason not to worry about foreigners becoming unwilling to finance the U.S. trade deficit (by investing extra dollars earned from exporting) is that this so-called problem is identical to what the worriers describe as the solution. If the current account deficit could not be financed, then it could not exist. Hard landing zealots begin by fretting about the gap between imports and export, and end by fretting the gap might disappear. They also claim trade deficits are bad because they will make the dollar fall, but the falling dollar is good because it will shrink the trade deficit. If a falling dollar reduces the trade deficit and a shrinking trade deficit lifts the dollar, then it follows a falling dollar must make the dollar rise. All this makes as little sense as the related pretense that “restoring confidence” in a currency depends on higher taxes.

Link here.


During “how long is a minute?” game at a children’s birthday party I realized a very important lesson about life, and investing. The game started with the kids sitting on the floor. Sitting in front of them was a mom, who held a stopwatch so that none of them could see its face. She clicked “go” on the watch, and then it was up to each kid to tell her when they thought a minute had gone by. Whoever was closest to an actual minute, won? Since I was getting a bit bored, I decided to play along in my head. Most of the kids started fidgeting as soon as the game started. You could see their minds racing, “Has it been a minute yet? This is way too long ... should I say, ‘stop’?” I just stood there calmly counting. Years ago, when I was responsible for timing a race between some friends of mine without a watch, I had discovered a method of counting seconds. Basically, I would click my tongue twice after each number, and that clicking would be the span of a second. It was the equivalent of counting, “1001...1002...1003...”.

So while all of these kids were working themselves into a frenzy, I simply stood there counting and clicking to myself. I knew I had a method that worked, and I did not need to worry about anything. Sure enough, I was within a second and a half of an actual minute, and I won, hands down. Of course, I did not say anything out loud, and some kid named Robby took the prize despite being off by 20 seconds. I was thinking about this episode the next day when I was talking about investing with a friend. “Don’t you worry about your money?” he asked, “everyday you’re watching yourself making or losing money. The market is continually moving. How can you stand it?”

The thing is, I do not worry about investing, just like I did not worry about when to yell stop in “How long is a minute?” I am not implying that I do not get concerned about my money, but I certainly do not lose any sleep over my investments. The reason is, that I know I have a method that works. In fact, I am certain it works. Not only from my own experience, but because I have read numerous studies that validated my own thinking, “tracking insider trading can make for some terrific gains”.

I am not the only one. If you look at each of the editors here, you will see the same mentality. They all have techniques that they know work, and they do not deviate from them. I know all of these guys personally and none of them fret or worry about investing. They know they have strategies that work, they do all of the research they can to find out about their picks, and then they sit back and wait for the profits to come. And they do not deviate from their personal trading styles. To paraphrase Peter Lynch, they buy what they understand.

It is not that great investors are inflexible. It is just that then do not run around following hot tip after hot tip, trying to make money. They find something that works, and they stick with it. And of course there is some overlap between methodologies. In my case, I do not just buy stocks that have a lot of insiders buying. Rather, I buy stocks that have a lot of insiders buying, that are also cheap, growing, and small. If I can find a stock that meets all of those criteria, I know it is a good investment and I do not have to worry about what is going to happen. Again, this does not mean that I am not careful or concerned. It simply means that I have done everything I can to find out about this company’s business, and I know that good things should happen to it in the future. Then it is just a matter of counting the days, and the dollars.

Link here.


U.S. house prices rose 13% in the year to Q3, including an astonishing 42% leap in Nevada, 27% in California and 23% in Washington DC. Prices have risen a long way on the coasts over the last 7 years with gains of 134% in California, 103% in Massachusetts and 92% in New Jersey and 89% in New York. Inland regions have generally been more stable so the nationwide average gains since 1997 is a more moderate 65%. Nevertheless, with house price inflation accelerating, it looks as though the United States is in the early-to-middle stages of a bubble. In the U.K. and Australia more advanced bubbles are key factors in economic performance and monetary policy. The U.S. is likely to go the same way.

