Finance Digest for Week of January 31, 2004

INFLATION IS UNDERSTATED, AND BONDS WILL SUFFER WHEN THE MARKET WISES UP

Ruinous rate hikes? Inflation jumps? The bond market has pretty much dismissed the threats. Fixed- income manager Garrett Thornburg has not. Thornburg, 59, left a Wall Street job 23 years ago and set up shop in Santa Fe, N.M. A feathered Navajo ceremonial garment hangs on his office wall like an enormous halo. From this perch he looks down on bond bulls back East as occupants of a fool’s paradise. The Federal Reserve, sighs Thornburg, “is really behind the eight ball.” And the bond market? “Totally clueless.” He believes interest rates are too low because inflation, officially 2.2% over the past 12 months, is understated by at least a full percentage point.

Thornburg Investment Management, which is controlled by Thornburg, oversees $12.6 billion in assets, $3 billion of which is invested in bonds. He cannot go all the way to cash, since his customers pay him to manage bond portfolios, though he does lean toward the short end of the maturity spectrum. That has hurt his performance in recent years but, he is sure, will save his neck in the coming bond market crash. The reckoning will not be a 1970s-style catastrophe, yet it will be ugly enough to hurt plenty.

Go out no more than five years if you are worried about rates. That is exactly what Thornburg has been doing lately. A 5-year AA-rated muni yields 2.9% these days; a 5-year Treasury, 3.7%. In any case, steer clear of the long end of the yield curve, Thornburg advises. “You go from 10 years to 30 years and all you get is an extra half point” of yield for all types of bonds, he says. “You just don’t get paid for the extra risk. We think it’s dumb.” In addition to fixed-income securities, Thornburg has an array of stocks he likes for his equity funds. His picks for us have, among other things, something many U.S. businesses lack nowadays: pricing power, a big plus in an inflationary time.

TECHNOLOGY’S GROWTH CHAMPS

Technology began to rebound last year -- this time with real, rising profits replacing the empty promises of the bubble era. This year’s roster of fast-growing publicly traded tech companies averaged 92% for 5-year annualized sales growth, up from the 78% rate last year. Only 14 companies were able to repeat. To get on this list a company must have at least a 10% sales gain in each of the last five years, $25 million in sales and a positive net income over the last 12 months, and no large legal problems or other open-ended liabilities.

Heading this year’s group in 5-year sales growth is newcomer AtRoad, which provides services and gear that help off-site workers keep in touch with the office. AtRoad generated revenues of $73 million over the past 12 months, a 23% increase over the same period a year earlier. Demand for flat-panel TVs helped Pixelworks and Applied Films earn their first spots on our ranking. Why is Google not on this list? Its financial history falls one year short of the period needed to calculate 5-year sales growth. It will probably qualify next year.

WHAT TO DO IF THAT GREAT FUND IS CLOSED TO NEW INVESTORS?

Some of the best funds have slammed their doors. The venerated Sequoia Fund has not accepted new customers since 1982. Vanguard Primecap and Vanguard Capital Opportunity funds, with records that rival Sequoia’s, are not taking new accounts and are limiting existing clients to annual additions of $25,000. Among the 133 domestic equity funds that are not taking new investors are 56 that get A or A+ grades from Forbes in up and/or down markets. It is, of course, the best-performing funds that are most likely to turn away customers. Having too much money would hamper their style, they fear, especially if they invest in smaller companies.

What should you do if there is a padlock on the fund you want? First, look for a back entrance. Some funds closed to the public are nonetheless still available on the 401(k) menus of certain employers. Other funds give a grandfather exemption to immediate relatives of existing shareholders. Yet another method: Buy the existing position of a shareholder who wants out. Indeed, a gray market developed in the 1990s for shares of Sequoia. Yet another option, plausible for a fund with very low turnover, like Sequoia: Just take a look at its portfolio, published quarterly, and ape it. If all else fails, you might be able to find an open fund similar to a locked-up star. Morningstar’s “Similar Funds” tool (available online with the Web site’s premium membership of $125 per year) helps you locate a good substitute.

WHY THE WORLD LOVES AMERICA’S DEFICITS

At the end of last year, the nation’s financial deficit -- what the U.S. owes the rest of the world, minus what the rest of the world owes the U.S. -- amounted to more than $3 trillion, and it is still growing. This account deficit means the U.S. imports more than it exports. To fill the gap -- and its budget deficit -- it borrows heavily. However, while the trade deficit weakens the dollar, it strengthens the world! For Europe, Japan, China, and even America, as long as the nation’s trade and budget deficits continue to grow and are financed by the world’s central banks, everyone seems to win! Let me explain.

For now, all the major countries seem to “win” (as their central banks print up new money to finance our trade deficit) because (i) the euro is secure; (ii) Japan can finance a 7% deficit; (iii) China gets everyone’s jobs; (iv) America gets its war paid for; (v) every major country gets financed, and (vi) all the produced goods get sold with that last $600 billion bought by Americans on credit.

Perhaps things will change as inflation bursts out into the open and exposes the fraud of prosperity through printing money. Or, at some point, central banks may discover that not only do they need to finance new U.S. debt being created but all the old debt as well, as the private sector dumps their dollars en masse. This would surely put into question the seemingly limitless dollar asset buying spree of the world’s central banks. The real question may be “when does the debt become so big that foreigners begin to worry about getting their money back with a reasonable return?” With America taking the short-term economic view, and Asia taking the long-term economic view, the future will prove very interesting.

The losers in all this will surely be those who want to save in dollars, insist on holding investments denominated in dollars, and Americans who would simply like a job working in the most efficient and productive factories in the world, rather than sit back and watch them be built, with the latest technology, half a world away. Unfortunately, since most Americans will continue to use dollars, you can guess who is going to be the big losers here -- just look in the mirror!

Will central banks ever say no to America?

Americans suffering from an immediate gratification fix should really monitor their decisions when they are restless. When feeling restless, they may decide to sell their house and buy a bigger, more expensive one. Then, they could easily take some cash out -- or simply a draw-down on their home equity loan -- and go shopping until they drop! Foreign goods fly off the shelves at patriotic stores like Wal-Mart, sending more dollars to China for goods we have imported. These dollars get stuffed into government securities -- in the U.S. and elsewhere -- where they wait to get spent.

