Finance Digest for Week of January 10, 2005

GAME OVER?

The unraveling of the Asset Economy could well be at hand. America’s Federal Reserve has finally woken up to the perils of the risk culture that its reckless accommodation has spawned. The Fed has sounded simultaneous alarms on two fronts -- inflation and excesses in asset markets. Such explicit warnings from the U.S. monetary authority are rare and should be taken seriously. This has important implications for the interest rate outlook, as well as for the asset-dependent U.S. economy.

The recently-released minutes of the December 14, 2004 Federal Reserve policy meeting were an eye-opener. The tone of the discussion was far more important than the policy action itself -- a fifth 25 basis point rate hike in the past five months. While the stilted language of the policy action, itself, made reference to balanced risks with respect to growth and inflation, the debate was laced with a very different distribution of concerns. The Fed made special note of inflation risks, citing recent weakness in the dollar, still-elevated oil prices, a cyclical slowing of productivity, and signs of deteriorating inflationary implications signaled in the TIPS market. At the same time, the Fed’s newfound concerns over “excessive risk taking” focused on unusually narrow credit spreads, a notable pick-up in corporate finance activity (both IPOs and M&A deals), and what the policy minutes referred to as “anecdotal reports” of excess speculation in residential property markets. Better late than never, I guess.

Rarely does the US central bank cast aside the rhetorical shackles of Fedspeak and express its concerns with such candor and fervor. Two earlier instances in the recent past stand out as intriguing precedents -- late 1993 and early 2000. In 1993 market participants all but ignored the warnings until the Fed finally delivered in the form of a 300 basis point rate hike over a 12-month time-frame beginning in February 1994. The result was the worst year of performance in modern bond market history. A similar, albeit belated, warning was sounded in early 2000, when the stock market was still bubbling to excess. The 100 bp of monetary tightening in the first half of 2000 was more than enough for the equity bubble and the excess demand growth it spawned.

In my view, the minutes of the December 2004 FOMC meeting follow these earlier precedents quite closely -- especially that of 1993-94. The Federal Reserve is sending a clear warning to speculators that should not be ignored. And yet, as was precisely the case in the immediate aftermath of the two earlier warnings, an ominous persistence of denial is evident today. Financial markets have barely flinched in response to this sea-change in Fed risk assessment. As always, it takes more than words to crack investor denial. Such a response leaves the central bank with little choice other than to up the ante on its tightening strategy. The big question in all this is whether the Fed is tough enough to face up to the task at hand. Unfortunately, that is a close call -- a sad comment on America’s so-called independent central bank. The Fed has put itself into a tough corner from which there is no easy exit. The Asset Economy has gone to excess, and it is high time to face the endgame before it is too late. The Fed deserves credit for finally bringing these critical concerns to a head.

World on brink of ruin.

Alan Greenspan has suffered precious few slings or arrows over his many years as chairman of the Federal Reserve. Even the White House has had to offer its critiques off the record for fear of roiling the markets or upsetting the chairman’s Elvis-in-Vegas-like following. So when the chief economist of one of the world’s most prestigious banks calls Greenspan a bum, that is a big deal. It happened. Stephen Roach, the chief economist for Morgan Stanley, one of the most powerful investment banks and one of the 50 largest companies in the world, says Greenspan has “driven the world to the economic brink”.

Writing in an upcoming issue of Foreign Policy, Roach says that when Greenspan steps down as chairman of the Federal Reserve next year, he will leave behind a record foreign deficit and a generation of Americans with little savings and mountains of debt. Americans, Roach says, are far too dependent on the value of their assets, especially their homes, rather than on income-based savings; they are running a huge current-account deficit; and much of the resulting debt is now held by foreign countries, especially in Asia, which permits low interest rates and entices Americans into more debt.

The “economic brink” line is from the headline of a press release sent by Foreign Policy. In an interview this morning, Roach said, “That’s a little extreme.” He does admit the nation has prospered on Greenspan’s watch. Still, he does not disavow the haymakers he directs at the chairman’s chin. “This is no way to run the global economy,” Roach says. So far, the Fed has bucked the odds, Roach adds. But the longer the situation exists, the more chance there is that it will spell danger for the U.S. and the world.

Roach lays the blame for the peril at Greenspan’s door. But first he takes out after his outsized reputation. Greenspan will soon surpass the fondly forgotten William McChesney Martin as the longest-serving Fed chairman. But his term as a member of the Federal Reserve Board of Governors expires in just over a year from now, and America will have to do without. Roach says, “Greenspan will be a tough act to follow.” But the difficulty may not be living up to the chairman’s reputation so much as cleaning up his mess.

BOND BUBBLE, AMERICAN-STYLE

We believe a nasty popping of the bond-market bubble lies in wait for investors. Why? In short, yields are too low, bond prices too high, and quality spreads too tight. The gargantuan rally, which actually peaked in June 2003, as evidenced in the monthly chart of 30-year bond futures, should soon be history. The engineering of the emergency Fed Funds rate, to save the world from the clutches of deflation (denying this as the proper cleansing agent for economic sins past) proved most impressive as bubble fuel. It is now the long march toward the elusive “normalization” of benchmark interest rates that will draw Zeppelin-like comparisons from observers as long-bond prices head toward earth.

We would not be surprised to see a surprise in the form of inflation scare, major hedge-fund collapse, or foreign bank reserve reallocation to hasten the descent of fixed income prices across the entire spectrum, from Treasury to junk. Those holding junk bonds, now the darling of yield chasers, will soon understand the moniker. Recent bond euphoria did give bonds a boost, but bond futures did not reach the highs made in early 2004 and are well below record highs made in June 2003. Prices have stalled and are turning over. It appears as a classic technical pattern of a failed high, leading to a series of lower highs that will lead to a series of lower lows. The market now realizes the Fed is serious about hiking the Fed Funds rate. That, we believe, is why the price action is turning negative.

There is a good chance that Fed Funds may rise more quickly than now believed. If the thinking at the Fed is anywhere close to that of Morgan Stanley economist Ted Wieseman, the rush out of bonds may morph to a stampede. Higher rates will play a role in healing U.S. and global “imbalances” -- the gaping twin deficits. This is the weighty justification the Fed will use for political cover.

The Fed’s “policy mistake” was its decision to run the printing press 24/7 in order save the U.S. economy from what it perceived as a Japan-style deflation. It was a conscious decision by the Fed to create asset bubbles rather than face the painfully healing music of recession. These asset bubbles and artificially lower interest rates have distorted consumer preferences. Instead of relying on genuine old-fashioned income growth to fund consumption, consumers have leveraged wealth off the stock and real-estate bubbles. And precisely because the yield on cash was at historic lows, both professional and not-so-professional investors quickly realized the advantages of borrowing short and lending long. In other words, the Fed has engineered the largest one-way bet in history. The bet: long rates will stay low as far as the eye can see. Risk and uncertainty do not enter into the equation when there is such “easy” money to be made.

Impervious economists, exploding myths.

I previously explained how the Federal Reserve’s monetary policy mostly follows U.S. interest rates, even though the media makes it sound like the Fed leads the trend. I also should have pointed out just how much establishment economists feed this misperception. They embrace the all-powerful Fed myth with both arms, and -- more than any other group -- economists are impervious to the facts that can and do explode the myth.

The Wall Street Journal’s “Semiannual Economic Forecasting Survey” reminded me of this today. Naturally the Journal was highlighting the forecasts for 2005, but instead I looked up the forecasts made last June for the second half of 2004 -- specifically what the 55 economists in the survey had predicted for the trend in 10-Treasury yields. The overwhelming consensus from these economists was that Treasury yields would rise -- a couple of them said yields would stay the same, but only one of the 55 said yields would fall. Let’s remember that yields had already exploded higher in the spring months, even though Mr. Greenspan & Co. had not yet raised the Fed Funds rate. Still, in June, the sentiment was unanimous that the Fed would indeed begin a series of rate increases.

