Finance Digest for Week of January 24, 2004

GOLD PRICES? THE DOLLAR OFFERS CLUES

To get a fix on the price of gold, precious-metals analysts examine mine production, estimate the recycling of gold scrap, weigh the demand for gold jewelry, assess investor interest in gold bars and coins and keep an eye on inflation. Lately, however, you probably could have done just as well by watching the price of the euro against the dollar. The euro, as compared with the dollar, has moved pretty much in lock step with price of an ounce of gold. When the euro has jumped in value -- meaning that the value of the dollar has declined -- the price of gold has generally also climbed; it is now at $426.90 an ounce.

Since the dollar began a sharp decline against the euro last August 30, there have been 82 days when the euro’s value and the near-term gold futures contract moved in the same direction in New York. On only 17 days did the two go in opposite paths, and just once did that happen two days in a row. It is no surprise that moves of the dollar and gold are related, with gold rising when the dollar falls. That is because many factors, like inflation or robust American stock and bond markets, often push the two in opposite directions.

But in predicting gold prices, the dollar’s strength against the euro has been a much more effective tool than its value against the Japanese yen. Over the same period, there were 34 days when the yen’s value against the dollar did not move in lock step with gold -- twice the number of days when the euro and gold diverged.

DELUSION, CONFUSION AND APPROACHING DISCONFIRMATION

The global and domestic economies are in upheaval. The basic macroeconomic organization and function of the U.S. is changing rapidly. Mid-quintile earnings have been stagnant for several years as debt levels rise. Likewise, the global economy is experiencing the end of an epoch, and the violent struggle to define new laws of motion. Free trade globalization is being replaced by increasingly hot and bilateral struggle and emerging alliance blocks. This is clear from Chinese and Indian energy deals, South American trade association wrangling, EU enlargement struggles and chaotic battles for control over former Soviet areas of influence. This would seem likely to call into serious question the passive assumption that past noise correlations are the stuff of prudent strategy moving forward.

Today’s American and world economies, live on debt, wealth, imbalance and speculation. So long as economists refuse to admit and factor these realities, forecasts and prognostications -- never terribly accurate - will rest on unsound foundations. Thus, the assumption that we can endlessly borrow and profit from speculative asset returns requires that historically unprecedented returns to wealth and ability to borrow big and cheap continue. There is an inherent plasticity to credit and speculative returns. Both are born of expectation and bubble prone. The extension of credit and buying frenzies that drive asset inflations can be led, over fairly long periods, by opinions, hopes, dreams and delusions. Elastic credit, already near the snapping point, and lightening fast speculative hot monies, are the pillars of today’s global economy. This creates instability and the possibility for rapid change.

The kind of confidence and surety that fill recent forecasts of stability are thus, delusional. If they prove correct it will be fortuitous accident and add undue credence to profoundly erroneous assumption. It seems clear that the prevailing average expectation will be tested by the likely tumult that increasingly defines an unbalanced global economy, gyrating under the strain of excess cheap credit, speculative hot money and geo-political flux.

SPENDING CAPITAL WISELY

In his post-election press conference of early November, President Bush famously said, “I’ve earned capital in this election and I’m going to spend it.” In his second inaugural address, the President gave every indication of sticking with this promise. This could be a very challenging commitment insofar as economic policy is concerned. While Mr. Bush is hardly lacking in political capital, financial capital is another matter altogether for a saving-short US economy. That poses two critical and related questions: Who will foot the bill for these bold initiatives? Will they solve America’s biggest economic problems?

An important hint to the answer of both questions was contained in the recently released November data on U.S. trade and capital flows. The trade deficit, of course, ballooned to a record $60.3 billion, whereas net foreign buying of long-term U.S. securities surged to $81 billion in the same month. These numbers hardly came out of thin air. In my view, they are telltale signs of the only incremental funding option available to a saving-short U.S. economy -- the need to import surplus saving from abroad and run massive current-account and trade deficits in order to attract that capital. They provide a very direct answer to the first question: As long as America’s domestic saving rate remains woefully deficient, any policy proposals which exert a further drain on aggregate saving will have to be funded by foreign savers.

That takes me to the second question -- America’s most serious problem. In my view, it is all about saving. In a world where saving must always equal investment, a chronic saving shortfall eats away at the sustenance of long-term economic growth for any nation. For that simple reason, I continue to believe that America’s saving deficiency is its most serious economic problem. It is against that backdrop that I believe we must evaluate the basic thrust of the economic policy agenda of the second Bush Administration. And from that perspective, I have serious misgivings. I would feel much better about the direction of economic policy -- as well as the outlook for the U.S. economy -- if Washington’s primary focus was on boosting national saving through a credible program of government deficit reduction and increased personal saving. Yet in their politically-inspired zeal for reform, politicians are leaning the other way and overlooking what the U.S. economy needs most -- a new approach to saving policy.

DEFICITS MAY BE WEARING THIN AT THE FED

They are only low-level rumblings, oblique signals of discontent that are stripped of any direct political threat. But as President Bush embarked on his second term last week, it was hard to escape the sense that his longtime honeymoon with the Federal Reserve may be ending. The Fed and its chairman, Alan Greenspan, have arguably been Mr. Bush’s most important economic supporters. Mr. Greenspan gave his blessing to the Bush tax cuts of 2001 and, less enthusiastically, to those of 2003.

Despite Mr. Greenspan’s reputation as a staunch opponent of fiscal deficits, he tiptoed around criticism of the soaring federal debt that Mr. Bush ran up in his first term and will almost certainly continue to run up in his second. Perhaps most important, the Greenspan Fed cut interest rates and showered the nation with cheap money to soften the recession of 2001 and to keep consumers spending through nearly three years of rising unemployment. But something new is afoot, and it is not just that the Fed is raising rates back to more normal levels. So far, a measured pace of rate increases has merely reflected the Fed’s increased confidence that economic growth is on a steady course.

The new element is a rising concern at the Fed about the nation’s imbalances: the federal deficit, which hit $413 billion in 2004; a low and declining national savings rate; evidence of speculative behavior among investors and consumers; and the country’s enormous trade and financial deficit with the rest of the world. In November, Mr. Greenspan noted that foreign claims on United States assets -- essentially the nation’s net indebtedness to the rest of the world -- were now equal to one-quarter of the nation’s GDP. The trade deficit this year is almost certain to exceed $600 billion -- nearly 6% of the nation’s economy, and still climbing.

“This situation suggests that international investors will eventually adjust their accumulation of dollar assets or, alternatively, seek higher dollar returns to offset concentration risk,” Mr. Greenspan said. That, he continued, would make the cost of foreign debt “increasingly less tenable.” To most economists, such comments are simply a statement of time-honored truth: a borrower who runs up huge debts will become a bigger risk to lenders and gradually have to pay higher rates. But Mr. Greenspan’s comments also carried a warning: rising budget and trade deficits come at the price of higher interest rates.

The Fed fired off another warning in the published minutes from its policy meeting on Dec. 14. More surprising, the minutes said that some policy makers worried that the prolonged strategy of low rates might be fostering “excessive risk-takin”q in financial markets and in the market for houses and condominiums. That sounded like a veiled reference to concern about a “housing bubble”, an idea that Mr. Greenspan has repeatedly shot down. A third veiled warning came on Jan. 13 from Timothy F. Geithner, president of the Federal Reserve Bank of New York. In a speech to financial executives about risk management, Mr. Geithner suggested that investors had become too complacent about risks posed by global imbalances -- particularly those in the U.S. In private sessions, Mr. Greenspan may well be warning Mr. Bush in blunter terms.

The Greenspan succession.

One Fed chairman famously described his job as being to “take away the punch bowl just when the party gets going”. Bond and currency markets want monetary policy in the hands of someone who will say no to politicians. Today it is even more crucial than usual that the Fed chairman have the markets’ trust. The U.S. is running record budget and trade deficits, and the foreigners we depend on to cover those deficits are losing faith. According to yesterday’s Financial Times, central banks around the world have already started shifting into euros. If Mr. Greenspan is replaced with someone who looks like a partisan hack, capital will rush to the exits, the dollar will plunge, and interest rates will soar.