But wait, there is more! The U.S. government is running federal deficits of over $400 billion a year, and we are not alone. JP Morgan Chase estimates that global government bond supply will be $2,320 billion, up two-thirds from 2001! This insatiable need to borrow by governments and American households totally overwhelms the world’s savings. So, where is all the money we are borrowing coming from? Thank the accommodative central banks.

Central banks create new money by buying something. The central banks almost always buy their own government debt, or debt of another country, theoretically printing money out of thin air (for a central bank to have a “reserve” it must buy the debt of some other country). Foreign central banks own $280 billion worth of securities issued by U.S. government agencies -- go Fannie Mae! The Federal Reserve, e.g., holds U.S. government and agency debt in custody for foreign central banks. We are looking at a mutual back scratching of world central banks printing up new money, the likes of which the world has never seen before! Will it ever end?

As long as commercial banks continue to offer home equity lines of credit, issue credit cards to anyone regardless of age or credit worthiness, and finance companies that are cash-flow-negative with more high-yield debt, this party will continue. Borrowing by the government and consumers creates new money and spending which “makes the world go ‘round.” Over the last decade, every world central bank has remained accommodative to America’s willingness to borrow and spend without limit. Meanwhile, over-spending in the U.S. has created a $650 billion trade deficit that threatens the very existence of the dollar as the world reserve currency.

The Federal Reserve realizes that if they raise interest rates to stabilize the dollar -- by making its yield more attractive on dollar investments, as well as lowering the trade deficit -- serious pain will be inflicted. Rising interest rates will crunch real estate sales as fewer consumers will be able to afford to pay current outrageous prices for housing, and service mortgages with higher monthly payments. If and when the Federal Reserve starts the “big squeeze” to save the dollar, the trade deficit will come down. But our trading partners will not be happy that the free ride on America is over. When 40% of S&P corporate profits are related to financing, higher interest rates do not bode well for corporate profits. The question is “will central banks stay super easy or will they start acting like adults at the end of a wild party?

THE GREAT DILEMMA

The Great Mortgage Finance Bubble is today’s creator of “marginal” purchasing power, as well as marginal global financial market liquidity. This has momentous ramifications that I think are only now just beginning to resonate in the marketplace. For one, the nature of ensuing Inflationary Manifestations is notably non-conducive to Federal government receipts. This is quite a contrast to the late-1990s equities boom and flood of capital gains taxes to federal and state coffers. Not only does home price inflation receive quite favorable tax treatment, (the Inflationary Manifestation) excess consumption of imported goods does a better job lining foreign government pockets than Uncle Sam’s. And a strong case can also be made that the resulting faltering dollar -- with rising energy and other costs, as well as stubborn unemployment -- will tend to inflate government expenditures.

The Great Dilemma is that inflating U.S. home prices have developed into the most important issue in global finance. And the tightening link between inflated American real estate prices, mispriced global finance, massive U.S. current account deficits, deteriorating government finance, a faltering dollar, endemic speculative leveraging, and deepening economic distortions is emerging as the crucial facet of latent financial fragility. The Great Dilemma is that an effort to rein in excess would begin with piercing the Mortgage Finance Bubble, something policymakers are not willing to do.

AN UNPREPARED WORLD

As I see it, investors are largely unprepared for some big changes coming in the global landscape in 2005. This potential disconnect is most evident in the debate over the U.S. and China -- currently the twin engines of global growth. America’s imbalances are widely recognized as both worrisome and unsustainable. There is a minority that believes in the new paradigm of the fungible global saving pool -- that the allocation of capital, consumption and production now flows seamlessly to its destinations of highest return or comparative advantage. In its simplest sense that translates into a world where China produces, America consumes, and the rest of the world gladly pays the bill and goes along for the ride. But with global imbalances expanding at an accelerating rate, even advocates of this point of view are starting to have second thoughts. America’s deficits are now being framed as a problem that will come to a head sooner or later. The hope of the global consensus is that it will be later.

As I have noted ad nauseum, macro is not particularly good on these issues of timing -- in making the distinction between the proverbial sooner or later. Like in 1994, 2005 is likely to be the year when the Fed finally gets “real” on real short-term interest rates and the carry trades they have spawned. But unlike the case in 1994, more than a decade later, the U.S. has been transformed into an asset-dependent economy that has given rise to massive global imbalances. To me, all this smacks of sooner rather than later on the rebalancing watch. Based on all my discussion and debates in the past few weeks, I would say that the world is largely unprepared for this possibility.

The Hollow Confidence of Davos

The consensus at this year’s World Economic Forum senses something does not add up in the global economy. There was concern over America’s seemingly chronic saving shortfall and its related twin deficits. There was concern over the lack of internal demand elsewhere in the world -- especially in the wealthy economies of Europe and Asia. And there were concerns over the lack of flexibility in markets, economies, and policies in many segments of the developing world -- from China to Latin America to Russia. In the end, the Davos crowd drew its greatest comfort from the passage of time -- that an unbalanced world survived yet another year without a disruptive outcome in financial markets. It was a hollow confidence, at best.

WHY BUSINESSES ARE ONCE AGAIN KEEN TO MERGE

Corporations are embarking on what is being called a “new wave” of mergers. Although this may result in tens of thousands of layoffs, it may also mean that the improved efficiencies are passed on to consumers. It is too early to say how large the wave will be compared with the late 1980s, when hostile mergers dominated the news. But they are likely to become more common, since U.S. companies have more than $1 trillion in cash. “What we are seeing is that as you get late in the economic cycle, companies look for alternative ways of growing their business,” says Fred Dickson, chief market strategist at D.A. Davidson. “Companies loaded with cash have to put it to work or face screaming shareholders.” And with the US dollar down against the euro and yen, analysts expect foreign corporations to begin to look to the U.S. for growth by acquisition.

A CAUTIOUS OPTIMISM FROM FUNDS-FLOW ANALYST LASZLO BIRINYI JR.

For 2005 I have some reservations, but I would still hope for a good year with an outside chance of a great one. The new year’s soft start does not surprise me. In December investors were buying too brazenly, in effect accelerating their 2005 purchases to take advantage of a then-rising market. My firm’s monitoring showed wholesale buying of the market, rather than of individual stocks -- not a careful, well-thought-out decision. A likely factor was heavy buying by hedge funds; these, of course, are paid a percentage of their profits regardless of what the benchmarks do.