And that is indeed what happened; five quarter-point gains in the Fed Funds rates in six months. The long-awaited effort by the Fed to move the interest rate trend higher appeared underway. If the Fed leads the trend, well, establishment economists knew what would follow. There was only one problem: Treasury yields did not follow. And not only did they refuse to follow, they moved in the other direction. Treasury note yields were within a hair of the 2004 high on June 14, the day the Journal’s survey began. From there yields steadily declined nearly into November. Here again I will say: A big move may well be ahead for Treasury yields; indeed, this is precisely what our technical studies suggest will happen. But the size and direction of this move have nothing to do with the Fed’s monetary policy.

IPO’S ARE SIZZLING HOT. UH-OH

By all accounts, 2004 was a very good year for initial public offerings. There were 242 IPO’s, which almost equaled the total from 2001, 2002 and 2003 -- combined. And the new stock offerings provided a handsome payoff to those brave enough to wade into these choppy waters. Investors who bought equal shares of every 2004 IPO would have had a 21% return on their investment, Linda R. Killian, founder of the firm that created the first IPO mutual fund, said. But as the second half of the 1990’s proved, a robust IPO market is not necessarily the same as a healthy one. “When you see riskier, less seasoned companies go public -- and then perform quite well -- then the natural question you have to ask is, have we learned nothing?” said Michael Moe, the chief executive of ThinkEquity Partners, a research-oriented investment bank based in San Francisco.

The share prices of any number of companies that went public last year rose despite little or no history of profits. According to data provided by Mr. Moe’s firm, 39% of the companies that went public last year were not profitable. That was a far cry from 1999 and 2000, when 74% of the companies going public were money losers, according to Ms. Killian, but the question is whether concern is warranted.

Investment bankers still seem to value the net income line of a start-up’s ledger. So often do they tell start-ups and venture capitalists that they want to see at least three quarters of consecutive profits before taking a company public that one former member of the fraternity jokingly referred to it as “The Speech”. The problem is that bankers’ standards tend to fluctuate with market conditions. “If you go back 30 years ago, the more reputable investment banks were insisting on four years of profitability before they’d even think of taking a company public,” said Jay R. Ritter, a finance professor at the University of Florida who studies IPO’s. “By the mid-80’s, it was more like one year of profitability,” he said. “Then, as the 90’s wore on -- and this was especially true in the technology sector -- first profitability was dropped, then sales, until all that was required was a good business model.”

Today, Professor Ritter is not sure what that benchmark is -- or if one still exists. “Younger companies that have little or no profit are companies where the upside potential can be greatest,” he said. “But they’re also where the risk is greatest.” A much more accurate predictor of a public company’s long-term success, Professor Ritter said, is its revenue. “If a company goes public with less than $50 million in sales, the chances of it being a big winner is minuscule,” he said. “That’s true whether they’re profitable or not.”

According to ThinkEquity, 40% of the companies that went public last year had annual sales of less than $50 million. “At the moment I’m not worried, but if this trend continues -- if we see the same thing happening in January and February like happened in December -- then by May we could see garbage going public at a huge valuation run by CEO’s who graduated from high school three years earlier,” Mr. Moe said. “That’s when I’ll say the world has gone crazy again.”

THE STRAIGHT STORY ON HEDGE FUNDS

With the exploding popularity of hedge funds, it is important to get the facts straight, and the straight story is this: Most hedge funds are little more than “momentum players”, as revealed in a recent study by two finance professors at Stanford and Princeton. Extreme sentiment readings among hedge fund operators have been remarkably good “leading indicators” of an approaching turn in the stock market (the same is true of the U.S. dollar), and today’s sentiment readings among “Large Speculators” (i.e., hedge funds) regarding stocks now stand at all-time record levels. Does this look like safety in numbers, or more like blood in the water? Eventually the answer becomes clear to everyone, and clearly too late to those who had it wrong beforehand. The facts and the evidence say that it is time to get the heck out of the water.

OLD HOUSES IN POSH AREAS OF PHOENIX ARE BEING RAZED FOR DREAM HOMES

Increasingly, homeowners across the Valley are buying perfectly good homes and knocking them down to build mansions. In the process, entire neighborhoods are being transformed. Home prices in the rebuilt neighborhoods have been soaring to the delight of buyers and sellers alike. advertisement. Reasons for this rash of residential teardowns vary. Some buyers seek large lots in central locations; others see them as can’t-miss investments.

Wrecking balls rip through the ranch houses at Shea Boulevard and 82nd Place. Other homes, just sold, await their appointments with demolition crews. In this middle-class neighborhood of 1-acre lots in central Scottsdale, residents used to look out their front doors and see horses. Today they are more likely to see bulldozers. “Get while the getting’s good!” laughed Andy LeVan, who just sold his house on 82nd Place for $629,500. He bought it four years ago for $270,000. “If we would have bought this lot two months ago, we would have saved $200,000,” said Theo Mandel, a software consultant who bought LeVan’s property and plans to build his dream home there. “It’s scary, but that’s the way it is.” Although the previous owner spent tens of thousands of dollars to renovate the house, Mandel said he and his wife are leaning toward a teardown.

Demolitions reflect buyers’ desire to build big, centrally located houses. And if that means tearing down a perfectly good 2,000-square-foot home, so be it. For buyers, the question is whether teardown lots are truly a bargain or whether they are selling for more than they are worth. Soaring home prices across the Valley have prompted some experts to predict a real estate bubble. Some buyers are acting based on “what they call irrational exuberance,” said Jay Butler, a real estate professor at Arizona State University. Whether that is the case with teardowns in Scottsdale, Butler said it is too soon to tell. But there are limits on how much a home will increase in value. And if history is any guide, Butler said, the bubble eventually will burst. “Whenever we’ve seen this in the past, it’s busted,” he said.

THE DOLLAR’S QUESTIONABLE FUTURE

If the love of money is the root of all evil, the depreciation of money must be the mainspring of all shams and frauds. It works silently and covertly, impoverishes many while it enriches a few, and thereby inflicts great harm on social cooperation and international relations. A few economists are sounding the alarm about the decline of the U.S. dollar. In recent months, it fell visibly toward the euro and Japanese yen and is likely to fall even lower. But most Americans refuse to be alarmed, as they are unaware of exchange rates and foreign exchange markets. Why should they be troubled about the financial affairs of money traders and dealers?

We may not be able to see the future, but always can learn from the past. Looking at the recent history of the dollar, this economist perceives distinct stages with various characteristics, causes, and consequences. One stage was from the end of World War II to 1971, when the U.S. dollar was tied to a small anchor of gold. President Nixon cut its ties and embarked on a wholly new road of fiat dollar management. Many other countries readily accepted the new system acclaiming its flexibility and manageability. At this time, the world is still traveling this road, but several countries are making preparations for leaving it and proceeding toward a multiple standard system. It is not clear whether they will depart in an orderly fashion or in crisis and contention.

According to some estimates, foreign banks and investors are holding some $9 trillion of U.S. paper assets. They own some 43% of U.S. Treasuries, 25% of American corporate bonds, and 12% of U.S. corporate equities. They obviously are suffering losses whenever the dollar falls against their respective currencies; even if they are pegged to the dollar, they are incurring losses against all others that are rising. The dollar standard surely would enter its final phase of disintegration if its holders would panic and start selling their American paper investments -- their U.S. Treasuries, U.S. agencies, and corporate bonds and shares. The crash would be felt around the world and neither foreign sellers, nor American authorities, could be trusted to react rationally in the fear and noise of the crash. The scene could be similar to the political bedlam of the early 1930s.

It is unlikely that the Federal government and the Federal Reserve will soon mend their ways, but it also is doubtful that foreign creditors will continue their support indefinitely. The U.S. dollar is bound to continue to depreciate and gradually surrender its role as the world’s primary reserve currency to a multiple reserve-currency system resting on the euro, Japanese yen, Chinese renmenbi, and the American dollar. The multiple-standard system is likely to perform more efficiently and equitably than the dollar standard. Competition would avoid the abuses and inequities of a monopolistic system. Confining the powers of the Federal Reserve System and constraining the deficit aptitude of the U.S. Treasury, it would ward off any further inundation of the world with U.S. dollars.