One of the causes of the bubble is that people seem to have forgotten that house prices can fall as well as rise. And the risks of a significant fall are more acute now than for over 50 years because of the low rate of inflation in consumer prices and the threat of deflation. Between the 1950s and the mid-1990s falling consumer prices, deflation, was virtually unknown anywhere. The world’s attention was focused entirely on battling rising prices, inflation, which had become the number one economic problem. But by the late 1990s the battle against inflation was won and deflation had emerged in several countries in Asia including Japan.

Deflation is a new and troubling threat for all of us, brought up in an era of continuous inflation. Almost nobody alive today, even the venerable Mr. Greenspan, was an active market participant or policy-maker in the 1930s, the last time the U.S. suffered deflation. Yet, during the 19th century and right up to the 1930s, deflation was common, indeed even normal, while inflation was usually only seen at the height of economic booms and in wartime. In the U.S., deflation is still only a hypothetical possibility, but in Japan it is a painful reality. As of the end of 2004 Japan’s price level has fallen a cumulative 10%.

A world of very low inflation, and potentially deflation, makes the current house price bubbles more dangerous than in the past and, from an investor and homeowner point of view, means that houses are a more risky investment. After past price bubbles, house price adjustments were limited in nominal terms by the cushion of high underlying inflation. For example, Californian home prices fell 10% in nominal terms in the early 1990s, with a 24% decline in real terms.

How much effect would a fall in house prices have on the economy? The bursting of the 1990s stock market bubble wiped about $5 trillion off U.S. household wealth. It would take a 33% fall in home prices to have the same impact. A decline of this magnitude cannot be ruled out if valuation ratios for housing, such as the house price-earnings ratio or the house price-rents ratio returned to past cyclical lows, but it would only be likely in the context of a serious recession and a new rise in unemployment. However, wealth effects from declining house prices are usually found to be more virulent than those from falling stock markets, so a fall of “only” 10-20% in house prices could present Mr. Greenspan, or his successor, with a similar headache to the aftermath of the stock crash.

How likely is a U.S. housing bust? The economy enters 2005 with considerable momentum and with interest rates still low so it seems likely that house prices will continue to rise for a while, inflating the bubble further. But house prices will also depend on whether the growing signs of a bubble mentality, now evident in some regions, extend further. The ideal outcome from here would be a period where house prices were broadly stable, allowing earnings and rents to catch up and valuations to moderate. The most dangerous scenario is if house valuations are still extended when the next major shock hits the U.S. economy. The U.S. avoided a major recession in 2001, with the help of massive fiscal stimulus and rapid cuts in interest rates. But another downturn will come one day and, if house building and consumer spending crashes too, the recession will be more severe than in 2001. In a low inflation world, housing bubbles are a much more dangerous phenomenon.

Link here.


There are two ways to be uninformed. 1) To know that you lack knowledge. 2) To be ignorant of your own ignorance. To know that you lack knowledge can actually be a kind of wisdom, especially if you go get the education or experience that you need. But a person who is ignorant of his or her own ignorance ... well, you will want to stay at a safe distance when that individual decides to take risks. The hard truth is, the second definition applies to most investors. In the coming political debate over Social Security and private investment accounts, this truth will very likely be the elephant in the corner that everyone pretends is not there.

Here is what I mean: About this time last year, the results of a very revealing survey made the news. The National Association of Securities Dealers (NASD) hired a research firm to conduct “a nationally projectable survey of individual investors across the United States,” which involved more than a thousand adults “who performed at least one stock, bond, or mutual fund transaction between October 2002 and early April 2003.” It showed that 48% of these investors believed that their money is “insured against losses in the stock market”. This exceeded the 38% who knew that their money is NOT insured against losses; the remainder either “didn’t know” or “weren’t sure”. Other questions in the survey revealed equally shocking examples of ignorance and misconception, such as only one in five investors knowing that a “no load” mutual fund is one that carries no sales or commission fees.