Yet President Bush, as you may have noticed, only appoints yes-men (or yes-women). This is most obvious on the national security front, but it is equally true with regard to economic policy. The current Treasury secretary has no obvious qualifications other than loyalty. The new head of the National Economic Council apparently got the job because he is a Bush classmate and fund-raiser. Of course, Mr. Greenspan himself has become a Bush yes-man. The chairman acted as a stern father figure, demanding fiscal rectitude, when Democrats held the White House. But he turned into an indulgent uncle when Mr. Bush took office. Nonetheless, Mr. Greenspan retains considerable credibility with the markets. Who else can satisfy both Mr. Bush and foreign investors?

A name one often hears is Ben Bernanke, currently a member of the Fed’s Board of Governors. If Mr. Bernanke were appointed directly from his current Fed position to the chairmanship, there would be general acclaim. But he may soon move to the Council of Economic Advisers. Why? I hope I am wrong, but my guess is that what is intended for Mr. Bernanke is a form of hazing: he will be expected to prove his loyalty by defending the indefensible and saying things he knows are not true. That might seem a tolerable price to pay for the Fed chairmanship -- but a year of it might well make Mr. Bernanke damaged goods from the point of view of the markets. It is a dilemma. I do not have any sympathy for the administration’s perplexity. But I do wish Mr. Bernanke the best of luck, and hope he knows what he is doing.

A big rise in interest rates could cost you a bundle.

Last spring I said the economy was not as strong as Washington was pretending, so interest rates would not go up. I was mostly right. What happened was highly unusual. The Federal Reserve has been trying to raise interest rates by boosting the so-called Federal Funds rate five times. The 6th hike may be on the way in early February. But borrowing costs in the real world have not moved very much. While savers can get a little more interest on short-term certificates of deposit, you will pay nearly the same rate on 30-year mortgage now as you did last summer. Same for car loans and money borrowed longer than a few months. Astoundingly, the financial markets did not obey the dictates of monetary regulators.

So here is the big question for 2005: Will bond prices finally get hammered because interest rates are rising in accordance with the Fed’s wishes? The value of your home or apartment could very well decline if borrowing costs go up. If rates rise substantially, the housing bubble that everyone else has been worrying about could burst. The second problem that higher rates could cause would come by way of the stock market. If interest rates climb, companies will join everyone else in paying more to borrow money. And if borrowing costs increase, corporate profits will decline. Investors -- already in a bad mood -- will not like that. But the big question is, will interest rates climb?

The answer is, I do not know. Nobody does. If you grabbed my feet and started tickling until I gave an answer, I would say there is a slightly better than even chance that they will. But the odds are only that close because even with all our problems, foreigners still think their money is safer here than anywhere else. And they are willing to accept less of a return for that peace of mind.

THERE’S A GOOD TIME AND A BETTER TIME TO INVEST; NOW IS A LESS-BETTER TIME

Over the last century, the average U.S. stock returned almost 10% per year, including dividends. But that number is misleading because it is the result of averaging wildly diverse annual returns. You will hear all kinds of happy talk about how stocks always do well over the long term, but in the long term we are all dead. The harsh reality is that investors unlucky enough to buy at the wrong time could earn piddling returns for more than a decade. Since the 1920s, there have been two such dry spells. The first began in September 1929 and lasted until April 1942. The second started in November 1968 and continued through July 1982. In each case, a process statisticians call “mean reversion” played out in fits and starts. Asset prices changed from expensive to cheap.

For those lucky enough to have their money in the right place at the right time, strong economic tailwinds can drive returns a long way. The latter part of the 20th century was one of those fortuitous periods. After the wars, scandals, inflations and stratospheric interest rates of the 1960s and ’70s, investors had thrown in the towel on stocks and bonds. By the summer of 1982, there were few sellers remaining -- and equally few buyers. Financial assets were considered passé. But as economic conditions improved over the next 18 years, equity investors gradually raised the price they were willing to pay from seven times earnings to almost 40 times. Coupled with normal profit growth, stocks gained 18.5% annually between 1982 and 1999, or almost double the historic average. A $25,000 investment in the S&P 500 in 1982 would have been worth $530,000 (before taxes) by 2000.

Unfortunately, financial markets do not send out engraved notices of pending trend reversals. If they did, stock investors would have received their letters in January 2000 and bondholders would have gotten the bad news in June 2003. Since then, the early stages of painful mean reversions have been under way in each asset class. My hunch is that home prices could be next on the chopping block. Cash is cheap and virtually everything else is expensive. Such a time is not the best time to buy.

LENDERS FIND A WAY -- DOWN PAYMENT OR NOT

Back in the bad old days, folks needed something called a “down payment” in order to buy a home. The size of the down payment was typically between 10% and 20% of the purchase price, so -- either you emptied out your hard-earned savings, or you earned and saved until you had a lump sum big enough to fork over. Only then could you become a homeowner. But now? Heck, it is not even normal to build equity in your home. The fashion these days is to cash it all out and then some. So saving -- as in, “for a rainy day” -- well, really, it is such a quaint idea.

If you want to be a homeowner, lenders will find a way, down payment or not. Subprime loans, shares of stock as a down payment, ARMs, no-equity loans: These and other “creative financing” schemes all shift the risk to the borrower, often in flagrantly onerous ways. Lenders are even willing to buy “mortgage insurance” policies when the borrower has only a small sum for a down payment. If the homeowner defaults on the mortgage, the lender still gets paid. The risk shifts to the insurer. And of course, you would expect mortgage insurers to set aside cash reserves for “estimated future losses”, in the same way that auto and property insurers do. Alas, according to the Jan. 21 Wall Street Journal, “Mortgage insurers don’t. In fact, they don’t have to book reserves until the delinquencies are reported.” So, when insuring higher-risk loans, these companies have not even taken the steps that other insurers take against “normal” risks.

Why is this a concern now? Well, according to the Journal story, “Mortgage defaults are most prevalent in the third year of a loan, and as 2001 and 2002 were bumper years for the business, some companies could start seeing more losses this year and next...” And even this comment assumes that the economy will be continue on a path of modest growth -- never mind a housing bubble that pops, or another turn south in the markets, or another recession or worse. It is one more large potential problem that is mostly overlooked, until the “potential” becomes all too real.

NEW STOCKS, SAME OLD PROBLEMS

Improving corporate governance has been at the heart of many new regulations in recent years. So you might assume that companies issuing shares to investors for the first time would take care to institute the most shareholder-friendly practices possible. You would, however, be wrong. This perplexing insight comes from Linda R. Killian, portfolio manager for the IPO Plus Aftermarket fund. She reports that 51% of the companies that went public last year had poor to very poor governance practices. That is even worse than the 37% of new companies with dubious governance identified by Ms. Killian and her firm during the maniacal stock market of 1999.

The most common governance problems cited by Ms. Killian in new issues are a dearth of truly independent directors keeping watch over the companies, meager stockholdings by top executives and big insider selling when the deal is done. That is different from previous eras, Ms. Killian said. “In the 1990’s, for example, there used to be more odious insider transactions,” she said, “or part-time chief executive officers who would have outside interests that conflicted with their running of the public company.” Many of the new issues scoring low in corporate governance are real estate investment trusts, Ms. Killian said. One reason is that many of them are set up to capture tax benefits and may not meet the same standards as other companies. REIT’s have also been such top performers in recent years that shareholders who buy them as new issues may be willing to overlook governance shortfalls. Last year, REIT’s returned 30.4%, on average.

As a practical matter, Ms. Killian said, shareholders should flex their muscle, rewarding companies with good corporate practices and penalizing those that fall short. “Over the long term, good governance at a company makes a difference in its performance,” Ms. Killian said. And investors interested in exceptional performance have to be watchful, even now.

COULD A STOCK MARKET FOR PRIVATE FIRMS SUCCEED?

The idea has been around for decades: a public marketplace for private-company stock. Now Entrex Inc. claims to have created such a market through a partnership sanctioned by the SEC. According to Entrex founder Stephen H. Watkins, the market has been set up as a coordinated effort with Niphix, a brokerage firm that operates an alternative online-trading system. Entrex provides the reporting infrastructure -- as EDGAR does for the public exchange -- while Niphix serves as the actual exchange. Watkins says the marketplace will take some 2 to 5 years to establish itself. “We are where Nasdaq was [originally],” he says.

Part of the appeal, says Watkins, is that the fourth market will provide exposure that private firms need to raise capital. “It will [provide] an increased valuation for companies because of the exposure, credibility, and liquidity that the market brings to shareholders,” he says. Georgetown University professor James Angel notes, “to be a public company, you need to be big enough to justify the overhead of all the reporting requirements of issuing stock.” In addition, “from a markets perspective, you have to be big enough to make it worth looking at by institutional investors.”