In idle reverie of years long past, this economist is tempted to compare the gold standard with the dollar standard. The quantity of gold is limited by nature and its value is enhanced by many nonmonetary uses; fiat and fiduciary moneys have no such uses or limitations. They are the sorry creation of politics.

THE SURE-THING SYNDROME

In the end, denial is usually the only thing left. In my view, that is pretty much the case today in world financial markets. Imbalances on the real side of the global economy have moved to once unfathomable extremes. And now the Federal Reserve belatedly enters the fray threatening to take away the proverbial punch bowl from a rip-roaring party. Financial markets hardly seem concerned over this impending collision. Spreads on most risky assets have fallen to razor-thin margins. Steeped in denial, investors have once again become true believers in the sure-thing syndrome.

There can be no mistaking the absence of risk aversion in most segments of world financial markets. Even in the aftermath of the Fed’s early January wake-up call, so-called spread products have barely flinched. That is true of high-yield and emerging-market debt, and it is also the case for investment grade and bank swaps spreads. Even pricing of the “riskless” asset -- U.S. Treasuries -- remains in rarefied territory, as yields on 10-year notes oscillate around the 4.25% threshold. At the same time, equity-market volatility has all but vanished into thin air.

Market chatter is laced with impeccable logic as to why it still pays to buy risk. In most cases, the arguments rest on perceptions of “improved fundamentals”. Awash in cash flow and riding the wave of a new era of sustained productivity growth, Corporate America has nothing to worry about, most believe. A similar verdict has been rendered with respect to emerging markets -- long the most crisis-prone segment of world financial markets. Improved external debt positions have the consensus convinced that emerging-market risk has also entered a new era.

America’s monetary authorities face a most daunting challenge. The theory of policy strategy is very clear on one key point: The longer the central bank waits to deal with a serious imbalance, the greater the imbalance becomes -- and the larger the policy adjustment that eventually is required to deal with the problem. That is precisely the problem the Fed now faces. The US central bank has waited too long. It can no longer address imbalances by simply taking the real federal funds rate out of negative territory. Nor will it be enough to return the real funds rate to its so-called “neutral” setting -- that level that is neither easy nor tight insofar as its impacts on the real economy or financial markets are concerned.

Given its publicly avowed concerns about the confluence of inflation and speculative risks, the Fed now has no choice other than to push the real federal funds rate into the restrictive zone. In my view, that means at least 100 bps beyond neutrality -- consistent with a nominal federal funds rate somewhere in the 4% to 5% zone. The Fed, in my view, sent a very clear signal in the December minutes of its policy meeting. A regime change in US monetary policy could well be at hand. These are the defining moments in history that are made for tough-minded, independent central banks. As was the case in 1994, I believe this Fed is up to the task. Investors banking on the sure-thing syndrome are in for a rude awakening.

TEN PROBLEMS FOR 2005

The confluence of predicted events will result in a very bad trading environment for U.S. equities and will create an environment where investors will continuously be disappointed with geopolitical events. Bad news will dominate the headlines and news crawls. Business and economic news will suffer. Business leaders will retrench again and will resist hiring new workers and will cut back on capital spending until a more stable world is evidence. This will result in lower equity prices and I think the major indexes will give back all of the gains of the last 2 years.

I continue to believe that we are in a long-term period of economic decline. I see the last few years, since 2000, and the next few years, till say 2008-2010, as the 2nd Great Depression for the majority of the U.S. population, especially the rapidly growing middle and lower class. As with most things, financial well-being and economic prosperity are “relative” and relative to past economic periods, the current state of our economy and the future economic outlook is at best “relatively” dismal. Unfortunately the baby boomers are unprepared for this economic reality, and the government is totally unprepared to take care of them. As the “greatest generation” lives longer than any of its ancestors, the economic reality of huge healthcare costs, lack of employment opportunity, lack of savings, and high costs of living will create a very difficult period of time for this huge swath of the population during their “golden years”.

ISSUES 2005

I do not see encouraging signs that the dollar’s three-year decline has started to incite global rebalancing. Global financial and economic imbalances have grown only more acute and unwieldy. But I do expect markets to (much belatedly) force the onset of this “rebalancing” process at some point during 2005. The U.S. Credit system and asset markets are the focal point of my analysis. Only restraint in Credit creation and the termination of asset Bubbles will initiate the required “rebalancing” -- domestic as well as global. Until asset and speculative Bubbles burst, the dysfunctional U.S. financial sector will maintain its dangerous fixation on asset-based lending and interest-rate arbitrage. At this point, only a crisis will force the curtailment of over-consumption and the misallocation of resources. And rather than viewing the dollar’s fall as an encouraging development, from a Credit Bubble perspective, it is exactly what one would expect to coincide with the “blow off” period of Credit and liquidity excess.

When I reflect back upon 2004 through my analytical framework, I see Reflation dangerously transformed into Gross Over-liquefication, on a global scale never before experienced. What do I mean by this? Ultra-accommodative Fed policies that reached a crescendo in late 2002 nurtured blow-off excesses throughout U.S. mortgage and securities finance -- Bubble at The Core. This dynamic set in motion an all-encompassing liquidity free-for-all domestically and globally, creating Myriad Bubbles all along The Periphery. From subprime, junk bonds and virtually all securities; to hedge funds, REITs and M&A; to energy, commodities and essentially all hard assets; to emerging debt and equity markets, cheap finance was abundant in virtually every nook and cranny across the globe.

I believe this is very pertinent analysis with respect to contemplating where and how we proceed from 2004. While some may view the weaker dollar and stronger global growth as factors reducing systemic imbalances and risk, I fear the exact opposite: An historic Bubble has gone to only more dangerous and endemic extremes. Indeed, Macro Credit/Bubble analysis leads me to place the potential for financial crisis at the very top of Issues 2005. From my analytical perspective, the notion of a secular decline in financial volatility is the ultimate in Analytical Irrational Exuberance. It is “secular” only so long as Credit Bubble and liquidity excesses are sustained; as long as inflated asset prices continue inflating.

As 2003 recalled the bond market mania of 1993, so 2004 brought back memories of the SE Asia/emerging market excesses of 1996. By promising little bitty Baby Steps (“Tightening Lite”) that would never ever dishearten the precious markets, the Fed last year avoided a 1994-style interest rate speculator boom turned bust. But the cost of sustaining the U.S. Credit Bubble was inflating myriad Bubbles around the globe.

Macro Credit and Bubble analyses are as fascinating as they are challenging. As much as we analyze and gain understanding from studying the intricacies of Bubbles, there should be an axiom that warns to absolutely avoid predicting when they are going to burst. What is more, the bigger and more conspicuous the Bubble -- and the more confident we are in our analysis -- the more likely that forecasts of its demise will prove as much as years premature. This was the case with the NASDAQ Bubble and now with the Mortgage Finance, Leveraged Speculation, and U.S. bond market Bubbles. Excesses go to unbelievable extremes -- and then “double”. Almost by definition, those of us that partake in Bubble analysis will, from the consensus’s point of view, be discredited and our analysis in disrepute at the pinnacle of the Bubble; it just goes with the territory. A sound analytical framework, along with perseverance, becomes an absolute prerequisite. With that caveat out of the way, I believe there is a reasonably high (much greater than 2004) probability that we will experience a major Bubble burst during 2005.

WHAT COULD GO WRONG IN 2005?

DeTocqueville once wrote, “The more things change, the more they stay the same.” In the case of the U.S. in 2005, the opposite might be true: the more things stay the same, the more they are likely to change ... for the worse. In that regard, compiling a list of potential threats to the US as we come into the New Year represents nothing more than a longstanding catalogue of economic policy making run amok. The same list could have been drawn up in 2004, 2003, and even the years before that. They include the persistent and increasing resort to debt-financed growth, a concomitant and growing external imbalance in the current account (leading to an ever greater reliance on “the kindness of strangers” who keep the U.S. economy afloat by enormous foreign lending so that consumers can keep buying more imports, thus further increasing an already bloated external trade imbalance).