Most disturbing of all was that investors are woefully ignorant of their own ignorance. They did not even know how wrong their answers were to the most basic financial questions: 69% of respondents said they are “somewhat knowledgeable” about investing, while 81% said their overall investing knowledge “had increased over the past three years”. The major media looks at the Social Security “reform” story from a purely political perspective, such as today’s New York Times story that emphasized the way Wall Street is quietly “lobbying” for privately held investment accounts. The story included a list of which Wall Street firms contributed the most to President Bush’s reelection campaign. Not that these issues are irrelevant, but what scares you more: The Wall Street lobby, or millions of investors who think their stock market losses are “insured”?

Link here.


The weak dollar has been a disaster for Americans traveling to or living in Europe. But for Europeans, it has been a godsend -- so much so that this year, many Europeans are making a trip across the ocean to do their Christmas shopping in America. Even after travel expenses, they still save a bundle on brand-name merchandise vs. what it costs in the Old World.

There is also another, slightly more unexpected consequence to the dollars weak position. In the past few months, Americans have been returning the favor to Europeans by buying up European stocks and bonds. The New York Times reports that both individual and professional U.S. investors are increasingly shifting their focus to Europe because of higher returns. In fact, 1997 was the last time U.S. investors were this hungry for European assets. What makes European markets so attractive these days? Well, the weak dollar, first of all. Once you transfer your European investments back into dollars, the weaker exchange rate helps boost your returns -- or helps reduce your losses.

But there is more to it than just the weaker dollar. Some short-term British bonds, for example, are now returning about twice as much as the U.S. Treasury bonds of the same maturity. Price-to-earning ratios of some European stock markets are now much lower than those in the U.S. For example, the average P/E ratio of the British FTSE 100 now stands at about 14. By comparison, the S&P 500’s average P/E is around 20. But if the U.S. dollar suddenly gains against the euro, many of these benefits will be lost. Analysts warn U.S. investors to be “cautious” in their expectations of further declines in the dollar. Is there still time for you to take advantage of this new trend?

Link here.


According to the December 21 New York Times, shoppers cannot reach the trains, teddy-bears, and toy soldiers in the windows of the newly re-opened FAO Schwartz without first passing by a few store-front display cases of a less wholesome nature: “Instead of the customary Santas and sprigs of mistletoe,” mainstream department stores such as Saks, H&M, and Bendel have positioned “skivvy-clad mannequins in languid poses” in their facades, making them “more evocative of sex shops than Fifth Avenue fashion emporiums.” One of these Christmas display windows -- styled by the costume-designer for the HBO hit series “Sex and the City” -- stands “cater-corner from St. Patrick’s Cathedral.”

But the way these retailers see it, there is nothing the matter here. As one manager explains, “There was a time when if you wanted a garter belt, you would ask for it in a low tone. Now, it’s a thing that’s out in the open... [Our] customers are in the mood for love -- the playfully kinky variety.” They aren’t kidding -- A recent market research firm confirmed a 6.2% jump in lingerie sales over the previous year, compared with a rise of only 1% in total apparel sales. Like it or not, sex is selling -- from the Big Screen to Bestsellers to Broadway and back. So, of course, retailers have decided to “flout taboos of their own”.

And the naked truth is, we are not surprised. The soaring success of sexually explicit fare is a perfect manifestation of the current mass social mood. From the October 2003 Elliott Wave Theorist: “Generally, all kinds of social units will trend toward the style of behavior [as characterized] by a downturn in social mood. We can attempt some specific forecasts... based upon the conjecture that social mood is about to accelerate toward the negative.” To name a few: “There will be an increased ‘interest’ in sex... hedonism will flourish, pornography will become more bizarre,” the risqué will take on more risks... you get the point. So, while you may want to shut your eyes to certain window displays on Fifth Avenue, the fact is -- they are actually quite eye opening as to the larger trend unfolding in the financial markets.

Elliott Wave International Dec. 21 lead article.


China’s thirst for oil has brought it to the doorstep of the United States Chinese energy companies are on the verge of striking ambitious deals in Canada in efforts to win access to some of the most prized oil reserves in North America. The deals may create unease for the first time since the 1970’s in the traditionally smooth energy relationship between the U.S. and Canada.