BEHIND THE NUMBERS, FANNIE MAE, GM ARE STRUGGLING

When companies implode slowly, folks often erroneously conclude that all is well. When Enron came unstuck, it unraveled slowly at first, before dropping from about $38 to $4 in two weeks. To my eyes, Fannie Mae is a train wreck moving in slow motion when -- in this modern world of finance, and given Fannie’s balance sheet -- one would think the wreck would occur at the speed of light. No sane person can now draw any other conclusion about Fannie Mae than that its business is forever changed, from what is believed to have been and what it was.

As Jim Grant said in the most recent issue of Grant’s Interest Rate Observer, “Before the scandal, Fannie’s business model was one part simplicity, another part privilege and a third part audacity: Borrow at a government-advantaged rate; invest at a slightly higher rate. Leverage the balance sheet as no private enterprise could. Grow and grow. Deliver predictable, stair-step earnings growth.” That pretty much sums up what Fannie Mae’s business plan used to be. Any time it was threatened, it invoked the sacred word, “homeownership”. That got anyone hassling the mortgage lender off its back. That, of course, has all changed. That change will have far-reaching ramifications which, to my mind, have not yet been felt.

Turning to my other favorite speculative financier, that being General Motors, I shake my head every time I think about their bonds trading at 400 basis points over Treasurys when the automaker willingly lends money to anybody, upside-down or credit-worthy, for zero percent. Likewise, General Motors (via General Motors Acceptance Corp.) is the company behind Ditech.com, an organization that prides itself on basically lending any amount of money to anybody. I certainly think that with GM and Fannie Mae coming under pressure, there is an ill wind blowing for housing -- and that is without even discussing all the other financial intermediaries which have blown up recently.

IBM’s just reported that its backlog for services was down, and its bookings were the lowest in three years. Yet, everyone was crowing about IBM because it was able to win at the silly game of beat-the-number. Well, nearly everybody wins at beat-the-number. Even GM managed to win at beat-the-number as it unraveled. Fannie Mae won at beat-the-number for years, but we now know it has been cooking the books. Ladies and gentlemen, any company that wins at beat-the-number on a regular basis most likely made it up. Multibillion-dollar businesses are far too complicated to be able to hit a number within a penny, time and time again. Could any of you project for me what your checkbook balance will be at the end of a month?

BYRON WIEN’S 10 SURPRISES INCLUDE HIGHER OIL PRICES

Each year I look forward to reading Byron Wien’s 10 surprises. Wien, a stock-market strategist at Morgan Stanley, manages to blend economic, political and stock market insights. Wien deals in probabilities. His 10 surprises are events to which he believes most people would assign less than a 33% probability, but which he thinks have a probability of 50% or more. Number 1 is that the price of crude oil, currently near $50 a barrel, will drop to $30, then rise to $60, Wien asserts. Number 2 is that the dollar’s weakness in 2004 will intensify in 2005, Wien thinks. The euro will jump to $1.50 from about $1.30 now.

He also predicts that the S&P 500 Stock Index will be flat in 2005, and that China’s economy will grow about 9% despite government efforts to slow it down a bit. In his most spectacular prediction, Wien suggests that Russian President Vladimir Putin will resign following revelations of corruption in the Ukraine election. While he believes that President Bush’s proposal to partially privatize the Social Security system will go down to defeat, he thinks Bush will push through tort reform, with some Democrats onboard because they are concerned about a doctor shortage outside major cities.

DR. KURT RICHEBÄCHER SAYS HIS PIECE

I returned to Dr. Richebächer’s apartment, and we immediately got back to work. For two and-a-half hours straight he answered my questions. Even when I had run out of tapes, he kept talking. My pen raced along to keep up. Among the most important information Dr. Richebächer gave me some was what to expect in the next few months. More importantly, he told me what to do about it. First of all, avoid U.S. stocks. Dr. Richebächer foresees serious dangers in the U.S. economy, and the stock market will be the first victim. Foreign stocks are only slightly safer. If the U.S. stock market sinks, it will take much of the world’s stock markets with it. A few foreign stocks could offer U.S. investors some modest returns, but only because of the currency exchange rate. If you must hold bonds, go short-term. Five years maximum ... and even that may be too much.

None of this was unexpected. But then I asked about gold. “I don’t touch gold,” he said gruffly. My eyes almost fell out of my head. Just about every financial writer I know is a big fan of the yellow metal. I was about to tell him that, but he cut me off... “Still, I have many good friends who are gold bugs,” he said, a little more warmly. “I know why they think it will go up. And I believe they are right about the price going up. But not for the reasons they say. The simple fact is,” he told me, “the gold price is psychological. It has nothing to do with economics.”

Dr. Richebächer is 86 years old, and he still has a fire in his eyes. He constantly watches financial news channels. His housekeeper has a hard time organizing the daily stream of newspapers and magazines. And he is now using the Internet for even more up-to-the-minute data. He explained that it was one of the few joys he had in life. “I only live for two things now,” he explained to me, “my grandchildren... and the other is my newsletter. I think the letter keeps me alive.” It was a little sad to hear Dr. Richebächer talk about his mortality, though. He often talked how there are so few people left he could have a serious economic conversation with.

He also mentions how no one in America recognizes the trouble he sees. And after spending so much time with him, I have to wonder why. Forget the fact that Dr. Richebächer has been right so many times before. It looks like his numbers today are just as solid. Yet no one notices. “It is almost as if Americans are afraid of any cracks in their optimism,” he said. “They completely ignore the negative.” Dr. Richebächer believes that things are too far gone to turn around. Is he right? I wish I knew. As an American, it was tough for me to hear all the horrible imbalances in the economy. It was even worse to be shown the numbers. The sad fact is, compared to the past; things were absolutely horrible this time. “The numbers haven’t been like this since the Great Depression,” Dr. Richebächer told me.

THE WEIGHTING GAME

One of the measures of supreme confidence in a sector has been an extraordinary weighting relative to the rest of the stock market. Over the past 25 years, there have been 3 such examples of phenomenal weightings that formally recorded big market compulsions that inevitably became unsustainable. At the end of 2004, the Financial Services Sector accomplished a 23% weighting relative to the S&P 500. This compares with the 7.5% recorded in late 1990 as the Fed had to suddenly bail out Citigroup and Chase as they became insolvent following their aggressive lending in real estate and energy. Banks are the most recent example and could be vulnerable to the typical post-euphoria loss of esteem so it is worth noting that the two previous examples were followed by a long period of dismay and, eventually, neglect.

The first occurred during the secular bear market that ended in 1982. Within a DJIA decline in deflated terms of 68% from 1969 to 1982, the energy play became compulsive and topped out in January, 1980 along with the frenzy in gold and silver. Plotted at month-ends, this chart shows the build in the energy mania from 15% in 1979 to 29% in 1980. The next rush to a phenomenal weighting was accomplished in the techs as they went from 7.5% at the end of 1992 to 34% in March, 2000 (chart). The special feature was that this occurred at the climax of a new financial era as previously exampled by the South Sea bubble of 1720 or the 1929 financial bubble.

The most recent example of an extraordinary weighting has been achieved by the banks (chart). Quite fittingly, the low of 4.5% was set at the same time as the mania in the energy sector blew out. For this study, we will focus on the action from the low of 7.5% in late 1990 to 23% at the end of December. This has occurred within the context of two cyclical bull markets and is all the more remarkable for maintaining the high weighting on the latest one for many months. The latest move, which started at 14% at the end of 2000, increased to a current 23% -- that is 9 points in 5 years. This has been a rather big event and vulnerable to a change of esteem.

Our Bank Trading Guide is building the most distinctive technical “sell” since 1998. To conclude this, the Guide has to break down. Another consideration is that credit spreads since year-end have been widening. Full reversals for both the Guide and credit spreads could be completed within 6 to 8 weeks. The sharp breaks in the other hot games, such as the stock market and base metal prices, are quite likely integrated with the sudden widening of spreads. While this increases our confidence in the pending bear market for global bank stocks, it is prudent to look to another approach. A few weeks ago, the ChartWorks noticed that Citigroup’s chart was showing some striking similarities to the pattern described by Bank of America’s stock peak at the beginning of the formidable January, 1973 to late 1974 bear market.