All of which is occurring against an increasingly problematic Vietnam-style quagmire in Iraq, and the ongoing (and related) problem of high energy prices, which are themselves spurring an ever more frantic competition for energy security, thereby intensifying existing global and regional rivalries. Just as a haystack soaked in kerosene will appear relatively benign until somebody strikes a match, so too it is worth noting that although America’s longstanding economic problems have not yet engendered financial Armageddon does not invalidate the threat they ultimately pose. But the key is finding out what represents the match that could set this “haystack” alight, if there is indeed one “event” which precipitates the bursting of a historically unprecedented credit bubble. The odd thing about credit bubbles is that they have no determinate resolution. There is nothing about a self fulfilling prophecy dynamic that generates a specific level of financial excess or an eventual end to it. It can happen at any level or at any time. There is also nothing about such a dynamic that specifies the path of its reversal

American military and economic dominance may still be the central fact of world affairs today, but the limits of this primacy (which dates back to the fall of the Berlin Wall) are becoming increasingly evident, just as dollar’s fall reflects this in economic terms. It all makes for a very challenging backdrop in 2005. This could therefore be the year when longstanding problems for the U.S. finally do matter. Do not expect Washington to accept the dispersal of its economic and military power lightly.

U.S. TRADE GAP WIDENED TO RECORD $60.3 BILLION IN NOVEMBER

The U.S. trade deficit unexpectedly grew to $60.3 billion in November, the widest ever, as demand for oil and consumer goods drove imports to a record. Exports fell. The trade gap increased 7.7% from the previous record of $56 billion in October, the Commerce Department said in Washington. The trade gap with China held close to the previous month’s record. The $561.3 billion deficit through November exceeds the record for all of 2003. A rebound in consumer spending during the second half of last year boosted demand for imported products in the world’s largest economy. Slower growth in Japan and Europe than in the U.S. may have limited demand for American goods, economists said.

The dollar and the deficit: the moment of truth.

If the story of Pinocchio panned out in the real world, then the January 12 mainstream financial press would have schnozzles a flock of seagulls could perch on. The difference is, while the little wooden puppet knew he was fibbing, the media is simply “puppeting” one of the most widely notions about markets and the economy, namely, that a rise in the U.S. trade gap causes a fall in the value of the greenback. However, in the December 2004 Elliott Wave Financial, we plotted the past three decades of the U.S. Trade Weighted Dollar verses the U.S. Current Account Deficit/Surplus (as a percentage of GDP) -- and recorded our finding in this very chart. Anyone with a grain of scents can see there is no basis in the media’s claims today. Don’t get strung along in the wrong direction like a certain sad marionette.

BASEBALL, STOCKS, & STEROIDS: THE FEW CONVINCED THE MANY

Today we know that the scandals of the 1990s came in many shapes and sizes, yet they all had one thing in common: A few people convinced many people that something was better than it really was. A definition this broad goes well beyond finance. It describes everyone from a street-corner grifter, to, well, baseball players who used steroids. Speaking of which -- can you name the year for the most Major League home runs (all players combined) in one season? In the Year 2000 an all-time record 5,693 home runs were stroked that season, a 71% increase over the total home runs hit in the 1990 season.

If you know baseball, or even if you casually follow sports news, you may be wondering, “What about Barry Bonds?” Mr. Bonds set the individual season record in 2001, with 73 home runs, and has continued to hit moon-shots ever since. Indeed, published reports say that in the five seasons beginning with 2000, Mr. Bonds has hit 23 home runs that traveled at least 450 feet; in the 14 seasons before then, he only hit three home runs that went that distance. In truth, Barry Bonds’s home run production over the past five years is the individual last gasp of a trend in baseball that peaked in 2000; and December’s revelations of his “enhanced performance” removed any chance that fans will consider his records to be authentic, never mind admirable.

Yes, enhanced performance comes in many shapes and sizes, yet in every instance the few convinced the many. It is no fluke that the stock market also peaked in 2000; we still see last gasps of the old bullish psychology, such as the recent revelations about Fannie Mae and its recently removed chairman, Franklin Raines. The “Cultural Trends” section of the current Elliott Wave Financial Forecast explains the social mood behind these (and many other) stories. You will not be thinking “coincident” after you have read our perspective.

A FAIRY TALE ... REBORN

The European art world continues to shock the public. Last month, it was the coronation of the controversial Marcel Duchamp’s Fountain (a men’s urinal) as the “most influential work of art of the 20th century”. Now, there is a scandalous new German play. Well, it is not exactly new -- Humperdinck’s Hansel and Gretel has been a family favorite for decades. But its new adaptation, set to open on January 15, is already stirring much controversy.

Deutsche Welle describes this adaptation as a “sinister study of pedophilia, violence and sexual abuse of children. The fairytale forest is replaced by a red-light district -- with high-rises, garbage dumps and begging children. The children’s mother is a whore and their father an alcoholic. The ‘sand-man’ is a cocaine-snorting pimp who pursues Hansel and Gretel with a video camera and hands them over to the wicked witch -- the modern ‘stranger”, who could be the man down the road, the local pervert, [or] the catholic priest.”

The director says he was deliberately trying to “horrify people”, even at the risk of being called “disgusting”. “Disavowing sentimentality seems to be fashionable right now,” summarizes DW, and they hit the nail right on the head. Sentimentality is out of fashion. Or, it is taking strange twists indeed -- like the emerging trend in German pop-culture to portray Hitler as a “human being”. The new Hansel and Gretel joins the ranks of similarly disturbing recent theatrical productions -- like the German ballet about the suicide of the wife of the former Chancellor Helmut Kohl, or the new “dark” treatment of Mary Poppins and the obscene Jerry Springer -- The Opera in London.

It is not just a coincidence that the new Hansel and Gretel is coming out now, after several years of high unemployment in Germany, flat (at best) economic growth, and gloomy business and consumer confidence. Social mood in Germany has clearly been in a bear market, with all its cultural manifestations, including these “anarchic” and “deliberately ugly” artistic expressions. But what we have observed over the years is that art usually takes on such “ugly” forms near bear market bottoms. On top of that, the German DAX has ended 2004 higher after bottoming mid-year. And, German investor confidence has been showing signs of improvement lately. Could Germany be finally ending its long recession? And what about the rest of the European Union?

THIS IS WHAT REAL GROWTH IN CREDIT LOOKS LIKE

The Federal Reserve keeps thorough records of U.S. consumer credit, and most of the data goes back 30 years or longer. They put it all on the Internet, too. Scroll through the numbers, and before long you will have what amounts to a crash course in how rapidly the debt levels have grown during just one generation. New car loans, for instance: In June 1971, the total amount financed averaged $3,045 for 35 months. Fast forward to November 2004, and the amount financed averaged $23,984 over 60.5 months. But that is just for starters. To see what real growth in the debt levels looks like, “revolving credit” (also known as credit card debt) is the place to look.

The Fed began keeping records on revolving credit in January 1968; the outstanding amount in that month was $1.4 billion. Jump a little more than five years ahead and you come to the first month that revolving credit exceeded ten billion, $10.2 billion in June 1973. Barely eleven years later came the $100 billion threshold, $106.26 billion in December 1984. The latest release was for November 2004, when revolving credit stood at $782.15 billion. That is a whole lotta credit card debt. As you scroll the data, you do occasionally notice a marginal decrease in the monthly debt figures, but “more” and “bigger” is the rule ... until November’s number, that is. As large as $782 billion sounds, it is actually an 11% decline from October, the single largest one-month drop since the Fed began keeping records in 1968.

Now, this data is always subject to “revision”, and one month does not a trend make. That said, it is amazing that a decline of this magnitude received so little coverage in the financial press. Credit card debt can keep growing explosively for years or even decades ... until it does not. And “does not” is exactly what no one expects, let alone prepares for. Credit, debt, and deflation are all part of the same overlooked and little-understood picture.