The late-2004 buying was so broad that the advance/decline ratio for the S&P was the 4th best since 1992 while the S&P only had its 7th-best gain. This suggests a great deal of program activity as investors gobbled up a lot of stock. Investors have been looking for gains without respect to risk. While my market outlook is not negative, I wonder if too many are forgetting the lessons of 2000 to 2002. Thus I want to be cautious in early 2005. At this juncture, the market continues to be somewhat flat, without especially strong areas, sectors or themes. Hence consider some broad baskets, namely through exchange-traded funds. A good idea is Rydex S&P Equal Weight (RSP), which abjures the index’s practice of tilting toward the biggest stocks. If large issues do better, Rydex will trail the more familiar Spiders ETF, which hews to the weighted market cap model. But unlike many observers, I believe small caps will continue to outdo large, making the Rydex product a better bet.

THE YEAR OF THE CONVERTIBLE

For 2005 the chances to earn a total return that is more than current yields will be few. My best advice: Buy more convertible preferreds. The last time I dedicated a column to convertible securities was July 2003. Convertibles had a 20%-plus year in 2003 because stocks had a good year. In 2004 stocks had a so-so year, but this was good enough to make my convertible picks a good sector within fixed-income investing, with a 14.9% total return.

Looking over the fixed-income landscape for 2005, I see few opportunities to earn a total return more than current yields. As has been clear since the beginning of 2004, the era of declining interest rates that began in 1981 has finally come to an end. As a result predictions abound that rates will inevitably trend upward. I am far more sanguine about bonds. I believe we are entering an era of stable long-term rates and a fairly flat yield curve, something not seen since the pre-Vietnam era.

Nevertheless, this landscape has mines. The most obvious area of risk is junk bonds in the B or CCC category. Those currently yield 7.3% to 10.2%, or only 3.1 to 6 percentage points more than ten-year Treasurys. You are tempting fate by staying with these junk credits to get the extra yield. Prices could go south overnight in reaction to an international crisis or economic disruption. Note that just two years ago these yields were 7.4 and 17.7 percentage points above Treasurys. The safer alternative for achieving above-average returns in a growing economy is convertibles. If 2005 proves to be a mediocre year for stocks, you stand to collect only your dividend yield. If it proves a good year, you participate with the rising stock. More important, if a hot stock market starts to push up interest rates, you have bought yourself some immunity against a rate-induced price decline, since convertibles are not pure debt. Their value would remain intact.

SAVING GRACE

Saving in the U.S. has been on a 20-year decline. This dismal trend cannot go on forever, and may reverse soon. People are going to start saving again. This momentous change will create winners in some sectors of the economy and losers in others. The saving rate -- the percentage of aftertax personal income not going into consumption -- has slid from 12% in the early 1980s to just about zero today. Americans’ debt-fueled spending on cruises and new SUVs has overshadowed their 401(k) contributions.

The inertia that dragged down the saving rate has been considerable. Some figure that the government will provide their future income needs. Many consumers feel they deserve to spend, and, like Scarlett O’Hara, will think about the financial consequences “tomorrow”. Others believe that houses appreciate forever and do the job. While the bursting of the 1990s stock bubble disabused people of the notion that stock market capital gains would take care of saving needs, the housing bubble has not yet broken. And so numerous homeowners have drained their equity through cash-out mortgage refinancing and home equity loans. Consumer debt has expanded to the limit of what many can service. Credit applications fill mailboxes, including those of people with lousy credit profiles.

Near term, I expect the saving rate may dip further, into negative territory. But forces are at work that will reverse the decline. Look for the tide to turn before longand for the saving rate to commence a steady rise, something like a percentage point yearly for a decade. The postwar babies desperately need to build retirement kitties. The younger generation has a saving incentive, as well. Few young people expect meaningful Social Security retirement benefits. The shift from the long-running borrowing-and-spending binge to a saving spree will probably require a nasty shock to consumer incomes and finances. The next recession with big layoffs might be the trigger. Another terrorist attack on U.S. soil might frighten Americans into saving. The collapse in the housing price bubble that I foresee would do the job.

A falling saving rate means that for two decades consumer spending has grown 0.6% per year faster than aftertax income. This is so long that few businesses benefiting are aware of it. Credit card issuers will be when they are transformed from growth companies to laggards. Ditto banks and other financial institutions focusing on consumer and mortgage lending. Purveyors of big-ticket discretionary goods and services also will suffer as spending is restrained. Doubly so in the mild, good deflation I foresee as consumers wait for still lower prices.

Saving-spree winners include financial service providers other than lenders: brokerage firms, mutual fund advisers, individual account managers, financial and estate planners, trust companies and life insurers. More saving and subdued consumer spending will depress interest rates, boosting holders of Treasury and other high-quality bonds. The havoc wreaked by American consumers on foreign exporters will help the buck, which I believe has bottomed anyway. That will aid dollar-denominated assets. Such a world will be very different from today’s.

THE PRICE MAKES THE STOCK

Cheap enough, any company is a buy. Costly enough, any company is a sell. The trick is finding what a company is worth. Two years ago, when I recommended Xerox in my newsletter, I received an irate letter from a subscriber pointing out that the company had suffered blunder after blunder and had even committed accounting fraud. He was absolutely right. Yet since then the Xerox stock price has tripled.

It happens all the time. A company that has been run into the ground, or that is getting killed by competition, or that has a debt-logged balance sheet, is nonetheless a terrific bet -- if it is cheap enough. The converse is true. Any great company is a bad investment if the price is high enough. Xerox was a great company in 1972, but it was overpriced. Amazon was a great company and a lousy investment five years ago. So was Cisco. So was Microsoft. The point is that investors frequently fail to distinguish between a company and its stock. If the stock fully reflects favorable information, it is not necessarily a good buy. Alternatively, the stock of a troubled company could be a great buy if the price more than discounts all the problems.

The trick, of course, is determining what the stock is worth. Analysts rely on a number of methods to determine this intrinsic value. Discounted cash flow is one of my favorites; this method recognizes, in theory at least, that a business must be worth the present value of all the cash flows it will generate in the future. Estimating these cash flows is the difficult part, requiring all kinds of assumptions and forecasts about future events. Absent magical powers, you stand a good chance of being wrong. That is why, when doing this exercise, you should use the most conservative projections.