BIG PHARMA’S AILS COULD SPREAD TO BIOTECH

It is astounding that biotech stocks have been largely sheltered from the news of drug safety disasters, high drug costs, and scientific roadblocks to creating new drugs. While the American Stock Exchange’s pharmaceutical index has sunk some 5% in the past six months, its biotech index has risen by 10%. Some have actually argued that big pharma’s ailments will be good for small biotechs, because big drug companies will be more likely to overpay for experimental medicines. This is shortsighted.

“Interestingly, we are seeing the distinctions between these two kinds of companies and their stocks sort of erode,” says Geoffrey Porges, a biotech analyst at Sanford C. Bernstein. “Any change in regulatory oversight of drug safety is also going to affect biotech companies, particularly as they start to stray from their original mission of focusing on expensive drugs for high-end diseases in relatively small patient populations.” No drug company is an island, and the same forces will work on all medicines, whether Amgen or Pfizer (nyse: PFE - news - people is the manufacturer.

Biotech companies are sometimes sheltered in ways older drug firms are not. For instance, they are far less likely to suffer from big patent expirations, both because they are drugs are newer and harder to copy. But investors should remember that at the end of the day, medicines from biotech and big pharma go through the same regulators to the same doctors and patients.

ECHOES OF THE ‘80S: JAPANESE RETURN TO U.S. COMMERCIAL REAL ESTATE MARKET

Japanese investment in U.S. real estate soared in the 1980s, as companies and financial institutions poured nearly $300 billion into high-profile properties like Rockefeller Center in New York and the Pebble Beach Golf Club in California. But the value of many of these assets plunged by as much as 50% in the early ‘90s, and for more than a decade, the Japanese have been sellers rather than buyers. After a 15-year hiatus, however, Japanese capital is re-entering the U.S. market, but much more quietly and cautiously this time. A survey released this month by the Association of Foreign Investors in Real Estate, a trade group, found that most of its members expect the Japanese to lag only Germans and Australians as the most active foreign buyers of U.S. property.

So far, much of this Japanese money has been used to buy shares in publicly traded companies, rather than individual buildings. In October 2003, it became legal in Japan to sell portfolios of shares in real estate investment trusts, allowing special funds to be marketed specifically to Japanese investors. Some of these funds buy shares only in REITs based in the U.S., which largely own property in this country, while other funds own a portfolio of REIT shares from various countries, including the U.S. Since these funds were first sold, investment in them has steadily increased, reaching $4.6 billion last month. Although this sum is just a fraction of the total $300 billion invested in U.S. REITs, real estate specialists say it is significant nonetheless.

A treaty that went into effect on July 1 gives Japanese investors in U.S. REITs the same tax status as American investors. REITs, which pool money from investors to buy property, are required to return 90 percent of their taxable income to their investors, which means that they usually offer higher yields than most other types of securities. The Japanese have their own real estate investment trusts, but the industry is still relatively new, with only about 15 so-called J-REITs in existence. The average dividend is about 3.5 to 4%, compared with an average of 6% for American companies.

Although the downturn in the U.S. real estate cycle in the early 1990s caused painful losses for many Japanese investors and banks, the Japanese continue to have significant holdings in this country. Mitsubishi Estate, for example, lost control of Rockefeller Center itself, but the company, through its wholly owned Rockefeller Group, still owns 7.7 million square feet of space there, including the Time & Life Building at 1271 Avenue of the Americas. Early last year, the Association of Foreign Investors in Real Estate reported that Japan was the leading source of foreign investment in American real estate, with a 26% share, the latest figure available.

Mr. McMahon, the Mitsui Fudosan America executive, said his company was not looking for trophy buildings but rather for those that have potential for improvement. He acknowledged that bidding for properties in Washington and Midtown Manhattan, is challenging. “We don’t know at this point whether we’re going to be successful,” he said. In the last decade, Japanese investors have become more sophisticated about market cycles, Mr. Morimoto said. “We learned a lot from the experience. The best strategy is to diversify the location and timing of the investment, and by doing that we could have diversified our risk.”

FOREIGNERS SWOOP IN ON U.S. EQUITIES

Foreign demand for U.S. equities has risen to its highest level since the September 11, 2001 attacks, says UBS, the Swiss bank. A sustained pick-up in overseas buying could yet steady the dollar and bring its 3-year slide to a halt, the bank believes. “Foreign appetite for real U.S. assets finally seems to be picking up five years after the bursting of the U.S. equity bubble,” said Mansoor Mohi-uddin, chief foreign exchange strategist at UBS. “This is a clear short-term risk to our underlying bearish dollar view.” UBS’s in-house proprietary data shows that net equity flows between Europe and the U.S. have turned positive for the U.S. on a 6-month moving average basis for the first time since the World Trade Centre attacks. Inflows in recent weeks are said to be “substantial”.

Why overseas investors should increase their exposure to the U.S. at a time when most observers expect the dollar to continue falling and Wall Street is trading on a higher price/earnings ratio than other major markets is less clear. Mr. Mohi-uddin believes the recent highs in the S&P have attracted foreign investors, while an increased global risk appetite may have increased cross-border equity flows in general. Whatever the reasons, rising foreign demand for U.S. equities is likely to be a crucial factor in the eventual stabilization of the dollar, particularly as equity purchases are less likely to be hedged than bond purchases.

WORLD’S BIGGEST ONLINE POKER SITE CONSIDERS IPO

PartyGaming, the online poker and casino operator formerly known as iGlobalMedia, and owner of Party-Poker.com, has appointed Dresdner Kleinwort Wasserstein and Investec to advise it on “strategic options”. PartyGaming has 5 million registered users. It has been sounding out banks in London over a potential flotation that could be worth more than £2.3 billion ($4.3 billion). Bankers who have seen the Gibraltar-based group’s accounts say that it generated earnings before interest, tax, depreciation and amortization of more than $350 million in 2004.

The group is keen to float in 2005, after witnessing the successful acquisition of Paradise Poker, a rival poker site, by Sportingbet, the UK-listed online betting company. After that deal, Sportingbet shares rose nearly 64%. With online poker booming, bankers say investors are clamoring for a listed vehicle to invest in. “[PartyGaming] knows there is a window of opportunity here which is why they want to get the float away,” said one. A successful PartyGaming float is expected to catapult the group into the FTSE 100, creating a business similar in size to William Hill, the quoted bookmaker.

WILL YUAN BE MADE FLEXIBLE FIRST?

Without announcing any time frames, China has vowed to make the yuan flexible and fully convertible. The order in which the authorities keep the two promises will decide how long the wait will be before predictions of a stronger Chinese currency come true. “The currency should be gradually moved toward full convertibility,” China’s central bank chief Zhou Xiaochuan said in Beijing this month. “This year there will be further steps in this aspect, but generally speaking the progress will be steady.” In a separate statement, also released this month, the People’s Bank of China said it will make changes to the exchange rate “actively and steadily”. Full convertibility means the yuan can be freely exchanged into foreign currencies and vice versa for investments. Flexibility refers to the degree to which the yuan can fluctuate before the central bank intervenes. They are two distinct goals.

Policy makers in Beijing seem to be indicating that they want convertibility, which is at least a few years away, to be the basis for flexibility. That is making analysts pessimistic about the likelihood of a big jump in the yuan’s exchange rate this year from 8.3 to the U.S. dollar, a level at which it has been pegged for the past decade. China is much safer opting for flexibility before convertibility. The country’s bad debt-ridden banking system is still too weak for the authorities to take away from it the punch bowl of super-cheap local deposits that, in the absence of full convertibility, have nowhere else to go.

If China shuns dollar, look out U.S. bonds.

Malaysia is not a place traders look for clues about the U.S. dollar, yet Asia’s No. 10 economy may be offering some ominous ones. They can be found in a recent report on international reserve holdings the nation’s central bank. It states that Malaysia made a $2.1 billion “revaluation gain” in 2004, “arising mainly from the depreciation of the U.S. dollar against the major currencies.” Is Malaysia buying an increasingly amount of euros -- or even yen -- these days? Its central bank sure did not make that kind of cash holding the dollar, the currency to which its own, the ringgit, is pegged. The plot thickens when you consider how such a shift away from the dollar would jibe not only with comments from top Malaysian officials, but trends throughout Asia.