BUYING EXPENSIVE STOCKS IS RISKY BUSINESS

I have watched the shares of Google almost everyday since it went public at $85. In only a few months time, Google had soared to $200 a share, making it one of the best stocks to own in 2004. At first glance, not buying Google was a big mistake. Google is certainly a great company. After only five years in business, it is already a household name. It has $2.6 billion in sales and 32% gross profit margins. With only 2000 employees, it is producing operating profits of $520 million each year. That is $266,000 in profit per employee. Google is also growing unbelievably fast -- its sales were up 233% last year. Plus, like Apple, this is one of those companies that is “cool”.

Ironically, Google is exactly the kind of stock I used to cover in my newsletter. It has great margins and is in hyper-growth mode. But I do not recommend stocks like Google anymore. I have found that profits like these are too hard to hold onto, that the volatility of the shares makes it nearly impossible for disciplined investors to lock in any profits at all. For example, I recommended Yahoo!, a business that is very similar to Google, in 2001. I bought at the right time, around $17.87 per share. But we were stopped out of the position after 9/11 happened, at a loss. Today Yahoo! trades at $35.00 per share. It was almost a huge winner for me. But not quite. We were stopped out too quickly. You might say, “Well, stop using a trailing stop loss!” But that is a recipe for total disaster.

I have good friends who lost millions and millions of dollars on Enron. They bought it all the way down. It only takes one big mistake like that to wipe out an entire lifetime of investing -- which is why you cannot afford not to cut your losses. I do not think you should buy Google -- because it is way too expensive and far too volatile. I have come to believe that buying expensive stocks is simply the wrong thing to do -- regardless. It might feel good. It might be exciting. But it leads you where you do not really want to go. And, what is worse is that by spending time with risky investments, you end up missing the truly great stocks to buy.

Imagine if, instead of buying Yahoo! in 2001, I had recommended shares in a boring, cheap and safe company, like NVR, the homebuilder. The business was booming. NVR, unlike most large homebuilders, does not buy and develop large tracts of raw land. NVR is simply a contract builder. In 2001, like today, NVR had a huge backlog of future orders. Mortgage rates were plummeting. And I knew the stock was extremely cheap. If I had recommended NVR in 2001, we would be sitting on a 1,500% profit right now, without experiencing much volatility at all. You might assume that bigger opportunities, wider margins, faster growth and new technology necessarily lead to bigger investment returns. But even when you discount volatility, they do not.

ANTI-SARBANES-OXLEY MOOD RISES IN EUROPE

Sarbanes-Oxley was intended to improve the transparency with which public companies in the U.S. conduct their businesses, but even private companies in the U.S. are feeling pressure to comply with its requirements. And they are not the only ones. In Europe, growing resentment at the unwanted pressure being forced on Europe’s businesses is persuading some firms to take drastic action, with some even threatening to delist from U.S. stock exchanges. But this may not solve all of their problems, since companies with 300 or more shareholders in the U.S. are also bound by the requirements of Sarbanes-Oxley and, as rules governing shareholding by U.S. individuals and firms have been loosened recently, firms no longer need to have a presence on the U.S. stock exchanges to generate a significant U.S. shareholder base.

According to estimates made by PricewaterhouseCoopers, there are 470 non-U.S. companies listed on the New York Stock Exchange, with a combined market capitalisation of $3.8 trillion -- or 30% of the total value of capitalization of companies quoted on the exchange. However, the costs of maintaining a U.S. listing are high and, combined with the costs of complying with the requirements of Sarbanes-Oxley, are making some firms question whether such costs outweigh its benefits. For example, German chemicals producer BASF estimates that the extra costs of Sarbanes-Oxley compliance are somewhere between $30-$40 million per year. Household names recently quoted as saying that they were at least considering delisting include the Rank Entertainment Group and British Telecom from the UK.

The prescriptive nature of the demands also rankle with European companies. In the UK, the combined code on corporate governance that was updated in 2003 uses a “comply or explain” approach, realising that one set of rules cannot be universally applied across all companies. This is something that Europeans find much easier to swallow. In addition, strict data protection laws in Europe may make compliance with Sarbanes-Oxley actually in breach of the Data Protection Act of 1998.

THE DARK SIDE OF THE BOOM: PROPERTY TAXES

Darlene Murdick, a registered nurse in South Bend, Indiana, began investing in real estate 14 years ago to boost her income and provide for the long-term care of a daughter with Down’s syndrome. By 2003, the 40-year-old owned 67 apartments in what was then a rising local real estate market. Murdick’s financial future -- as well as that of her daughter -- looked bright. Then came Indiana’s statewide reassessment. “It was crazy,” she says. “The actual values were nowhere near what the assessed values were.” Murdick’s total tax bill doubled just when her local rental market had softened. Tenants moved out, fearing rent hikes. When she tried to sell properties, no buyers were willing to meet her asking prices. “Not with the taxes jacked up,” she says. Unable to come up with the additional taxes, Murdick walked away and let the banks foreclose. Her experience may be extreme, but it is emblematic of a nationwide property tax phenomenon.

The spike in U.S. house prices -- 36% over the past four years -- has been a boon for sellers, yet rising values can be bittersweet for neighbors left behind. Higher prices mean higher property tax assessments, but since these price gains exist only on paper, many homeowners struggle to pay their suddenly higher tax bills. In the second quarter of 2004, for example, state and local property tax collections increased 9%, double the growth rate for personal income in the same period. The good news is that property taxes are one area where fighting city hall usually pays off. According to the American Homeowners Association (AHA), just 2% of assessments are appealed, even though about a third of all properties are overassessed. Among those that are appealed, a whopping 75% result in a reduction of taxes.

DID THE STOCK MARKET BUBBLE TEACH US ANYTHING?

The millennium started with such promise. Investors began 2000 having enjoyed four years of amazing stock market gains, fueled by the rise of the Internet and explosive growth in a variety of technologies. The economy was growing at an explosive rate. Everybody was in the market. On Jan. 14, 2000 -- five years ago this week -- the Dow Jones Industrial Average closed at 11,722.98, a record high that stands to this day. The other major indexes would follow in March. The Nasdaq composite index topped out at 5,048.62 on March 10, while the Standard & Poor’s 500 index rose to 1,527.46 on March 24. Few were prepared for the bottom to fall out, with the indexes eventually tumbling to 5- and 6-year lows, or for the market’s recovery to take so long. Approaching those 2000 highs again could take years, especially for the Nasdaq.

October 9, 2002, would be the final day of reckoning on Wall Street, with the Dow, Nasdaq and S&P 500. The final tally: the Dow had fallen 37.8% from its high, the S&P 500 lost 49.5%, and the tech-heavy, startup friendly Nasdaq tumbled 77.9%. Billions of dollars simply ... evaporated. So did some investors. Many others did come back, however, and the impressive gains in 2003 -- a 25.3% rise in the Dow and a 50% rise in the Nasdaq -- showed that the market could recover. Still, for many investors, stellar returns may have created an unrealistic picture of a stock market that historically has gained only about 8 to 10% a year.

That is not to say nobody paid attention. For many, the bubble illustrated what happens when you hold on to stocks for too long, ignoring sound investment decisions in favor of what Federal Reserve Chairman Alan Greenspan famously called “irrational exuberance” -- and that term was coined back in 1996. Still, a recent poll of American investors showed that the lessons of the dot-com bubble may not have sunk in entirely. According to a poll, 22% of the 1,110 investors polled said real estate was the best investment, followed by 16% favoring pharmaceuticals and 14% eyeing technology. Those are pretty high percentages, considering that earnings at technology companies have flattened considerably, while the pharmaceutical industry has been rocked by allegations of shoddy research and heightened risks of serious health problems in its products. And real estate, while still enjoying historically low interest rates, is booming with eerie similarity to the dot-coms of the 1990s. And those rates will inevitably rise.

IS THE BOND MARKET STILL TOO COMPLACENT ON FORD, GM?

The $231 billion question facing the global credit market this year is whether Ford Motor Co. and General Motors Corp. will keep their investment-grade ratings. The combined amount the two automakers owe in the bond market is how much investors have at risk as the pair continue what looks like an inexorable slide toward junk. Crippling pension and healthcare costs, rising prices for raw materials, and higher U.S. interest rates are just some of the reasons to be skeptical about their ability to dodge the drop.