Canada, the largest source of imported oil for the U.S., has historically sent almost all its exports of oil south by pipeline to help quench America’s thirst for energy. But that arrangement may be about to change as China, which has surpassed Japan as the second-largest market for oil, flexes its muscle in attempts to secure oil, even in places like the cold boreal forests of northern Alberta, where the oil has to be sucked out of the sticky, sandy soil. “The China outlet would change our dynamic,” said Murray Smith, a former Alberta energy minister who was appointed this month to be the province’s representative in Washington, a new position. Mr. Smith said he estimated that Canada could eventually export as many as one million barrels a day to China out of potential exports of more than three million barrels a day.

Chinese companies are also said to be considering direct investments in the oil sands, by buying into existing producers or acquiring companies with leases to produce oil in the region. In all, there are nearly half a dozen deals in consideration, initially valued at $2 billion and potentially much more. Higher oil prices have recently made oil sands projects profitable, justifying the expense of the untraditional methods of producing oil from the sands. Large-scale mining and drilling operations are required to suck a viscous substance called bitumen out of the soil. Canad’qs oil production from the sands surpassed one million barrels a day this year and was expected to reach three million barrels within a decade.

China’s appetite for Canadian oil derives from its own insatiable domestic energy demand, which has sent oil imports soaring 40% in the first half of this year over the period a year ago. China’s attempts to diversify its sources of oil have already led to several foreign exploration projects in places considered on the periphery of the global oil industry like Sudan, Peru and Syria.

Link here.


Although the federal government stopped giving away free land when it repealed the Homestead Act in 1976, cities, school districts, economic development groups and individuals in rural communities have been donating land for the cause. In Ellsworth County, Kansas, for example, there are 23 lots available for free to individuals, assuming they are pre-qualified to build a house that is at least 1,000 square feet and agree to build a house on the land within two years time.

In addition to the land, families with children stand to receive $1,500 to $3,000 toward a down payment when they buy in the area. In nearby Marquette, 80 building lots became available for the taking in May, according to Carol Gould, director of the Kansas Center for Rural Initiatives at Kansas State University, and nearly half have been claimed. In Minneapolis, Kansas, newcomers not only have dibs on free land, they qualify for a 75% rebate on city and school taxes for five years.

Some rural communities in North Dakota have similar incentives. New residents of Crosby, for example, are eligible for free land and welcome package that includes free memberships to the golf club, hockey club and curling club, as well as $500 worth of gift certificates redeemable at local businesses. These efforts may be paying off. According to Census statistics released this week, North Dakota’s population between July 2003 and 2004 grew for the first time since 1996.

You do not need to become a truck driver to move to a small town. At the same time rural communities are recruiting new homeowners, they are also going out of their way to attract entrepreneurs and telecommuters who, they think, can benefit from the low cost of living, tax incentives, skilled labor pool and the do-anything spirit of a small town. It goes without saying that if you are serious about quitting the city or suburbs for the simplicity of a small town, you will want to make sure you can handle life without Starbucks and the multi Cineplex. Meanwhile, you can get more information about free land and other small-town goodies online.

Link here.


If you enjoy watching average people rush headlong into hazardous situations, all in the hopes of winning a bag full of cash, we have got two words for you -- and they ain’t “Reality T.V.” Try “Wall” & “Street.” See, according to the December 21 Financial Times, “US high yield, or junk bond issuance has reached record levels this year, edging ahead of the all-time high set in 1998.” Not to mention the fact that the spread between these “high yield” bonds and U.S. Treasury bonds is at the highest level in 14 years.

It is as if a rapidly growing number of investors hoped to earn their spoils by pedaling a stationary bicycle while strapped to the wing of a low-flying airplane as it somersaults through the narrow gorge of a mountain range. And why the heck not? After all, in the eyes of the “experts”, the risk is worth it. Ah, but the (dare)-devil doth lurk in a few major details, such as that while the junk bond rate of default (i.e., failure to repay) fell to 9.2% in September from 9.6%, this number is still well beyond the bounds of what is considered healthy territory: To wit, the average annual junk bond default rate from 1970 to 1999 was 3.45% ... not to mention that on a dollar-volume basis, September’s junk bond default rate was actually 18.3%.