Great buying opportunities sometimes arise when investors overreact to bad news. They more than discount all the pessimism about a company, and the stock price falls below intrinsic value. Then the sellers are almost giving the stock away. That is not to say the price will not go lower before recovering. But unless fraud or bankruptcy turn up, it usually does recover, and the patient investor is often handsomely rewarded. Thanks to bad news, the three following stocks are currently selling for less than intrinsic value.

RISKS ABOUND IN OWNING GOLD, AND IN NOT OWNING GOLD

“You should consider carefully the risks described below before making an investment decision,” advises the prospectus of the streetTRACKS Gold Shares (NYSE: GLD). “Fluctuations in the price of gold could materially adversely affect an investment in the Shares.” We had a hunch, even before reading the prospectus, that a falling gold price might be a bad thing for GLD -- an exchange-traded fund “designed to mirror as closely as possible the performance of the price of gold bullion.” But we also had a hunch that a falling dollar might be a good thing for GLD. Reading the prospectus confirmed both hunches. By definition, a buyer of dollars is a non-buyer of gold. Any examination of gold’s “risk factors” would not be complete, therefore, without also considering the risk of NOT owning gold -- also known as the risk of owning dollars.

Falling inflation, for example, is the sort of monetary trend that a gold bull would call a “risk factor”. But rising inflation, which happens to be the monetary trend of the moment, is a clear and present danger to holders of U.S. dollars. Notwithstanding official assurances to the contrary, a new inflationary trend seems to have sprouted from the seeds of Alan Greenspan’s overly “accommodative” monetary policies. “Investors should be aware,” the GLD prospectus continues, “that there is no assurance that gold will maintain its long-term value in terms of purchasing power in the future.” Again, we would respond: What about the dollar? What assurance do we dollar-holders possess that the greenback “will maintain its long-term value in terms of purchasing power?”

“All forms of investment carry some degree of risk,” the bullish discussion cautiously begins. “However, including gold in a well-balanced portfolio can help diversify risk. Gold’s ability to serve as a portfolio diversifier is due to its historically low-to-negative correlation with stocks and bonds.” In other words, the ancient monetary metal tends to perform well when faith in paper assets wanes. But the strongest aspect of the bull case for gold relies upon the fact that the “Risk Factors” for owning the U.S. dollar are far more numerous, far more serious and far more likely than those for owning gold.

Gold’s $4 drop yesterday reminds us of the risks of owning the yellow metal. On the other hand, the dollar’s 40% drop over the last three years reminds us of the risks of owning the alternative. So far, no one has approached us to write a prospectus for the U.S. dollar ... not yet.

HEALTH CARE, OTHER RISING COSTS TO STRAIN BUDGETS IN U.S. AND ABROAD

When President Bush delivers his State of the Union address Wednesday night, his prescriptions for Social Security are likely to vault that issue to the front of the nation’s political agenda. But Social Security’s financial problems are a relatively small sliver of the far larger challenges posed by an aging population, economists say. From untamed health care programs to military pensions, housing and heating assistance to coal-miners’ benefits, programs for the elderly have proliferated and grown more generous, even in the face of an aging trend that demographers have long seen coming. In that light, the fight over Social Security marks only the beginning of a national debate over the cost of a graying society -- and the inevitable reallocation of resources that is sure to produce winners and losers, in the U.S. and around the world.

“The question is whether we can support the elderly with a decent standard of living without imposing a crushing burden on the young,” said Richard Jackson, director of the global aging initiative at the Center for Strategic & International Studies. “Whether we can is a real concern.” In just 10 years, spending on the elderly will total nearly $1.8 trillion, almost half the federal budget, according to new Brookings Institution and Congressional Budget Office projections. That is up from 29% in 1990 and 35% in 2000. The bulk of that growth is spending on the federal government’s two largest health care programs, Medicare and Medicaid. Their combined costs are projected to more than double, to a combined total of $1.2 trillion in 2015 from $473 billion last year. Social Security spending is expected to rise to $888 billion from $492 billion in that span.

Other countries are not likely to help foot the bill for the U.S.’s aging population, as they currently do with the U.S. trade and budget deficits. The populations of Japan, Germany and other countries that have large pools of savings are aging even faster than the U.S.’s, and as they do, retirees will start to spend their nest eggs, sapping the capital that now helps drive business expansion and rising living standards worldwide, including in the U.S. China, because of its one-child policy, will face a demographic crisis of its own, and India, though growing fast, cannot hope to accumulate enough capital to help, international economists say.

Some economists and interest groups say fears are overblown. The real problem, they say, lies not so much in demography but in a health care system that is the world’s most expensive and least efficient. The cost of Bush’s Medicare prescription drug benefit alone -- $8.1 trillion in 75 years -- dwarfs the $3.7 trillion estimated shortfall in Social Security in that stretch. Get control of federal health care costs -- through better use of technology and better management of chronic illnesses and disabilities -- and the problem of an aging population will look a lot less intractable, said John Rother, policy director at AARP, the advocacy group for retirees and near-retirees.

Europe and Japan have already entered the demographic crunch that American policymakers fear, Rother said. And although economic growth in those countries has slowed, standards of living have remained high. If the U.S. economy could better harness the strength of an elderly workforce, through job creation and volunteerism, he said, some of the anticipated economic impact of a growing pool of retirees could be mitigated. Besides, technological progress will continue to make workers more productive, even as their numbers diminish relative to retirees, said Dean Baker, co-director of the liberal Center for Economic and Policy Research.

Performance, fortune, and the U.S. president.

Many people study U.S. political history, others study U.S. economic history, and a relative few individuals look closely enough at both to see the strong connection -- specifically, the link between the performance of the stock market and the fortunes of the president. The closer you look the more obvious the link becomes; only war does as much to shape public perceptions of a U.S. president’s performance during his term in office.

The bear market that began with the 1929 crash put the Democratic Party in office for the 20 years that followed the 1932 election. A war-hero Republican took the White House in 1952 -- as the Dow Industrials began to approach its pre-crash high -- and Eisenhower became the dominant political figure during that bull market decade. Democrats lost the White House again in 1968, almost three years after the Dow had reached a high that it would not finally surpass for nearly 17 years. Three U.S. presidents came and went during the bearish 1970s, one of whom resigned in disgrace. The great bull market that began in the early 1980s helped keep Republicans in office for 14 years; a Democrat won by a plurality in 1992, yet the bull market saw him through two full terms of office, notwithstanding multiple scandals and impeachment.