Common sense might suggest that any bond investor concerned about the outlook for Ford or General Motors has had ample opportunity to dump U.S. auto bonds and switch to more palatable investments. Yet, a market quirk that is dubbed “the tyranny of the indexes” prevents money management from working that way. Ford debt accounts for 3.21% of the Lehman Brothers investment-grade credit index for dollar bonds, while General Motors obligations are 2.98% of the $1.7 trillion index. Only General Electric Co. bonds are more significant, representing 3.51%. Put simply, if you are using the Lehman index for gauging performance, you are forced to own Ford and GM bonds because they make up almost 6.2% of your chosen market. Otherwise, you risk underperforming against your benchmark in the event that their debt gains compared with their borrowing peers.

Standard & Poor’s affirmed Ford’s BBB- assessment on October 14, the same day it cut General Motors by one level to the same grade, the final stop before junk. S&P says the outlook for the creditworthiness of both companies is stable. Ford owes bondholders about $110 billion, while GM is in hock to the tune of $121 billion. Investors decided during the course of last year that they are more bearish on the outlook for GM than Ford. They drove the yield on GM’s 8.375% bonds repayable in 2033 to about 300 basis points more than U.S. Treasuries, from less than 200 at the start of the year. The spread is currently about 325 basis points. By contrast, Ford’s 7.45% bonds maturing in 2031 ended the year yielding about 235 basis points more than Treasuries, after starting the year at about the same spread as the General Motors issue. The Ford debt currently yields about 266 basis points more than government securities. The average yield spread on U.S. BBB rated bonds is just 115 basis points, according to Merrill Lynch. Nevertheless, you would be hard-pressed to find an analyst willing to predict a cut to junk this year.

While bond prices seem to already anticipate a rating deterioration, that is little help to money managers trapped in the debt by their benchmark indexes. In a survey of European investors last month, JPMorgan Chase asked what the consequences would be of a cut to junk for General Motors. Sven Kreitmair, a credit analyst at HVB Group in Munich, reckons the trigger for S&P to cut the outlook on its GM rating to negative is likely to be weak 3rd-quarter results in about mid-October. He is expecting Ford’s rating to remain unchanged. Investors stuck with their U.S. automaker paper should be looking to the credit derivatives market to buy insurance against the day when the ratings for Ford and GM reflect their diminished status on the world’s roads.

WHAT THE “BIG MAC” INDEX REVEALS

After a career of crunching numbers, it is rare that the results of my number crunching just blow me away. But that is what happened today. I found yet more proof that 2005 will be a year that surprises everyone: it will be a year where the dollar strengthens dramatically versus the euro, and we will make money in our three new True Wealth investment recommendations. It all started innocently enough. The Economist recently put out its “Big Mac” Index, which shows the price of a Big Mac in many countries in the world. The Big Mac Index is a handy way to gauge whether a currency is undervalued or overvalued RELATIVE to its peers. But to me, it is only useful on that relative basis.

A Big Mac in Britain is 20% more expensive than it is in the States right now. I collected 17 years of data from back issues of The Economist. The typical (median) difference has been for Big Macs in Britain to be 19% more expensive than in the U.S. So the fact that a Big Mac costs 20% more in Britain right now does not mean Britain’s pound is 20% overvalued. It is about in line with history -- which is NOT what most experts would tell you right now. In 2001, a Big Mac in Brazil was 35% cheaper than a Big Mac in the States, however, a Big Mac in Argentina was only 2% cheaper than in the States. The Big Mac Index should have been a good warning sign that the Argentine peso was overvalued and could crash. Argentina’s peso did crash, and today a Big Mac in Argentina is 9 percentage points CHEAPER than a Big Mac in Brazil, instead of 33 percentage points more expensive. So what was it that surprised me so much today?

Well, the dollar allegedly crashed in 2004. However, the price of a Big Mac is almost EXACTLY at its 17-year premium or discount norm for most countries ... EXCEPT when it comes to the euro and the Japanese yen. Simply put, based on history, the Japanese yen looks cheap, and the euro looks pretty expensive. A Big Mac in Japan used to cost twice what it did in the States. Now a Big Mac is cheaper in Japan than in the States. A Big Mac in Europe is 25% more than a Big Mac in the States -- the highest overvaluation since the introduction of the euro in 1999, and well above the 17-year level of 14% more expensive than the U.S. I have no good explanation for this, except that the euro is overvalued.

Everyone believes the dollar will crash in 2005. The U.S. dollar versus the euro will likely be the contrarian trade of the year. It has got what I look for in a trade: VALUE (the dollar is cheap versus the euro), it is HATED, and the UPTREND in the dollar may have just started.

Universal Disdain

Sometimes it is too easy. Sometimes everything just lines up. If you are open enough to listen, the profits are right there in the corner, just waiting to be picked up. I try to listen, even when the message is extremely uncomfortable and does not seem to make sense. I find that my biggest winners are often the most “uncomfortable” trades. I started in this business as a broker specializing in international stocks and bonds. My dad was kind enough to be one of my first and biggest accounts. Of course, I wanted his account to grow the most, with the least risk, but other clients’ accounts were simply rising faster. After a year or so, I realized the problem. Being so careful not to lose any of Dad’s money, I would only share an idea with my dad once it was “comfortable”. That often meant after the good, safe stock I was buying for other clients had risen steadily for weeks. In other words, we bought too late.

The lesson there was, when all the stars are fully aligned and yet I am still uncomfortable, chances are, it is going to be a good trade. Let me give you an example: The headline of the September 2004 issue of True Wealth, “Bull Run in A Bear Market Starts Now”. It was a bold and uncomfortable position to take. To make it even more uncomfortable, it looked like tech stocks were the right place to be. There was no historical precedent, or proof. But things just lined up. I had to listen. It was right, and felt wrong. Perfect! Since everyone was bearish, I simply saw it as limited downside -- there was nobody left to sell risky stocks. So we stepped in, as the first buyer of risk. Risk was cheap, I thought.

Let me ask you: can you please name one asset where everyone is bearish? When you think about it, it is easy -- it is the U.S. dollar. Everyone hates it. And now the media coverage (an excellent indicator of when the trend is at an end) has now reached an extreme. Everyone is bearish... so there are only potential buyers. Let us be one of the first. The absolute ideal situation is when everyone is bearish, yet the factors that will cause that investment to rise are actually in your favor. And that is what we have with the dollar right now.

In my research, I have found that only two things are PROVEN to affect a currency: 1.) purchasing power and 2.) interest rates. Right now, the dollar is cheap versus the euro (that is purchasing power), and your money is now treated better in U.S. dollars (2.25%) than in euros (2.0%). In short, the only two fundamentals that have been proven to matter over the long run favor the dollar over the euro right now. So everyone hates the U.S. dollar. But the dollar is actually fundamentally more attractive than the euro right this moment, by the only things actually proven to matter. Perfect! Of course, nobody will believe us now. And that is just what we want.

The only thing keeping me from jumping into the dollar with both feet is the current price trend. As I write, the euro is still strengthening versus the dollar, though its pace has slowed. Once the trend reverses, that is it! Now I understand if you are bearish on the dollar, and uncomfortable with this idea. Remember, everyone is. And I understand that the U.S. has big deficits. Remember, everyone else knows that too. That is not new news -- it is currently baked into the price of a euro. Here we are, we have got a slam-dunk coming. But with the euro still rising slowly, the price trend says we are not quite there yet.

EURO CRISIS? WHAT EURO CRISIS?

Europeans, many of whom worked themselves up about the swooning dollar and the stampeding euro last year, suddenly seem to have mellowed, as the dollar has rebounded in recent weeks. Public and private comments by central bankers and other officials here have been noticeably more relaxed since the beginning of January, when the dollar reversed its relentless decline against the euro -- even though economists caution that underlying trends have not changed. The European Central Bank left its benchmark interest rate unchanged at 2%, and its president, Jean-Claude Trichet, delivered a more sanguine message about growth prospects and inflation.