The clincher is, junk bond holders cannot just click a button when they want to eject and parachute safely out of their holdings; they are fastened into the investment via a brokerage firm. If the plane crashes, they go down with it. But these facts are no secret to the public, which makes the “unquenchable thirst for junk” so much more remarkable. We write: “The froth is so thick that ... pay-in-kind deals are back, whereby interest on the bond is paid in the form of more junk debt, rather than cash ... It’s probably one of the few times in history when the market has rewarded investors for taking huge risks because so many are desperate for a big return.” The question is -- will they get it?

Elliott Wave International Dec. 22 lead article.


Last week, something happened in the art world that surprised even the seen-it-all modern art connoisseurs. “Fountain” by Marcel Duchamp -- a white porcelain gentleman’s urinal first presented to the public in all its aseptic, utilitarian beauty in 1917 -- was decidedly (64%!) voted “the most influential work of art of the 20th century”. Works by Pablo Picasso, Andy Warhol and Henri Matisse did not do so well and came in 2d, 3rd and 5th. Now, I am not an art expert by any stretch. But from my laymen’s point of view, it seems that an actual work of art where some elbow grease and imagination was involved -- a painting, for example -- deserves more recognition than a readymade piece of a men’s bathroom interior that many of us have seen -- and used -- oh so many times.

Even the former curator of interpretation at London’s Tate Gallery confessed to being “a bit shocked” at the results of the vote and added: “Ten years ago Picasso or Matisse would have won. They were the twin kings of modern art but not any more it seems...” What has happened to us -- the public and art critics -- over the past ten years?

Our regular readers know that in the late 1990’s, a radical change in social mood occurred, as was indicated by the plunge in global stocks in the early 2000s. Negative social mood first prompted investors to be more cautious with their money, causing them to sell stocks, which sent global indexes down. Now, the same mood is working its way into other areas of the culture, art being one of them. Naming one of the most controversial art pieces “the most influential work of art of the 20th century” is consistent with the effects of bear market psychology. As collective mood shifts from positive to negative, art forms go from “structured, traditional” when social mood is rising, to “colorful, wild, alive” as the mood peaks, to “anarchic -- anything goes” when the mood is falling, to “deliberately ugly, heavy, sedate”.

But while the downbeat collective psychology is manifesting itself in these unusual ways in the social sphere, the financial realm seems unaffected. After all, European stocks have rallied for almost two years now. Is what we are seeing in the art world just an aftershock of the negative mood from a few years ago? Or will European stocks soon return into their bear market mode?

Link here.


In 1996, the New York Federal Reserve did a study on what indicators were the most reliable predictors of a recession. The only one of six indicators that was significantly reliable was an inverted yield curve. They later did a private study with over 20 factors and still the only dependable indicator was the inverted yield curve. I read the studies in 1999. In a normal world, short-term rates are lower than long-term rates. This makes sense, as investors want to be compensated for the risk of the longer holding period. But at times short-term rates rise above long term rates, giving rise to what is known as an inverted yield curve. In the U.S., every time we have had a period of negative yield curves, we have had a recession within a year.

Thus, in August of 2000, as the yield curve in the U.S. went negative, I predicted the United States would enter a recession in the summer of 2001, and since the stock market loses an average of 43% in a recession, it followed that the stock market would tank. Quite the out of consensus call at the time. Although the NASDAQ was still in a swan dive, the New York Stock Exchange was climbing to within shouting distance of its previous high. The economy seemed to be moving along quite nicely. But the yield curve was staring us right in the face. Now, I was not the only one that had read the Fed report. I am almost sure that every one of the Blue Chip economists had read it as well. But none predicted a recession. Things just looked too good, and none of the other data suggested a recession in the works.

While today the U.S. yield curve is slowly flattening, it is nowhere near an inverted yield curve and not signaling a recession. But I have spotted an inverted yield curve in the world, across the pond, in England. And it worries me, as I wonder if it is a pre-cursor to problems in the U.S. If I lived in England, I would be getting my personal house in order. No long-only stock funds, switching to bonds and absolute return type investments and funds. While the Fed study on yield curves was based on U.S. precedent, the rule generally applies everywhere. Thus, precaution is the order of the day. But does the English situation shed any light on the U.S.?