Which brings us to the current Commander-In-Chief, a title which goes a long way toward explaining his reelection this past November. The 9/11 catastrophe, and the military invasion of two countries, tell you most of what you need to know about why George W. Bush won a second term. The 3-year bear market (2000-2002) began before he took office, and he benefited from the 2003 recovery. Yet, because of his ambitious agenda to partially privatize Social Security, President Bush has directly linked his fortunes to the stock market to an unprecedented degree -- far more than he himself probably realizes.

HOME EQUITY USED TO FINANCE SUPER BOWL TRIPS

Some Philadelphians are so desperate to get down to Jacksonville for the big game that they are borrowing against their homes to pay for the tickets. Mortgage bankers in the Philadelphia-area say that Eagles fans have been inquiring about refinancing mortgages, or taking out home equity loans or home equity credit lines, to pay for “the chance of a lifetime”. Eric Reeber, a mortgage banker in Mount Laurel, N.J., said his office has gotten at least a dozen calls from Eagles fans looking for some quick cash. He said two couples have already been approved and were scheduled to close on their loans. ut some bankers are wary. Dave Brekher, president and co-owner of North American Federal Mortgage Co., in blue-collar northeast Philadelphia, said his company has turned down homeowners who wanted to refinance their homes to raise cash for Super Bowl trips. “If someone is that desperate, there’s always repercussions,” he said.

STUDY TIES BANKRUPTCY TO MEDICAL BILLS

Sometimes, all it takes is one bad fall for a working person with health insurance to be pushed into bankruptcy. Hundreds of thousands of Americans file for personal bankruptcy each year because of medical bills -- even though they have health insurance, according to a new study by Harvard University legal and medical researchers. “It doesn’t take a medical catastrophe to create a financial catastrophe,” said Elizabeth Warren, a Harvard law professor who studies bankruptcy and is one of the authors of the study.

The study, which is scheduled to appear on the Web site of Health Affairs, an academic journal, provides a glimpse into a little-researched area connecting bankruptcy and medical costs. About 30% of people said they filed for bankruptcy because of an illness or injury, even though most of them had health insurance when they first got sick. Many lost their jobs -- and their insurance -- because they got sick, while others faced thousands of dollars in co-payments and deductibles and for services not covered by their insurance.

ARE SHARES IN U.S. REGIONAL BANKS SET TO FALL?

With the stock market valuing one dollar of their earnings at $15, are shares in U.S. regional banks set to fall? Legg Mason analyst Adam Barkstrom thinks so. He says that these banks are drawing far too much earnings from yields on mortgage bonds and other securities they have bought recently -- and far too little from commercial loans. The problem is, banks borrow money to buy these securities and, while that cost is increasing, the yields on those securities are not rising to compensate. In Wall Street parlance, the yield curve is flattening, which means banks have to make more loans, or buy more bonds, to get the same kick to their earnings. “There is pressure on margins -- and we’ve already seen this in the fourth quarter,” says Barkstrom. Yet regional banks “are still trading at a full valuation.”

Barkstrom has drawn up a list of 16 regionals he thinks are especially vulnerable. What these banks have in common are big holdings of securities. They also rely on short-term loans to fund themselves -- that is, borrowings coming due in a year or less, which have rates that are likely to increase upon renewal. He notes that his table -- based on third-quarter financial statements -- does not consider the effect of any hedging with derivatives that might protect against interest-rate moves.

GATES, BUFFETT AND CHINA GANG UP ON DOLLAR

The dollar can add the world’s two richest men to its list of detractors, something that is raising eyebrows in Asia. Bill Gates, chairman of Microsoft, left no doubt of that, telling television host Charlie Rose “I’m short the dollar.” The world’s wealthiest man called the record $7.62 trillion federal debt “a bit scary” and lamented that the U.S. is in “uncharted territory” fiscally. And he is right. Just ask Warren Buffett, the world’s No. 2 moneyman, who has been buying foreign currencies since 2002, citing concerns about the U.S. deficit. The bet is paying off, too. Buffett’s Berkshire Hathaway reaped a $412 million pretax gain on the trade in the third quarter of 2004.

Gates and Buffett may not be reading from the same playbook as George Soros, though their investments bear some similarities. Financier Soros has long since given up on the world’s reserve currency, and U.S. President George W. Bush’s competence on economic matters. Yet the U.S. is managing to run afoul of an even more powerful force than wealthy individuals: the world’s fastest growing major economy. China, it seems, has had just about enough of the U.S.’s bickering about its currency policy.

“The U.S. should take the lead in putting its own house in order,” said Chinese central bank adviser Yu Yongding. It is breathtaking, really, to see the U.S. being chastised by Chinese policy makers. Perhaps it is payback for all the lecturing Treasury secretaries from Robert Rubin in the 1990s to John Snow today have done here in Asia. More likely, though, Chinese officials are getting antsy about their own U.S. dollar holdings. If Gates sunk his entire $46.6 billion fortune into U.S. debt, it would only amount to about a quarter of China’s holdings. The issue is coming to a head days before Group of Seven officials meet in London. There is little doubt the dollar’s weakness, and the euro’s resulting strength, which will be the center of attention.

G-7 needs cathartic conversation about currencies.

Meetings of the Group of Seven finance ministers are like Christmas with a fractious family. Everyone tiptoes around trying to be tactful for fear of spoiling the turkey dinner, while current hurts and past insults threaten to bubble to the surface and spoil the party any second. A therapist would counsel that repression is unhealthy and dangerous, storing up trouble for the future. What the G-7 needs is a bout of bloodletting, Jerry Springer-style, to clear the air by bringing grievances into the open. This weekend’s meeting in London offers a great opportunity for some primal screaming.

There is plenty of angst to go around. The U.S. looks at the moribund European economy and sees a gaggle of work-shy French and German underperformers relying on state handouts, and accuses Asian nations of stealing American jobs by manipulating currency rates to prop up their exports. Europe sees the U.S. as an overspending economic bully trying to use an undervalued dollar to reverse its $60 billion trade deficit, threatening to bankrupt the 12 nations sharing the euro in the process. Japan, in the meantime, is terrified that a renewed slump in the U.S. currency will snuff out its own nascent recovery as a surging yen crimps exports.