U.K. JANUARY HOUSE PRICES REBOUND

U.K. house prices rebounded in January after falling the previous month, suggesting a five-year housing boom may be ending without a slump, the nation’s third-biggest mortgage lender said. Home values rose 0.4% from December to 151,757 pounds ($285,607) after a 0.2% decline the month before, according to Nationwide Building Society. Annual house-price inflation slowed to 12.6% from 12.7% in December, the lender said. “With prices having been broadly stable for six months and the market nearing the end of the usual seasonal lull, there are indications that sentiment may be about to turn more positive,” said Alex Bannister, an economist at Swindon, England-based Nationwide on the group’s Web site. “We continue to expect small price rises in some months and small falls in others.”

S.E.C. GIVES FOREIGN FIRMS SOME HOPE ON NEW RULES

William H. Donaldson, chairman of the S.E.C., while in London, said that the commission was considering tweaking some rules for overseas companies listed in the U.S., after an outpouring of foreign criticism of the Sarbanes-Oxley Act. Mr. Donaldson said that the S.E.C. was also considering making it easier for foreign companies to delist from exchanges in the U.S., and that it planned to consider requiring fewer years of past financial statements that comply with U.S. accounting principles. The agency would also consider pushing back the deadline for foreign companies to comply with the Sarbanes-Oxley rules on internal controls, Mr. Donaldson said. At present, that deadline is the next annual report that comes after April 15 of this year.

The S.E.C.’s willingness to consider changes is the first sign that some concessions might be made for foreign companies whose shares are listed in the U.S. Since the Sarbanes-Oxley Act was passed in 2002, some overseas companies have been trying to delist from American stock markets and others have opted to list elsewhere because they say the expense of complying with the rules outweighs the benefits. As a consequence, U.S. delisting rules have come under fire. According to a rule that dates back decades, companies with 300 or more shareholders in the United States cannot delist their shares from the exchange where they trade. Consequently, they need to comply with Sarbanes-Oxley.

In addition, the S.E.C. is rethinking how it treats companies listed in Europe that must convert to the E.U.’s new international foreign reporting standards. In coming months, Mr. Donaldson said he expected the S.E.C. to look at a proposal to allow those using the new European standards to reconcile two years of financial statements to U.S. accounting principles, instead of three.

NOTHING VENTURED, NOTHING LOST

An experienced investor is a humble investor. He knows that “correct” is not the same as “successful”. He understands that compounding wealth relies more upon a vigilant defense than upon a sporadically brilliant offense. He is not ashamed of the wounds he has suffered in past stock market campaigns, but neither does he seek to earn any additional purple hearts in the pursuit of wealth creation. Thus, the experienced investor understands that fighting against prevailing fundamental trends is one of the best ways to suffer serious financial wounds. In short, the experienced investor is one who would be more likely to sell U.S. financial assets on January 25, 2005, than to buy them. For long periods of time, the stock market can withstand the onslaught of adverse fundamental influences like high valuations, declining corporate profits or rising interest rates.

Indeed, stocks sometimes manage to excel amidst seemingly impossible odds. In the bubble years of the late 1990s, stocks soared despite ridiculous levels of overvaluation. They soared and soared ... until they crashed. Then, in October 2002, the market found its footing and charged ahead once again. Valuations were still high by historical measures. But corporate profits were recovering and most of the underlying fundamental trends supported -- or at least permitted -- rising share prices. Eventually, however, the favorable underlying trends became somewhat less favorable. Few investors cared.

The stock market closed out 2004 in very fine form, inspiring widespread confidence and optimism as the New Year dawned. Unfortunately, rising interest rates, rising oil prices, rising consumer prices, a tumbling U.S. dollar and slowing corporate earnings are not bullish trends. They are bearish. The owner of U.S. stocks, therefore, does not lack for reasons to sell at least some of them. We do not know if the Nasdaq’s steep 8% drop year-to-date is the beginning of an even bigger sell-off. But it ought to be.

Two weeks ago, Federal Reserve Bank of New York President, Timothy F. Geithner, highlighted four of the major macroeconomic trends that may be worrisome for a few experienced investors: 1.) Rising debt-to-GDP ratios throughout world economies. 2.) America’s massive reliance on foreign capital. 3.) The competitive pressures of a rapidly industrializing China and India. 4.) Volatile and unstable foreign exchange rates. The bad news is that any move toward fiscal responsibility and/or exchange rate stability would likely remove economic stimuli from the global economy. In other words, the cure might be worse than the disease, at least for the short-term, and at least for the buyer of overpriced U.S. financial assets. If it is true that discretion is the better part of valor, today’s investment climate would seem to require more discretion than valor.

WEIRD STUFF IS HAPPENING IN THE MORTGAGE AND HOUSING MARKETS, NOT TO MENTION AT THE FED

Rates for 30-year mortgages fell last week to the lowest level in more than three months. By itself this is noteworthy enough, yet the real curiosity about this trend comes from the contrasting one in the housing market: while mortgage rates have fallen, housing activity has slowed down. The Mortgage Bankers Association reports that its index of mortgage application activity decreased 3.6% for the week ending January 21; this was also the third consecutive week that home buying activity registered below the levels from a year ago. The slowdown appeared in mortgage loan requests, refinancing applications, and sales of existing homes.

Meanwhile, over at the central bank, the fed funds rate keeps going up, one small step at a time, and at least one important measure shows that the money supply is contracting. So: The housing market seems to be taking its cue from Mr. Greenspan, unlike the mortgage lenders who want to keep the party going, nor like the bond market where Treasury yields have not gone up, even though the fed funds rate HAS. Is it possible that the Fed is trying to slow down an economy that never got going to begin with? As I said, Weird Stuff. I am just glad I am not an establishment economist trying to explain all of the above (and more) to investors, since the textbooks would say none of it is possible.

KEEP YOUR EYE ON THE ASSUMPTIONS (ESPECIALLY THOSE OF ACADEMIC ECONOMISTS)

I love to read economist Steven Landsburg, even though I almost always disagree with him. In the present article, I will focus on a chapter from Landsburg’s forthcoming book entitled More Sex Is Safer Sex, which could pass as a parody of economic analysis worthy of Swift. As I will explain more carefully in a moment, Landsburg argues that the way to slow the spread of AIDS is to encourage certain individuals to have more sex! To this end, naturally, the government must get involved with complicated subsidy schemes (which must be read to be believed).

As with most other neoclassical conclusions that defy common sense, this is just another case of faulty reasoning from a clever mainstream economist. Were we to actually follow Landsburg’s advice, I would predict an increase in AIDS cases. To defuse the reader’s immediate skepticism, let me say that Landburg’s analysis is not as crazy as it initially sounds; it is surprisingly difficult to pinpoint precisely where he goes astray. Nonetheless, I ultimately agree with the knee-jerk reaction of the typical prude: Landsburg’s arguments are dead wrong, and will only encourage the spread of AIDS. As with other counterintuitive neoclassical arguments, Landsburg goes wrong by (1) making simplified assumptions about people’s preferences, (2) restricting the options under consideration, and (3) thinking in static (rather than dynamic) terms.

PENNY STOCKS, PENNY WISE?

When you turn to the New York Times business section, you often expect to read about and see the photos of the nation’s top financial big wigs: Here an Attorney General, there a Disney executive, and everywhere a corporate celebrity. But in a January 23 article, the accompanying photo was of a wild white-haired, white bearded, bespectacled no name whose role in the world’s largest economy is -- well -- spokesman for a penny-stock success story. No joke. As the long profile of the man reveals, he and 15 friends succeeded in turning a pink sheet investment into a silk-sheet standard of living in two short years.

Here is how: In February 2003, when the Internet stock of their eye was officially delisted by falling to 15 cents a share, they decided to “strike on this buying opportunity of a lifetime”. Which -- when the stock soared to a split-adjusted $10 a share in June 2004 -- seemed to materialize as just that. (Today, the stock sells for $25.47 a share) While their story may be exceptional, their “gung-ho” attitude about penny stocks is anything but. The NYT piece cites a few chief market strategists who also propose using your cents to bring in the big bucks. For example, “The ranks of penny stocks are about the only place to find real bargains. They are ‘mispriced pieces of paper,’ which is to say, stock certificates that are undervalued.”