A strong housing market that might be peaking. A central bank that has been raising rates. A solid economy with inflation starting to pick up. A stock market that looks like it may have peaked? Oh, and did I mention a very large trade deficit? Sound familiar, my fellow countrymen and women? The only thing we do not have is an inverted yield curve ... yet. However, England did not have one as recently as six months ago, and was not all that out of bounds a year ago. England may be six to nine months ahead of us in the softening process. It may very well be a canary in the coalmine.

Yes, I know many will point to the positive economic data on both sides of the ocean. But that misses the main point. The data stays positive, as will the mainstream economists, up until they turn negative. The upshot of the Fed study was that only the yield curve showed any reliability in its predictive ability. Everything else was “noise”. Let’s watch that canary closely.

Link here (scroll down to piece by John Mauldin).


It is one thing to generate profits, it is another to do so efficiently. ROE, or return-on-equity, measures how efficiently a company uses its earnings, to grow earnings. The Street helpfully defines ROE as a company’s annual net income (less non-recurring items) divided by its shareholder equity, or book value (total assets less total liabilities), but this is a deceivingly simple definition. Understanding the more complex formula will help highlight its limitations.

ROE is actually the product of three ratios: profit margin (earnings/revenues), asset turnover (revenues/assets), and leverage (assets/equity). An increase in any of the three ratios-- all other things being equal -- produces a higher ROE. For instance, a company can increase profit margin by cutting costs, or it can increase asset turnover by introducing new products that can be manufactured with current equipment. Both of these will also increase ROE. That is fine, but eventually we want to see an increase in earnings that is the result of growing revenue; not just constantly reigning in expenses.

Likewise, a reduction in any of the denominators of any of the ratios that comprise ROE will also artificially boost this efficiency ratio. A write-down, for example, which shows up on an income statement as an expense, dampens earnings (the numerator) only in the year the write-down is taken, but it has a prolonged dampening effect on shareholder equity in subsequent years, which means in those years, ROE may display mathematical improvement in the absence of actual operational improvement. A company can also increase ROE by increasing leverage, and it can increase leverage by borrowing, which, of course, increases the company’s debt. This may be ROE’s primary weakness: Its failure to recognize an increase in debt beyond acceptable levels. When screening for stocks boasting high ROE, it is crucial to include a debt-to-equity filter.

ROE has other limitations, too. Because it includes earnings in its calculation, it is intrinsically susceptible to manipulation. If earnings figures have been pumped up, profit margin will look artificially high, which, in turn, artificially inflates ROE. In addition (or subtraction?), ROE fails to account for intellectual property, like patents and trademarks, which means that shareholder equity may be undervalued, which also results in a misleading ROE. Well, that is a long list of caveats. Why bother with ROE at all?

While ROE can be deceptive, it can also indicate how effective management is at wringing profits out of its operations. Companies that do well at this, tend to have a distinct advantage over their competitors, which tends to translate into superior price performance. The most effective way to use ROE is in combination with other metrics and as a comparative measure of efficiency within industries. So long as we are armed with all its potential pitfalls, we can regard a high ROE as an indication of industry leadership and potential undervaluation relative to a company’s own growth potential and that of its peers.

Link here (scroll down to piece by Carl Waynberg).


As the song goes: “It’s the most wonderful time of the year” ... unless you happen to enjoy eating sweets, smiling, or offering denominational seasons greetings in public to neighbors and friends. See, due to an explosion of BANS over the past few months, our world is tasting, looking, and sounding a lot less cheery than before: On June 8, a Duxbury, Massachusetts elementary school enforced a “Sweets Ban” on cupcakes and other unhealthy food in classroom birthday parties. On August 6, the UK Passport Service banned “toothy, open-mouthed grins” from passport photographs, ordering “travelers not to look happy” for security reasons. And now, according to the December 22 USA Today, an unwritten ban on the word “Christmas” is underway in our nation’s schools, retail stores, and municipalities.