The world has moved on from the post-World War II Bretton Woods system of fixed exchange rates, through floating rates, to the current mixed system. It is about time the G-7 dropped its pretence of politeness and had a cathartic conversation about currencies, deficits and trade flows.

Sorry Mr. Gates ...

“The dollar is going down, there’s no question,” Bill Gates said at the World Economic Forum in Switzerland. Since it is such a certainty to Mr. Gates, the world’s richest man, is putting his money where his mouth is. “I’m short the dollar,” he said in an interview. “The ol’ dollar, it’s gonna go down.” Gates’s reason? “We’re in uncharted territory when the world’s reserve currency has so much outstanding debt.” The world nods in agreement. Me? I actually find it unbelievably silly.

Contrary to what nearly everyone believes, you do not make money buying an investment when it “looks good” and everybody knows it. It has ALREADY gone up. For example, “you cannot go wrong in real estate on this island now,” is something I hear all the time where I live. This just tells me that the boom in real estate here must be close to over. Equally and oppositely, you do not make any money shorting an investment when it looks very bad and everybody knows it. It has ALREADY gone down. Sorry Mr. Gates...

If I wanted insight into where computers are headed, I would love to talk to Bill Gates. But if I am interested in where currencies are headed, I would rather talk with someone like 30-year global investment analyst Marc Faber, with a proven track record of seeing what nobody else sees when it comes to investments. And nowadays Marc Faber says, “The only asset that is undervalued is the U.S. dollar. In the long term it is a doomed currency, but now it has a good chance to appreciate.”

What Bill does not understand is that WHAT THEY KNOW IS ALREADY PRICED IN. Everybody knows about U.S. debts and deficits. It is not a secret. And therefore everyone is short the dollar, right alongside Mr. Gates. The trade is too crowded. Warren Buffett has a $20 billion dollar bet against the dollar. It is the same way for the collective world of investors, who are all short the dollar. By betting in favor of the dollar you will be taking the opposite of a bet being made Bill Gates and most of the doctors, stockbrokers, and bureaucrats of the world. Call me crazy, but that is actually where I want to be.

ALL SIGNS POINT TO BUBBLE

In its Jan. 10 issue, Business Week carried an article, “A Gold Medal for the Fed’s Inflation Fighters”. The key point of this article is that “by holding inflation down, the Fed has boosted the economy.” We mention this article because it is highly typical of the prevailing systematic disinformation about the U.S. economy. Given a U.S. inflation rate of 3.3% during 2004, any talk of “ridding the U.S. economy of inflation” is, first of all, grossly misplaced. Even more absurd is the further assumption that the Federal Reserve has distinguished itself as a great inflation fighter. In actual fact, in the past few years, the Greenspan Fed has systematically and deliberately fostered parabolic credit and financial excess with the explicit purpose of inflating asset prices. What manifestly is duping most people is the fact that the bulk of the credit excess poured into asset prices and the soaring trade deficit, rather than into the CPI, as had been usual.

As we have repeatedly stressed, speaking of inflation requires a distinction between cause and effects. It ordinarily has one and the same cause: excessive creation of money and credit. But its impact on the economy and its price system depends entirely on the specific purposes for which the borrowed money is used. Therefore, its effects may differ immensely. Principally, credit excess may find three different outlets: first, rising prices of goods and services; second, rising prices of financial and tangible assets; and third, a rising trade deficit. The conventional focus is exclusively on the first outlet -- that is, on the movement of consumer prices, popularly called CPI in America. Amazingly, even most experts flatly deny a causal connection between a rampant credit expansion, rising asset prices and a rising trade deficit. The rampant inflation in U.S. stock and house prices is actually hailed as “wealth creation”.

For years, the strange coincidence of soaring asset inflation and simultaneous moderate consumer price inflation was hailed as a sign of economic health and dynamism. It has long been one of Mr. Greenspan’s favorite arguments that this unusual coincidence proved the existence of a “new paradigm” economy. While stock prices have recovered from their lows in 2001, in general, their gains during 2004 were very limited. Instead, a developing property bubble has gone global. Full-blown housing bubbles with double-digit annual price increases now exist in many countries, for an obvious cause. Ultra-low interest rates introduced by central banks to fight threatening recession have triggered an explosion in borrowing for house purchases in many countries.

Observing this, it must be stressed at the outset that from a macro perspective, the crucial issue is not an asset price bubble per se. The key question is whether and to what extent asset owners convert the asset appreciation into higher borrowing and spending. Asset bubbles as such constitute little more than a temporary economic nuisance. France certainly has a house price bubble, but it does not have a “bubble economy” in the sense that the rising house prices are used to boost consumer borrowing and spending for other purposes. In the late 1990s, the U.S. stock market bubble went global. The same has happened in the last few years to the property price bubble. According to reports, full-blown housing bubbles currently exist in many countries around the world. As explained, their common cause is obvious: Ultra-loose monetary policy and ultra-low interest rates. In due time, sharply rising house prices added to the interest incentive. Under these monetary conditions, it made sense to buy a house.

In the U.S., mortgage borrowing by households during the first half of the 1990s increased by an annual average of $168 billion. This accelerated in the decade’s second half to $296.9 billion. But after 2000, it virtually exploded to an average annual growth rate of $615 billion. It is undisputed that the greater part of the escalating mortgage borrowing in the U.S. was for purposes other than house purchases. In short, it boosted consumption as a share of GDP at the expense of business investment and the trade balance. That is, it radically changed the U.S. economy’s pattern of growth -- actually an unsustainable pattern of growth. Yet America’s consensus, amongst it Mr. Greenspan and the Fed, categorically refuse to see any proof of a “bubble economy”. To quote a commentator, “The complacency of the central banking fraternity and their academic standard-bearers is a wonder to behold.”

WILL COMMODITY PRICES BE DENOMINATED IN EUROS?