Sound familiar? Well, it rings a bevy of bells for us. In September 2003 we said, “Back in the 1980s, when the bull market was young, the financial media continually warned investors about the dangers of penny stocks. These days, a low stock price is not a red flag, it’s conclusive evidence of a bargain.” Today, the financial media is still warning investors about the risks in penny stocks. That same Times article mentioned many potential hazards, but who can remember such dreary details when they are scattered in a rags to riches story of this caliber: In the final paragraph of the piece, the man and his 15 friends who made it big gathered at the “high-roller” Mirage Suite (the “Ritz” of Las Vegas) to toast their success. Essentially, the mainstream “experts” are saying yes, there is risk -- but just see how much it is worth it. But when psychology produces such a flight from quality into the riskiest of ventures -- rare exceptions duly noted -- we know that one kind of wave pattern in stocks is set to unfold.

BUNKERED: THE GREAT CRASH OF 1980

“I was just trying to make some money.” That is what Bunker Hunt said to his sister having just bankrupted one of America’s richest families. It took him just three months to lose a multi-billion dollar fortune. The Hunt brothers will always be remembered as the fools who dared to corner “the market”. To paraphrase a long story, they bought as much silver as they could ... silver futures, silver coins, silver ingots, silver mines. By January 1, 1980, they had accumulated over 192 million ounces of the metal, valued at $35 an ounce. On the other side of the trade, a whole group of Wall St. types had gone short silver futures, and were getting “squeezed”. These firms had a legal obligation to deliver silver at predetermined prices to the counter-parties in the trade. Only problem was, the counter-parties -- the Hunts and the other silver bulls -- already controlled the world’s supply of silver.

The “shorts” were trapped, so what did they do? They changed the rules at the silver exchanges, limiting the amount of silver any one individual could own and increasing margin requirements. Stability was the official justification. It is one of Wall Street’s favorite tricks ... if the rules don’t work in your favor, you get ‘em changed. Whatever the case, the Hunts were forced to liquidate parts of their position, and silver crashed -- from over $50 at its intra-day peak, to below $10 less than two months later. The Hunts went bankrupt and Paul Volcker organized a $1.1 billion dollar loan to “prevent the very fabric of American finance from tearing apart.”

That is the story we were told at school. It is also what you read in the newspapers and in most books. But as we found out, it is not necessarily the TRUE story. Paul Sarnoff, research chief of a large commodity house and a major player in 1970s and 1980s commodity trading, had first-hand knowledge of the entire episode, and knew many of the principles personally. The Hunts were not motivated by greed in the slightest, Sarnoff explains, but more by paranoia. Think of it like this: Everyday his family was trading innumerable gallons of a scarce natural resource -- petroleum -- for paper dollars. Not a great trade if you are worried about inflation. “Bunker and his family had the ability to see twenty years down the road and realize that the purchasing power of paper dollars could only go one way: down,” explains Sarnoff. “So it is understandable that Bunker searched for a natural asset to replace the one sold by the Hunts, which over a period of time would appreciate in value despite inflation.”

In fact, Bunker Hunt and his brother still own large quantities of silver. How much? “If you can count it,” says Bunker, “it can’t be very much.” In 1989, Bunker left bankruptcy with a net worth of between $5 and $10 million, according to Forbes, though he still owed the IRS more than $90 million to be paid over 15 years. By 2000, he had already paid it off.

WHAT CAN WE LEARN FROM THE 1965-1982 SECULAR BEAR MARKET?

Commencing months ago -- many analysts have decided that instead of experiencing a cyclical bull inside a secular bear, we are now involved in a new secular bull market. Maybe, maybe not -- but I personally believe the secular bear is still with us, will be with us for a considerable time yet, and it is about to reassert itself, if it has not already done so. In this regard, let us go back to a point in yesteryear to see if it might not provide some guidance.

There is always at least a modicum of controversy in dating such major market events. In passing, therefore, I will quickly explain why I use 1965-1982 -- specifically, 12/31/65 through 8/12/82. It is mostly a matter of “big-picture” configuration, as well as a little convenience. The Dow finished 1965 at about 969, the closest it had come up to that time to closing at or above what would become the highly elusive 1,000 mark. (The industrials finally made it on 11/14/72, 1,003.16 on 11/14.) A long time later -- 8/12/82 -- the DJIA closed at about 777, 19.8% below where it had stood at the end of 1965. In between, the industrials closed as high as about 1,052 and as low as roughly 578. Thus, someone buying the Dow at the end of 1965 and holding it through 8/12/82 had roughly a 20% principal loss, offset by dividends, of course. Although there was no net forward progress over this approximately 16.6 year period, there was a great amount of volatility.

From its 1973 high close -- a record -- through its final 1974 low, the DJIA fell 45.1% -- from 1,052 on 1/11/73 to 578 on 12/6/74. This 23-month, 45%+ decline equaled a little more than half of the DJIA’s 1929-1932 Great-Depression era loss of 89.2% (381 on 9/3/29 to 41 on 7/8/32). I was managing a sizable amount of aggressive equity money around the time. Therefore, I remember the 1973-1974 episode quite vividly. I also remember that many pundits of the era were convinced that the 1974 lows marked the end of the great secular bear market of 1965-1982. Since I have dated the end of that affair as 1982, the pundits were wrong, or at least they were as I assess the situation, as discussed earlier. But after the DJIA’s 1974 low was made, happier days indeed returned -- for a while.

The DJIA’s highest post-December 1974 close came on 9/21/76, at 1,015. Over this 33.5-month period, the Dow gained more than 75% -- a nice rise that nevertheless failed to take out the 1973 high. And of equal if not greater importance, almost six years later, the DJIA stood at 777, 23.4% below 1976’s high water mark and more than 26% below 1973’s record high. During the current cycle, the Dow fell almost 38% between 1/14/00 and 10/9/02 (11,723 to 7,286). From October 2002 through its next high close -- 10,854 on 12/28/04 -- the DJIA was up almost 49%. Other bellwether measures rose a good deal more.

Conclusion: As always, the market will do what it will do. Using an example from a past situation with similarities to the current one, I wanted to illustrate that just because the stock market has risen a good deal over a meaningful period by no means assures us that the long-term bear market -- the secular bear -- is over. All that may have occurred was a period intersection between the long-term negative trend and a shorter-term positive one.

FEAR FACTOR

Before I tell you what the greatest single secret of investing is, I want to tell you why I am going to give it to you. I am going to tell you this secret because it is hiding in plain sight. I bet going public with it will not hurt me any, because knowing it does not change the fact that you still have to do lots of work to take advantage of it. So here it is, the #1 secret of investing: fear is the dominant emotion in the market at all times. I have never heard anyone say this, but I know of several famous investors whose actions reflect a clear understanding of it. When Warren Buffett bought shares of Wells Fargo back in the early 1990s, everyone thought he had lost his touch. He got a call from a colleague in New York -- strictly on the QT -- saying that Wells Fargo was not going to make it. Buffett never let the fear get to him. Today, Wells Fargo is the only AAA-rated bank in the country. Buffett has made in the neighborhood of 20% a year on it.

But even Buffett has misquoted the secret. He said once something like, “To make money, you have to be greedy when everyone else is fearful and fearful when everyone else is greedy.” I think Warren Buffett is wrong about that one, and I bet if I called him up and told him, he would agree with me. If people were really greedy, they would wait until stocks were in their darkest hour -- and therefore at their lowest prices -- to buy them. But most people do not do that. They wait to buy. Nobody wanted stocks in 1982, the perfect moment to be greedy. There was no reason to be afraid, no reason to wait. You do not wait to buy something that is priced right unless you are afraid. Period. That is why I say that fear is the dominant emotion in the market at all times.

Instead of doing their own work and relying on the conclusions of their own thinking, most investors -- including most of Wall Street -- let the price action of the entire market, or even of a single stock, pinch hit for their own intellects. Maybe it is not great insight to say that everyone is afraid at market bottoms. But what about tops? Everyone is greedy at tops, right? Wrong. The reason so many people become involved in stocks at market tops is because ... everyone else is buying. That is what everyone is waiting for. When you are filled with fear, you wait for some sign that it is safe to buy again. The sign investors choose most often is the actions of others.

Otherwise sensible people, crazy as it sounds, though blessed with a perfectly good brain, often choose to substitute the product of someone else’s brain for the product of their own brain. Somehow, if someone else is doing something, it makes it more legitimate than if they thought of it on their own. Here we are, the paragon of animals, and most of us do not get past the behavior of lemmings when it comes to investing. But in order to make money investing, you have to stand on your own. You have to do your own thinking. You have to do your own research. You have to make your own decisions, and handle the consequences every step of the way.