The USA Today article cites a number of disgruntled citizens who are “fed up with what they view as the de-emphasizing of Christmas as a religious holiday”. So, many are filing lawsuits, promoting boycotts, and launching campaigns to save the word from a mass secularization of the season, whereby phrases such as “Happy Holidays” have replaced “Merry Christmas” at public venues. We are not here to agree or disagree. The point is, no matter what your religious affiliation -- Christian, Jewish, Muslim, Buddhist, Wiccan, Pagan -- December is universally a time meant for coming together, celebrating life, and starting anew.

Instead, we have picketers angrily shouting Carols into a crowd of people as they watch a Holiday Parade in Denver, Colorado: they were protesting the city’s rejection of a “Christmas-themed” float. Or millions of dollars in federal court cases over the right to allow Nativity scenes and other religious displays on public property.

Why are we NOT surprised, you ask? Simple. This kind of conflict-ridden environment is a classic manifestation of the current trend in mass social mood. From the October 2, 2003 Elliott Wave Financial Forecast: “Based upon the conjecture that social mood is about to accelerate toward the negative ... we can attempt some specific forecasts” for the year ahead in cultural trends. To name a few: “There will be a collective increase in discord, exclusion, opposition; a shift away from the permissiveness and feelings of alignment with others to a sudden public fetish for restrictiveness and control; social groups, including religious, will polarize and splinter both internally and with respect to opposing groups ... and religious advocates will become increasingly passionate.” Sound familiar?

Which means we are not leaving on a sour note at all. The fact is, such a broad change in the social realm -- like this massive shift toward seasonal unbliss -- helps build our confidence in the wave pattern in every major financial market.

Elliott Wave International Dec. 23 lead article.


Christmas is no time for insults, but somehow it is the only season when someone can slap you with the one name that really hurts: Scrooge. Simply say the word and there is no explanation necessary. It is often a playful insult, but when spoken seriously you know what it means: Heartless. Unforgiving. Spiteful on a day that calls for generosity. Well, on this Christmas Eve, I wish to defend -- yes, defend -- Ebenezer Scrooge.

Last year I saw a version of A Christmas Carol, with Patrick Stewart (of Star Trek: Next Generation fame) as Scrooge. Obviously, the challenge of the role is to be as unlikable as possible, and Mr. Stewart was all this and more. He was loathsome: his Scrooge bristled with a hatred that was hard to watch. There was even a moment when I wondered why an actor would take such a part. Right away, however, I remembered that Patrick Stewart is just one of many gifted and famous actors who have interpreted Scrooge over the years -- George C. Scott, Albert Finney, and even Mr. Magoo among them.

Yet A Christmas Carol itself gives the best reply to why the role has dramatic appeal; it is the same answer to why he deserves a word of defense. Ebenezer Scrooge changed for the better. He emptied his own repulsive character, and filled himself instead with goodwill and charity. Scrooge experienced the spiritual transformation that was first explained to a fellow named Nicodemus a very long time ago. Charles Dickens knew this when he wrote A Christmas Carol; he would find it a curious irony indeed that we remember who Scrooge was, instead of the new man he became.

Link here.


Awhile back I ended my usual practice of concluding articles (preceding a holiday) with some type of simple holiday greeting. It was a kind of awkward. “Everything sure looks horrible for the markets, the economy is about to fall off a cliff, and there is a pyramid of excess compounding upon excesses -- but go out and have a splendid Fourth of July!” Or, “The entire Credit system is running completely out of control and our (acutely fragile financial and hopelessly maladjusted economic) system is chaotically and irreversibly self-destructing -- have a joyous Easter weekend!” “It looks like the end of the financial system (both domestically and globally!!!) as we know it -- have an especially Merry Christmas and Happy Hanukkah!” Well, I always strive for (slow but steady) refinement and improvement.

This year, I will limit myself to a brief comment about what I view as the overriding shortfall of current analysis, while attempting to use less than half the typical bevy of adjectives. When discussing the dollar (normally I would write “faltering” or “sinking” – perhaps in parentheses -- before “dollar”), the current account deficit, the federal budget deficit, mortgage lending excesses, housing Bubbles and the like, there is little if any attention paid to the most important facet of the ongoing inflationary Credit Bubble: distortions and impairment to the structure of the economy.