Oil, metals and even aircraft may one day be priced in euros, not dollars. Dream on? As the dollar stays weak on foreign-exchange markets, with little sign of a sustained recovery, there is speculation that at some point commodity prices will drop the U.S. currency. If that happens, it would herald a wider realignment of the global financial system -- and would indicate that the dollar’s reign as the world’s reserve currency was coming to a close. It is too early to conclude the dollar is finished. Yet the challenge is real and growing. The world may well be set for a period during which the dollar and the euro compete for reserve status -- hardly a promising situation for global stability.

The dollar is being shunned for obvious reasons. The trade deficit grew to a record $609 billion last year, and George W. Bush’s administration expects the budget shortfall to reach a record $427 billion in the year ending in September. The New York Board of Trade’s Dollar Index, which measures the dollar against a basket of six currencies, has dropped 18% since the end of 2001. There are three key responses to the changing status of the dollar in the global financial system. Central banks may shift their reserves out of dollars. The Asian currencies could end their pegs to the U.S. currency. And lastly, we could witness a breakdown in the pricing of commodities in dollars.

Central banks are already slowly raising the proportion of their reserves in euros, and reducing their dependency on dollars. That is likely to continue. Yet it will be a slow process -- not least because no central bank will want to dump dollars into an already fragile market. Asian nations may or may not end their dollar pegs. Politics as much as economics will play the main role in those decisions. That leaves commodity prices. It will only take one commodity producer to break ranks, and the move will be widely imitated. At that point, the dollar’s decline could well turn into a rout. Commodity pricing is now the weakest line of defense for the dollar.

EX-NYSE CHIEF HAD “UNFETTERED AUTHORITY”

Few people ever came to dominate a financial institution as Richard A. Grasso, now 58, did the New York Stock Exchange. He worked there for 35 years, starting as a 21-year-old clerk in the stock listing department, and was the exchange’s No. 1 or No. 2 official for 20 years. But the extent of his control of its board, as laid out in a report just released by the exchange, still came as something of a surprise. As told by Dan K. Webb, a partner in the law firm of Winston & Strawn in Chicago, who was retained by the market’s new management to prepare the report, Mr. Grasso had a major influence on who was named to the board. He also “had the unfettered authority to select which board members served on the compensation committee and, likewise, to select the committee chair.” As a result, “Grasso hand-selected the members of the committee charged with reviewing and recommending his yearly compensation.”

Who was picked? The report says that Mr. Grasso chose directors who were themselves highly paid, and thus less likely to be surprised by big payments. And he chose people “with whom he had or developed friendships or personal relationships.” One director, not identified by Mr. Webb, was said to have told Mr. Grasso that he had little time to devote to the exchange, and “was assured by Grasso that he did not have to attend all the meetings and it would not be that much work.” The director was put on the compensation committee.

The committee often did little work as Mr. Grasso built up a web of interlocking payments under a bewildering set of management compensation plans that reinforced each other in ways the board members often did not understand. Directors asserted that they relied on a consultant who later said that he had never endorsed the big payouts and had objected to them in 2001. The Webb report became public because the exchange, ordered by a judge to give a copy to Mr. Grasso, chose to share it with the public as well. The result is unlikely to enhance either Mr. Grasso’s reputation or that of the parade of Wall Street executives who served on the board -- though by often not naming specific directors, it avoids being too critical of them.

Mr. Grasso was forced to resign after the exchange disclosed that it had paid him $139.5 million in 2003, largely in accrued retirement benefits. The report concludes that his pay from 1995 to 2002 was “far beyond reasonable” and calculates that during his tenure as chairman and chief executive, Mr. Grasso was overpaid by at least $113.6 million. New York State attorney general Eliot Spitzer is trying to force Mr. Grasso to repay much of the money he received. Mr. Grasso has previously maintained that he was paid by an informed and independent board whose judgment he gratefully accepted. Instead, Mr. Webb concluded that Mr. Grasso had improper influence over a board that performed poorly.

Two big psychological trends: a fight by proxy?

If you have not tuned in to the latest episode in the Dick Grasso/Eliot Spitzer deathmatch, all I can say is: You do not know what you’re missing. Grasso, the former head of the New York Stock Exchange, has been sued by Spitzer, the New York Attorney General, who claims that “the $139.5 million payout that Mr. Grasso received in the summer of 2003 was exorbitant and in violation of New York’s not-for-profit law.” Grasso says his pay was set by a legal employment contract, and that “Every dime of compensation was voted on unanimously by a Compensation Committee.”

That is the background: News stories today focused on the sensational details of a year-old report into Grasso’s pay, though the report itself was made public only this week. For instance, it seems the former NYSE chairman needed not one but two drivers, who were each paid $130,000. That is a good wage, even if Manhattan was the place where these guys toiled behind the wheel of a limo. But frankly, the more interesting (not to mention relevant) details were further down in the news stories, likewise the report itself.

In fact, the report was made public by a judge’s order, not because Spitzer wanted it public, but because Grasso’s lawyers did. Apparently the former chairman “was willing to stomach a few days of bad publicity in return for receiving a copy of the report, which casts a fresh and in some cases unflattering light on the behavior of the directors of the exchange’s board.” Indeed, not only the board, but especially the board’s compensation committee and its chairman and consultants, will all be less than flattered by having the light shining on their behavior in this sordid mess.

Attorney General Spitzer has picked a lot of fights in a lot of boardrooms, but he has not lost one yet. Dick Grasso is a 35-year veteran of the NYSE, who crossed the river as a 21-year old kid from Queens, grabbed a bottom-rung job on Wall Street, and climbed to the very top. Neither man appears to have any incentive (never mind the inclination) to back down and settle the case. What is more, this looks unmistakably like -- dare I say it -- a battle by proxy of two large psychological trends in the stock market in recent years: the old bull market mania that helped make Mr. Grasso, and the bear market accountability that made Mr. Spitzer.

“ZERO INTELLIGENCE” TRADING CLOSELY MIMICS STOCK MARKET

A model that assumes stock market traders have zero intelligence has been found to mimic the behaviour of the London Stock Exchange very closely. The result does not mean traders are actually just buying and selling at random, say researchers. Instead, it suggests that the movement of markets depend less on the strategic behavior of traders and more on the structure and constraints of the trading system itself. The research, led by J. Doyne Farmer and his colleagues at the Santa Fe Institute, New Mexico, say the finding could be used to identify ways to lower volatility in the stock markets and reduce transaction costs, both of which would benefit small investors and perhaps bigger investors too.