2005 PROGNOSTICATIONS FOR NATURAL RESOURCES MARKETS

It is time to make a few predictions for 2005. In my opinion, you really do not need to be psychic. You simply need to make general conclusions based on past trading history and current events. So below are a few of my straightforward predictions for some of the major markets. All are subject to change and adjustment as events as the year unfolds. The point is all of these predictions serve as a macro base of my viewpoint, just as technical indicators do, and seasonal trends as well. But all are subject to change. A good trader is flexible when need be. However, I feel strongly that the predictions below are very likely and serve as a good barometer for a market that is heating up fast with investors, the resource markets.

Crude oil will trade between $38-52 for year, and spike at some point to $60 or above --possibly as high as $100 per barrel. I believe there will be an attack on a major oil installation in Saudi Arabia in 2005. I believe we will see $3 gasoline this summer -- supply levels are not seeing the builds they need this time of year, and this is likely setting things up for a summer similar to 2004. Natural gas will continue to gain favor, but will be extremely volatile as it moves ultimately toward the $8 mark. Coal companies will continue to grow throughout 2005 as the world energy complex is strained to capacity. Companies to watch: CONSOL Energy (NYSE: CNX) and Foundation Coal Holdings (NYSE: FCL).

Gold prices will certainly be determined by dollar strength or weakness. However, if the dollar resumes its decline, as I feel strongly it will, gold could reach the $500 mark before summer. I feel the upside potential for gold is to $550, barring any major event or a complete collapse of the dollar. Shipping Companies, drillers, refiners and the major oil companies will all have another record year of profits and see their share prices climb significantly. With the resource markets gaining huge market share, few investors will be able to turn away from this important sector - a sector that has long been shunned as “high risk” and gambling.

Jim Rogers, the famous “Investment Biker” and guru, is also the creator of a commodities index and matching mutual fund that carry his name. “Everybody has a brother-in-law who bought soybeans on a 5% margin and then got wiped out.” But things have changed. An NYSE membership trades for under $1 million for the first time in a long time, yet a New York Mercantile Exchange membership just sold for $1.7 million. The commodities markets are gaining in stature and respectability and cannot be brushed off as easily by old school money management professionals anymore. Rogers points out, “People who have always ignored and scoffed at commodities can no longer afford to do so.”

An astute observation from Rogers is that prices move to the extremes. This has happened so many times since 1960 that “You would have made more money in the last 45 years in commodities than in stocks and bonds,” he says. “You would have had less risk and a better inflation hedge.” So one prediction I will stand by 100% is that the future of the resource markets and related equities is solid and will keep growing as demand for raw materials, foodstuffs, energy and anything else the world uses remains in high demand and short supply.

The Dow will reach 11,000-plus, but will finish the year lower. China and India will begin cutting more and more deals with Russia, Venezuela, Nigeria and elsewhere, as the Chinese population is projected to grow by 60 million in five years. The United States will entangle itself in yet another crisis, this time in Iran, and the results will be even worse than Iraq. Russia will continue to recoup its “plundered” natural resources and the companies that use them, similar to the YUKOS battle. This will caution investors from the West, but will ultimately have little effect.

A trillion barrels of oil ... and prices rise?

The notion of a “coming oil shortage” has been around for decades. I remember the lines at the gas pumps in 1973-74 all too clearly. The economic wise men of the time made dire predictions. If they had been right, the world’s oil supply would have been long gone by now. Still, the notion persists as strongly as ever in some quarters. A professor at Princeton published a book in 2002 with “Impending World Oil Shortage” in the title, which was favorably reviewed in all the right places. The price fluctuations over the past year have only fed the beast.

Now, I could give you my opinion of all this, but it is probably better to stick with the facts, to wit: There is no shortage of oil. There will be no shortage of oil. Not now, not next year, not in 50 or 100 years. “Oil, Oil, Everywhere...” is the title of a fact-filled essay in the Wall Street Journal, which shows how absurd the “oil shortage” fears truly are: “To pick just one example among many, finding costs are essentially zero for the 3.5 trillion barrels of oil that soak the clay in the Orinoco basin in Venezuela, and the Athabasca tar sands in Alberta, Canada. Yes, that’s trillion -- over a century’s worth of global supply, at the current 30-billion-barrel-a-year rate of consumption.” Mind you, those are merely two oil fields in Venezuela and Canada, comparative little leaguers vs. the major league oil fields in the Persian Gulf region.

Shortages have nothing to do with oil prices because there is no shortage. In truth, when it comes to the price of a barrel of oil in today’s market, there is virtually no evidence that supply and demand has anything to do with it. Total world supply and demand have grown at the same constant pace since the mid-1980s. And by definition, two constant factors cannot account for wide fluctuations in the outcome (namely price) of an exchange. The explanation lies elsewhere. Prices in a freely traded market are always a function of what the seller asks and what the buyer bids. Innumerable factors will affect the psychology of the buyer and seller -- yet when their minds meet, you get a price. And make no mistake: that meeting of those minds is, above all, psychological.

This is why Bob Prechter talked about the manic psychology that he witnessed at a recent investment conference, where “The consensus that oil prices can only go upward for the rest of human existence is as broad and deep a conviction as I have ever witnessed toward any market in 30 years in the financial analysis profession. When oil was selling for $12 a barrel a few years ago, no one was interested. There were no booths at conferences touting higher oil.”

JANUARY EFFECT A NO-SHOW THIS YEAR

The famous 19th century satirist Mark Twain put it this way: “October. This is one of the peculiarly dangerous months to invest in stocks. Other dangerous months are July, January, September, April, November, May, March, June, December, August, and February.” Well, we have all heard of the October “Curse” and the “Sell in May and Go Away” theory for why summer slumps often occur. But December and January are expected to be about as perilous as a bed of tulips, thanks to what Wall Street mavens have dubbed “The January Effect”. In short, the first month of the New Year will see a rally in small cap stocks, as investors pour into the market as the tax calendar starts fresh.

As December news stories reveal, mainstream strategists take this idea very seriously. E.g., “Stocks that have been beaten up all year tend to levitate at this time of the year as the January effect comes in.” (Wall Street Journal Dec. 28) But so far in 2005, the S&P 500 is down 3.1%, the DJIA is down 2.6%, and the Nasdaq 100 is down about 6%. The last time all three indexes closed down for the first three weeks of a new year was 1982. On December 31, the barometer for small-cap stocks -- the Russell 2000 index -- peaked.

Not only has less money been going into stocks, but according to a January 27 New York Times article, a rare “outflow” of money from mutual funds has occurred: Through January 19, investors pulled out a net $3.2 billion from the sector, making it only the second time money has left mutual funds in the month of January in 15 years. In the words of a January 27 Business Week, “January is usually the best month for stocks, but this year seems like a bad joke.” So is it “As January goes, so goes the market”, or not?

WHO ARE YOU GOING TO BELIEVE? THE NUMBERS, OR YOUR LYING EYES?

Most of the financial headlines noted that Friday’s GDP report showed slower growth in the fourth quarter of 2004 (3.1%), but then emphasized how “the full-year picture was more encouraging”, since overall growth on the year was 4.4%. Maybe it’s just me, but weigh that 4.4% figure against what your eyes tell you about the direction of the trend in GDP growth on this chart. Would you call the trend since the third quarter of 2003 of “encouraging”, or is the blunt truth more like “heading slowly in the wrong direction?”

The “consensus estimate” among 56 economists surveyed recently by The Wall Street Journal was for the GDP number to come in at 3.5% -- in fact, that is also the GPP growth estimate for this quarter, with a higher number still for the rest of 2005. Not one economist forecast even a single negative quarter for the whole year. The chart picture is worth more than the words; it helps you know how much to credit the words to begin with.

IS THE DOLLAR READY TO CRASH? OR CONTINUE ITS SURGE?

Every student of the market knows that the financial press is most often a contrary indicator. Three weeks ago, when the dollar hit its all-time low of 73 euro cents, you would be hard-pressed to find any media outlet that would dare report a bullish dollar opinion. The media was full of stories about the “disappearing dollar”. Sure enough, the dollar’s fortunes reversed. Last week it broke below the psychologically important level of $1.30 against the euro.