The ECB has tried to avoid being buffeted by the daily swings in the currency markets, resisting pressure last month to reduce interest rates, as the euro set daily records against the dollar. European exporters complain that this has depressed their sales in the U.S. Mr. Trichet reiterated that sharp currency moves were unwelcome and undesirable for growth. But his otherwise relaxed tone suggested that for now, the euro was a manageable problem.

Economists warn that the dollar’s recent rebound is probably a technical correction rather than a lasting shift. Most expect the euro to resume its upward course against the dollar, especially since the U.S. reported a record trade deficit and Asian countries, notably China, show few signs of letting their currencies appreciate against the dollar. But even at an exchange rate of $1.36, which the euro reached on Dec. 30, most economists say the pressure on European exporters is bearable.

For the first time in years, economists are starting to speak of Germany as a potential engine of growth for Europe, rather than a dragging anchor. Retail sales picked up over the Christmas holiday season, and surveys of German business confidence turned up sharply in December. The recovery of the dollar has also shifted many Europeans’ gaze from the U.S. to Asia. While European leaders were calling on the U.S. to tackle its trade and budget deficits last month, they are now calling on the Asians to allow their currencies to rise. There is still plenty of skepticism here about the readiness of the U.S. to confront the deficit or stanch the fall of the dollar, especially since a weak dollar benefits American exporters. But after months of frustration, some here are choosing to look on the bright side.

Is Germany making a comeback?

Germans got something to cheer about: “The German economy, Europe’s largest, returned to growth in 2004 after the longest period of stagnation since World War II, as an increase in exports overcame a slump in consumer spending.” (Bloomberg.com) Whoo-hoo. Who would have guessed that after the negative 2003 GDP growth, Germany could actually add 1.7% to its economy last year, even surpassing the average 1.2% growth rate of the previous decade? A remarkable comeback, especially considering how concerned economists have been that the strong euro would kill German exports and thus the prospects for economic improvement.

But instead, to everyone’s surprise, German exports jumped by 8.2% in 2004, effectively pulling the country out of the recession. Which brings us to a very interesting question. How does the conventional economic theory explain this phenomenon of growing German exports amidst the strengthening German currency? The conventional import/export theory goes something like this. A strong currency makes foreign goods cheaper on the domestic market, which boosts imports. Simultaneously, the strong currency hurts the country’s exports as its goods become more expensive to foreign buyers. Well, the German currency -- the euro -- has been getting stronger. As of today, it takes $1.32 to buy one euro. Such tremendous appreciation should have considerably slowed Germany’s exports in 2004. Yet, the opposite has happened, defying the conventional economic “wisdom”.

This chart below summarizes the situation best. The conventional theory implies that there should be an inverse correlation between the top graph (the euro-dollar exchange rate) and the bottom one (the German trade balance), but it seems that this correlation is not as clear-cut as the conventional economics would have you believe. What is more, the traditional approach does very little to help you forecast the future of the German economy. To do that, you must look to the German stock market. The DAX has been rallying for the past six months, indicating improving social mood, and if it can keep it up in 2005, the German economy will follow.

ALL HANDS ON DECK-ADENCE?

Has the ocean gotten smaller in the past three years? A January 12 article in Australia’s Herald Sun observes, “Luxury yachts -- the bigger, the better -- are the latest indulgence for the super wealthy. The trend worldwide is that the man who bought a 100 foot boat five years ago now wants the 120. Figures suggest the international yachting industry has grown by as much as 90% in the past 10 years as the competition for the elite few amongst the super rich to stay ahead of the ordinarily wealthy has intensified.” And nothing makes that distinction clearer than billionaire Paul Allen’s 414-foot yacht, equipped with its own helicopter-landing pad.

But while it may sound like these boat owners have gone off the deep end, the titanic size and sale price of these privately owned vessels is no surprise to us. In the January 2005 Elliott Wave Financial Forecast we remark that, “The big-boat fling appears to be satisfying the social craving for separation and detachment along with the grandeur and hope of a great bull market. Given the current glut (there are now more yachts than world-wide berths), the craze for bigger and bigger boats should, well, do exactly what it did during the last ‘great yacht boom’.”

LESS A SECRET NOW, IF NO LESS DIRTY

Homeownership rates in the U.S. have been remarkably constant over the past 40 years, almost always in a range between 63% and 66% (Census Bureau data). In fact, I would not need to say “almost always”, except for a change in the data that began to unfold in the late 1990s. Homeownership reached 67% for the first time ever in Q3 of 1999, then 68% in 2001, then 69% in 2004. These record levels of homeownership have received a lot of positive attention, and I am not about to suggest that it is bad to own a home. “Low interest rates” is the usual explanation for this unprecedented rise, but in fact this premise is flawed. Rates did not begin to fall until 2002, and by then the rising trend in homeownership was clearly under way already.

The dirty little secret is this: The unprecedented growth in homeownership is related directly to the explosive growth of “subprime” debt. As you may know, subprime lenders charge higher interest rates to borrowers with poor or no credit histories. Subprime lending practices are somewhat less a secret now (if no less dirty), thanks to a series of USA Today articles last month. The series detailed the sort of hair-raising abuses that define the word “predatory”. “Subprime mortgage activity grew an average 25% a year from 1994 to 2003,” and “accounted for about $330 billion, or 9%, of U.S. mortgages in 2003, up from $35 billion a decade earlier,” the article noted. Subprime lending is no different in kind than a host of other bullish excesses and extremes that characterized the 1990s. All of them crossed the line from risk to recklessness, or enticed others to do so.

FEWER WORDS THAN FIVE YEARS AGO, SAME FAITH

These days you do not hear many talking heads on the financial channel proclaiming that “the stock market always goes up”, at least not as often as you heard it five years ago -- which happened to be January 14, 2000, the day the Dow Jones Industrial Average closed at a record 11722.98. Still, the advice you DO hear from Wall Street always implies that stocks always go up, if not in so many words. What is more, most investors believe this advice, as evidenced by the financial choices they make.

In truth, the stock market does not always go up. You could add “in the long run” to the phrase, yet even then you need to define your terms. It took some 35 years for the Dow to return to its 1929 high; there was also a gap between record highs lasting from 1906 to 1916. That was a long time ago, but then we come to the more recent past, in the dry years between highs from 1973 to 1982. Stock market trends move in BOTH directions, and sometimes those trends last a long time -- and both directions present risk and opportunity. Investors who fail to understand and act on this truth miss half the picture. It is like having two good eyes, but wearing a patch over one of them.

FANNIE, FREDDIE INADEQUATELY PROTECTED SAYS FED’S POOLE

Fannie Mae and Freddie Mac, hit hard by accounting woes in the past two years that led them to oust top executives, should be required to hold more capital to cushion against shocks, even ones that seem unlikely, St. Louis Federal Reserve President William Poole said. “Their capital positions are thin relative to the risks these firms assume,” Poole told the St. Louis Society of Financial Analysts. In his speech, he reiterated his belief that the companies pose a “substantial risk” to the U.S. economy and told Reuters in an interview they should be cut loose from government protection and privatized.

During audience questions, he said he would raise the companies’ capital requirements to the equivalent of banks. Markets would then be the arbiters of adequate capital. Poole’s comments came hours after Fed released three studies suggesting, among other things, that the companies were falling short of one of the core goals that justify their government backing -- lowering borrowing costs to make home ownership more accessible.

In one study, Fed economist Wayne Passmore said the perceived government backing for the firms is worth billions to shareholders but does little to lower mortgage rates, raising fresh questions about their future as Congress considers tougher oversight. Passmore said Fannie Mae and Freddie Mac’s “ambiguous relationship” with the government generates a subsidy worth $122 billion to $182 billion. Shareholders retain $53 billion to $106 billion of that, the study said. Poole, a frequent Fannie Mae and Freddie Mac critic, said while investors may think the government would bail them out, it was unclear what would occur if either spun into crisis.