And there has developed a false sense of confidence and security that whatever financial difficulties arise can be rectified through Federal Reserve and global central bank actions -- reliquefication, “reflation” and “monetization.” Any type of loss can be more than made up for with additional Credit creation, and any bursting Bubble mitigated by collapsing interest rates and manipulating the yield curve. Yet, at this late stage of the Credit Bubble, inflationary manifestations have effects on the economy (I removed “blow off” in parentheses before “stage”; “Great” before “Credit Bubble”; “powerful” before “inflationary”; “especially deleterious” before “effects,” and “real” before “economy.”) Story to continue…

But such boilerplate is certainly not tantamount to spreading holiday good cheer; and I do very much want to wish readers the Merriest of Christmases and the happiest of holidays. I don’t know about everyone else, but I am getting quite excited for 2005! It seems destined to be fascinating, challenging and historic. Such opportunities do not come around all too often. So everyone get plenty of rest, clear your heads and, most importantly, forget about all this “stuff” for a few days. Cherish your time with dear friends and family.

Link here (scoll down to last section of article).


Maids-a-milking, gold rings and turtledoves were a relative bargain this year, but anyone who shopped for French hens, geese and ladies dancing may have been in for a touch of sticker shock. So said PNC Advisors, the wealth management firm that each year tallies the putative cost of assembling all the items from the song “12 Days of Christmas”. This year, all those goods and services would have set a buyer back $66,334. That is a record price for the 364 tokens of affection ranging from a partridge in a pear tree to a dozen drummers drumming. Still, the cost is up only slightly, 1.6%, over last year’s total, and compared with the 1984 total, is 5.9% higher.

PNC Advisors started tabulating the gift package two decades ago to see whether the costs of the presents in the English carol tracked the U.S. government’s Consumer Price Index. The general conclusion the firm has drawn is that they usually do. This year the prices went up in the low single digits on a percentage basis for goods and remained steady for services. The flat prices for services, according to the group’s chief investment strategist, Jeff Kleintop, reflect an hourly compensation anchored by a static minimum wage and the outsourcing of unskilled labor. Hence, the eight maids-a-milking, who earned $26.80 for the chore 20 years ago, put a buyer out only $41.20 today, at $5.15 an hour.

Skilled labor, like the nine ladies dancing, would make the biggest dent in a budget, at $4,400, up 4.0% from last year. The 10 lords-a-leaping went up 3.0%, to $4,039.08, and the 12 drummers drumming rose 3.6%, to $2,224.30. Among the assorted fowl named in the song, there were various breed-based price differentials. Swans, doves, partridges and calling birds (today’s canaries) cost about the same as last year, according to information from the Cincinnati Zoo and Botanical Gardens. But the price of French hens, which are a slightly more exotic version of American hens, went up 200%, Mr. Kleintop said, largely because American breeders of French hens introduced a more expensive variety.

PNC Advisors’ news release elaborated: “The price for French hens and geese saw significant increases, which may be due to fewer hatchlings during this breeding cycle creating an imbalance in the supply-demand chain. Turtledoves, on the other hand, may have had a more fruitful breeding cycle, creating an oversupply of birds and a 31% decline in price. All told, the cost of the birds in the Christmas classic totaled $4,201, just 1.5% more than the $4,138 it would have cost a year ago.”

Mr. Kleintop said the trumpeter swans could now and then really jolt the index, because breeding cycles vary and affect the price. In 1984, for instance, the seven swans-a-swimming called for in the song cost $1,000 each, but in subsequent years the price of the long-necked birds slumped. Since 2001, the price has risen, to $500 each. Every year, PNC offsets the swans’ variable cost by calculating a core index that excludes such cost anomalies. Taking that into consideration, the PNC index rose 3.1%, roughly in line with the 3.7% increase in the first 11 months registered by the Consumer Price Index, which measures a much broader range of goods and services.

Link here.
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