But last week we read a story by a major financial data provider quoting three forecasters who all agreed: The “technically significant” move below $1.30 “confirmed that the ongoing dollar bull trend will continue.” So what about this article that now quotes bullish analysts? Many investors might jump to the conclusion that it is the harbinger of another dollar turnaround. Is this a proper interpretation of this article? The answer, surprisingly, is NO.

DUMB MONEY

Dumb money is here to stay, whether we like it or not. So we might as well figure out ways to turn this negative into a positive. Fortunately, the task is relatively simple: If the dumb money is buying, sell. In general, it is best to “fade” the dumb money’s activities -- in other words to move gradually against whatever they are doing. In recent weeks, the dumb money has been loading up on stocks -- a worrisome trend in and of itself. What is somewhat more worrisome is that the dumb money remains bullish and confident, even though share prices are falling.

“Dumb money” takes many forms, but its underlying nature rarely changes. It never becomes “smart money”, for example, though it make masquerade as such for a while. Dumb money is a financial hydra -- one head may be that of an odd-lot options trader, another might be an AAII survey respondent, another a “small speculato”q in the commitment of traders report, and another might even be a commentator on CNBC. Each head of the Hydra is different of course, but all are part of the same dumb organism -- a creature with an uncanny knack for buying or selling stocks at precisely the wrong time. Monitoring the activities of the dumb money, therefore, can sometimes offer helpful clues about the direction of financial markets. So let’s take a moment to have a face-to-face-to-face-to-face with this Hydra and try to gauge where the stock market may be going next.

First up, options buyers on the Nasdaq 100 Index remain remarkably bullish, despite the index’s nearly 10% drop from its January 3rd high. Like every other type of dumb-money crowd, this one tends to become most bullish as stocks are topping out, and most bearish as stocks are bottoming out. “If a good, healthy advance were under way,” options pro Jay Shartsis noted yesterday, “we would be seeing much more put-buying. This recent sell-off has been truly remarkable from the standpoint that so few investors are buying puts. There is simply no fear in the marketplace.” The “odd-lot” options traders -- known to be among the dumbest of the dumb money cohorts -- are similarly bullish.

Small futures traders are also brimming with confidence, which is almost never a good sign. As the nearby chart illustrates, the “small speculators”, as they are called, have amassed their largest net-long position in S&P 500 futures contracts since the market peaks of March and June 2004. Not surprisingly, the commercial traders -- the “Commercials” -- are taking the other side of this trade. The Commercials, often called the “smart money”, have amassed a rather substantial net-short position in S&P 500 futures contracts. They have placed their biggest bet against the stock market in recent memory. “The stock market is setting up for a significant decline beginning early this year and continuing into 2006,” Comstock Partners warns. “In our view current conditions resemble those of past tops,” Comstock continues. “The market has gotten off to a poor start in January, indicating a potential end to the counter-cyclical bull market of the past two years as the new money flows so widely expected have so far failed to materialize ... Although the recent drop has brought the market into temporarily oversold territory and a test of the recent highs is still possible, we think that the risks have increased substantially and that stocks are highly vulnerable to a sudden downdraft.”

[Ed: If you do not know whether you are part of the “dumb money” crowd, assume that you are.]

THE WISDOM OF CROWDS REVIEWED

When we took our leave last week, we had just read part one of Mr. James Surowiecki’s much-discussed book, The Wisdom of Crowds. It was not as bad as we feared. Mr. Surowiecki seemed to us like a teenager who had just discovered sex. He did not quite know what to make of it, but he was clearly looking forward to it. What he had stumbled upon was civilization, the infinite and subtle private arrangements that allow people to get along and make progress, without anyone in particular telling them what to do. Alone, a man cannot really do much. He is only in his present state of comfort as a result of centuries of tugging by millions of different people. Even with access to all the accumulated knowledge of 100 generations, a man alone could never manufacture even a single automobile. The more elevated a man’s situation, the more he relies upon the knowledge, expertise, capital, and goodwill -- not only of past generations, but of his neighbors...and many people he has never met. That is how civilization works. Two heads are better than one.

Mr. Surowiecki seems only dimly aware of what goes on in the human heart. Yes, groups of people can solve problems. Yes, groups of people can come up with good ideas. Yes, groups of people -- drawing on diverse information and insights -- can create things that no individual alone could possibly imagine. And yes, as the author allows, sometimes groups get things wrong. They are often bullied by a single person. They tend to think alike. They are easily distracted. But when people can work together -- with no one holding a gun to their head -- people have a way of getting along and accomplishing things. But a group of people working together is not the same as a crowd. And a crowd is not the same as a mob.

A group is merely an aggregation of individuals, each with his own independent opinions and information. A group is also a collection of private individuals, each with his own private goals. A crowd, on the other hand, comes together and begins to act as one -- and soon makes a public spectacle of itself. An army, for example, is a crowd. In an army, independent thought is discouraged. Deserters are shot. As we have pointed out often, you would not want to go into battle with a free-spirited intellectual at your back; you want a real blockhead with a singleminded goal: to kill the enemy and protect you. Groups of investors sometimes turn into crowds. They do so when they all stop thinking independently, and begin to act as one. The crowd may be moved by fear or greed. In either case, it is likely to overreact to news, and overprice its favorite investments.

Mr. Surowiecki notices all these things, more or less. He notes that neither voters nor investors are exactly the rational creatures of academic imagination. He realizes that they are, from time to time, led astray by various influences. Yet, somehow, he fails to notice the key feature of the “crowd” that separates a healthy, efficient group from a great mob ready to get itself into trouble. Once again, like his New Yorker feature on gold, he has managed to write something that is wise and moronic at the same time. It is wise to notice that two heads are sometimes better than one. It is moronic to fail to notice why.

Yesterday marked the 60th anniversary of the liberation of Auschwitz. The extermination of the Polish Jews was something that no man could have accomplished on his own. It took the cooperation of thousands -- no, probably millions -- of people to make it work. Where was the wisdom of the crowd? Surowiecki does not bother to raise the question. Perhaps there was not enough “diversity” in the Nazi ranks, he might suggest. Maybe, the Nazi leadership was not open enough to different points of view, he might say. The Nazis were not “independent” enough, he might add; nor were they allowed to express their “private judgment”. All of these things may be true. But who was going to stop a top SS meeting and suggest that they bring in a gay gypsy or Bantu democrat to give an alternative point of view? Who among them doubted that they did not already have all the judgment, opinions and information they needed?

Likewise, at the peak of the bubble market in tech stocks at the end of the 1990s, what investor who had made a fortune on Microsoft and Amazon wondered if needed more diversity in his portfolio? When the crowd takes up a corrupt wish -- to get something for nothing...or to make the world a better place by killing people -- the last thing it wants is another point of view. It is already too late for that. The few people who are able to think clearly can only try to get out of the way. If they are in a bubble market -- they can easily sell. If they are in a country that has lost its head, they can try to leave. If they are in an army, there is not much they can do at all. And so we come to the end of Surowiecki’s little book and we realize that he missed the whole point.

Had he merely thought a little harder, he might have found something important: What he is describing as “wise crowds” is really the fluid, unfettered interactions between individuals in a civilized society. In many cities, for example, people drive around with hardly a traffic light or traffic cop anywhere. Yet, most get where they are going without accident. Groups of people -- aggregating individual strengths, compensating for individual weakness, composing individuals’ knowledge -- have always been successful. This kind of cooperation is the foundation of civilization, the division of labor, and the accumulation of expertise and knowledge. Of course, crowds are going to go wrong from time to time. Human nature has not changed. Crowds can be swayed by skilled orators, the popular press and false signals from central bankers. But where the crowd really goes wrong is where it turns from cooperation to force ... when it begins to insist, and build concentration camps. This is where it becomes uncivilized.

Democracy, says Surowiecki, demonstrates the wisdom of the crowd. And yet, it seems to demonstrate the exact opposite. Voters have no independent information. They have no way to make independent judgments. They are easily swayed by the press and rabble-rousing politicians. They are a crowd -- not a group of aggregated individuals -- from the very beginning. They pass judgment on people they have never met and ideas they cannot understand, eventually taking money that does not belong to them, and spending it on things that are usually disastrous. Democracy replaces cooperation with force, consensual civilization with the tyranny of the majority, the wise crowd of independent citizens with a mob of voters, with silly slogans on their bumpers and mischief in their hearts.