Passmore said 44% to 89% of the companies’ market value is due to perceived government support. But that implicit subsidy does not benefit homeowners, and the companies’ activity has a “negligible” impact on long rates, even during periods of market stress, Passmore and other Fed economists argued. In another study, the Fed economists studied Fannie’s and Freddie’s impact on mortgage rates during the 1998 liquidity crunch in the market and found the companies’ mortgage loan purchases did not affect spreads.

GREENSPAN MAY LEAVE PROBLEMS IN HIS WAKE

There is a worry building on Wall Street about what the future holds when, in a little over a year, the Alan Greenspan era ends. In a recent piece for Foreign Policy, Morgan Stanley chief economist Stephen Roach recalls a similar anxiety before Paul Volcker’s departure in the summer of 1987. Except for 1987 crash, which turned out to be a teensy blip in an 18-year bull market, the economy made the transition seamlessly. As to the condition in which Mr. Greenspan will leave the economy, Mr. Roach says, “The jury is still out.”

Congress mandates that the Fed accomplish three tasks: price stability, full employment and economic growth. Mr. Roach concedes that Mr. Greenspan’s Fed has made progress on all three. “However,” Mr. Roach says, “some unintended consequences of Greenspan’s efforts may jeopardize the United States’ long-term economic future.” Our primary vulnerability is the “profound shortfall in U.S. savings,” exacerbated by Mr. Greenspan’s insistence on keeping money so cheap for so long.

Mr. Greenspan has long preached that households’ financial assets play a critical role in an economy. That is paper wealth that makes people feel so good, they borrow and spend against it. It happened with stocks before the meltdown, and it is happening now with home equity. “Only in the United States are people aggressively tapping into the savings in their homes to finance current consumption,” Mr. Roach observes. The cachet surrounding the über-economist who advocates such behavior does not intimidate Mr. Roach. Some wrongs simply cannot be made right.

SAGE OF ETHICAL ACCOUNTING FORETOLD ARTHUR ANDERSEN’S DEMISE

“The most serious problems in our profession are caused by our own self-indulgence.” -- Leonard Spacek, 1956

Spacek was the chief executive of Arthur Andersen from 1947 to 1973, when Andersen was the moral voice of public accounting, and the ironic truth of his comments lingers even as the Supreme Court decided last week to consider overturning the accounting firm’s conviction for obstruction of justice. The court will review whether U.S. District Judge Melinda Harmon’s jury instructions were too vague when it came to determining whether Andersen employees knew it was a crime to shred documents related to Enron.

The Supremes’ decision, though, does not really involve the particulars of Andersen’s demise. Regardless of how they rule, it will not bring the firm back, and it will not change the fact that Andersen was a victim of its own self-indulgence. After all, jury foreman Oscar Criner said that Harmon’s instructions pertaining to the document destruction did not affect the panel’s decision. He said the nail in Andersen’s coffin was a memo written by in-house attorney Nancy Temple advising colleagues to alter documents that discussed Enron’s finances.

Make no mistake, the government’s decision to indict Andersen was harsh, and prosecutors knew it would kill the firm. Andersen, though, was a recidivist. It was the third time in a year that the firm was mired in a major accounting scandal, each bigger than the last. Seven months before Enron’s bankruptcy, Andersen had been hit with the biggest fine ever for an audit failure because it approved bogus financial statements at Waste Management. Punishment did not change the firm’s behavior. Andersen’s role as Enron’s shredder-in-chief was not a fluke, and it was not a mistake. It was inevitable given the firm’s track record.

The tragedy of Andersen’s collapse is that thousands of good, honest accountants were caught in the vortex of its failure. As too often happens in corporate malfeasance, the innocent bore the penalty. The legions of loyal Andersen partners did not deserve to be put out on the street, and they did not deserve a leadership that kept the firm on the wrong side of too many blown audits. Between 1997 and 2001, the year Enron collapsed, Andersen paid more than $500 million to settle claims of blown audits, including four of the five largest settlements.

The Supremes can weigh the legal technicalities of the case, but Andersen failure was preordained. It was foretold by its revered leader almost 50 years ago. Andersen was a victim of its own self-indulgence.

GIANT FUND MANAGER CUTS INVESTMENT BANK COMMISSIONS

Capital Group, the giant fund manager, has cut the trading commissions it pays to U.S. investment banks. The move intensifies the squeeze on research budgets and has sent shockwaves through Wall Street, which fears pressure for increased disclosure of commissions will reduce the amount funds will pay for research. The cuts by Capital, which manages funds worth more than $800bn, have added to the uncertainty over the future of bank equity research units already badly hit by reforms agreed two years ago with Eliot Spitzer, New York attorney-general.

Fund management groups pay Wall Street billions of dollars a year in trading commissions, a proportion of which are earmarked to pay for investment research. But large groups such as Capital also do their own research through teams of in-house analysts, raising questions about whether they still need brokers’ research. Capital says it has never paid for research via commissions and that if the issue of payment for research it values is raised it pays separately with so-called “hard dollars”. But it does receive research from brokers without making extra payments. Wall Street executives say that Capital’s portfolio managers and in-house analysts still seem to want access to Wall Street research especially the complex computer models analysts maintain on companies they cover.

Some brokers say it has been made clear to them that if they withdrew the “free” research they would lose Capital business. Commission rates have been falling for years and total commissions generated on U.S. equities fell to $11.3 billion last year. Capital’s move is a further setback for sell-side research departments as they grapple to find a new business model after Mr. Spitzer revealed widespread conflicts of interest in equity research during the stock market boom of the late 1990s. Most banks have pruned their research departments, but still feel that a credible equity research department is needed to help them win trading business.

THE MONEY PIT

The financial media is full of bores and quacks -- just like Congress. But all the hacks share a common and vulgar hustle: They all promise you more money. There is something unbalanced about it. Only half a man’s life is passed in trying to make money, and not necessarily the better half. The other half is spent trying to get rid of it. The following little letter is designed to help.

IT CERTAINLY FEELS LIKE 1929

When you think of a bubble in the 1920s, what comes to your mind? We are willing to bet that it is not the Florida real estate craze of 1925. That is right, in the early 1920s, land prices in Florida began to rise as tourism was thriving and celebrities from around the world were spotted partying in and around Miami. Add to that exponential population growth and the superficial, money-centered culture of the time, and housing prices in this new playground of the wealthy and famous were guaranteed to grow exponentially.

By 1924, the Miami Herald was rumored to be the nation’s heaviest newspaper in terms of weight because of the colossal amount of real estate classified ads in its pages. Easy credit was abundant and it seemed like 99% of the public was either a real estate investor or broker. Stories of property prices rising 500% in less than a year reached the rest of the country and soon capital poured in at an even faster pace. The music finally stopped during the summer of 1925 and prices started to decline by Christmas. The pace of selling increased and, just when it could not get any worse, a hurricane wreaked its havoc the following year. Game over. Economic historians will tell you that the only reason why Florida real estate saw any relief at all in the late 1920s was because of the wave of nation-wide prosperity from a dramatically rising stock market. But as you all know, the stock market stopped rising and crashed in October of 1929. Stocks collapsed and took everything down with them including real estate.

Today, we see many parallels to the 1920s, except this time the stock bubble came first. We suspect that when history books are written about the first ten years of the millennium, it will be a (credit crunch-induced) real estate collapse that is most memorable, rather than the NASDAQ collapse of 2001. Perhaps 2005 will be the year that real estate takes everything down with it, similar to how 1929 saw stocks take everything down with them. The parallels are obvious. How many people do you know who are real estate agents, mortgage brokers, appraisers, builders, developers, etc? Can you recall the last time you were at a restaurant or cocktail party and the conversation did not swing to real estate?

What we see coming is classic deflation folks, where cash is king and all other assets will suffer. Hold on a second -- are we suggesting you dump all of your money in some junky money market with an anemic yield? Of course not! There are other cash alternatives to the U.S. dollar. Our two favorites are gold and silver as they are the world’s oldest forms of money -- dating all the way back to biblical times.