A spokesperson for the London Stock Exchange says, “It’s an interesting bit of work that mirrors things we’re looking at ourselves.” Most models of financial markets start with the assumption that traders act rationally and have access to all the information they need. The models are then tweaked to take into account that these assumptions are not always entirely true. But Farmer and his colleagues took a different approach. “We begin with random agents,” he says. “The model was idealized, but nonetheless we still thought it might match some of the properties of real markets.”

COMPETITION AND UNEXPECTED OUTCOMES

Suppose you had a company that provided a technology service. And suppose you held a legal monopoly to provide that service. And, finally, suppose that your monopoly controlled the largest market of its kind in the world, so large that your company needed a million employees to meet the demand. Question: Once this company lost its monopoly, how do you think it would fare after 20 years of competition? Answer: If the technology service was a telephone & a dial tone, and if the company in question was AT&T, and if you have followed the financial news this week, then you already know the answer. Some two decades after the court-ordered break up in 1984, what was once the world’s largest phone company has been swallowed by one of its offspring. Ma Bell is no more.

When AT&T was the 2,000-pound gorilla 21 years ago, imagine predicting that it would not even be an independent company by early 2005. You would have been laughed out of the room. A Wall Street Journal on AT&T’s fall story says that in 1984, a study of the potential cellphone market predicted 900,000 users in the U.S. by the year 2000; it says “Many thought the prediction was too high. The actual number was more than 100-fold greater than the prediction.” Back then, AT&T passed on getting into the cellular business. The unthinkable happens, which is why it sometimes deserves a lot of thought indeed.

BLOWING HOT AND COLD

Historically, there has been a negative correlation between the price movement of stocks and commodities. Commodities were hot in the period between 1906 and 1923, when stocks went nowhere, and the reverse was the case during the Roaring Twenties. Many of us still remember the hot commodities -- and cold stocks -- of the 1970s. Quite the opposite was the case during the 1980s and 1990s. Now the cycle is turning in favor of commodities.

Studies have confirmed this negative correlation between stocks and stuff. Two recent studies, for example, headed by Barry Bannister, a capital-goods analyst for Legg Mason, the Baltimore-based financial services company, show that for the past 130 years “stocks and commodities have alternated leadership in regular cycles averaging 18 years.” Bannister heard me talking up commodities in the early 2000s and kindly sent me his own research on bull markets in stocks and commodities since 1880. When you look at these trends on a graph, it is positively eerie. It looks as if God himself were a trader who enjoyed playing the stock market for 18 years or so and then switched to futures, until he got bored again, after another 18 years or so, and went back into the stock market.

Why the negative correlation? I am not sure, but I have a theory. Consider the Kellogg Company, the world’s leading cereal producer. It stands to reason that when the prices of the commodities Kellogg needs are going up, the company is under more pressure to control costs and profit margins. And so a rising commodity market would hurt many companies and their margins, while decreasing prices for those same goods over long periods would help them. In theory. It would also explain why commodity-producing companies (oil and mining companies, for example) and those that support and serve them (oil-rig manufacturers, tanker and container owners,etc.) tend to do well during commodity bull markets.

Bannister and an associate actually began their analysis of the commodities and equities markets by asking their clients, “Do commodity-serving companies deserve your capital?” They concluded that, while stocks for most companies went down during a commodity bull market, companies connected to the commodities business-their focus was manufacturers of heavy machinery used in agriculture, such as John Deere and Caterpillar, were likely to do quite well.

An even more recent, and extremely important, study from the Yale International Center for Finance entitled “Facts and Fantasies About Commodity Futures”, found that returns from investments in commodities were “negatively correlated” with equity returns (and bonds). Ignoring commodities in a bear stock market, as so many tend to do, turns out to be quite irrational-and fiscally irresponsible. The 20th century’s longest bull market in commodities began during the Great Depression in 1933. Economies all around the world suffered, yet commodity prices kept rising. And 30-odd years later, during the famous worldwide recession of the 1970s, commodity prices skyrocketed again. In both cases, supplies had dwindled during previous years, while demand rose or at least remained flat. Supply and demand, that’s what it is about.

The Yale study also concludes that, “commodity futures are positively correlated with inflation, unexpected inflation, and changes in expected inflation.” That was pretty obvious to those of us who participated in the commodity bull market during the 1970s, when double-digit inflation was rampant. Looking for an inflation hedge, some head for stocks, others head for short-term government bonds and treasuries. Back in the 1970s, as a young investor searching for ways to make money I actually drifted into commodities for the first time because I saw so little value anywhere else. According to the Yale study authors, commodities have been a better hedge against inflation than stocks and bonds for the past 45 years. Today, as a much more experienced investor, I would have been dumbfounded if they had discovered otherwise.

If I am right that current supply-and-demand imbalances will be pushing up most commodity prices for years to come, that will be the root of inflation. Most people just do not notice it until those higher commodity prices are passed along to them-when more expensive oil and metals, for example, raise the price of their cars and gasoline. If inflation were a marching band, higher commodity prices would be the majorettes leading the musicians down the street. And by investing in commodities you can beat the band.

GERMAN UNEMPLOYMENT IS NOW AT 12.1%, BUT THE STOCK MARKET DOES NOT CARE

The German government announced that the country’s unemployment is now at 12.1%. A record 5,000,000 Germans are out of work. Last time the job situation was this dire was right after World War II. Germany has been struggling with high unemployment for several years now. The rate has hovered near 10% for a long time -- until now. To add to the problem, the German work force is aging rapidly. To remedy that, the government is now proposing to raise the retirement age from 65 to 67. But while it may help pay for retirement benefits, it will most likely only make the unemployment situation worse.

Just how bad is it? A story in this week’s Telegraph reports that a 25-year-old waitress and former IT professional was offered by her local unemployment office a job to provide “‘sexual services’ at a brothel”. She turned it down, and now her unemployment benefits may be revoked. Thanks to a new German employment law adopted two years ago, “any woman under 55 who has been out of work for more than a year can be forced to take an available job -- including in the sex industry -- or lose her unemployment benefit.” Under the new regulations, “working in the sex industry is not immoral any more” -- so take it or leave. This is not an isolated incident. Another case documents a young woman being ordered to attend a job interview as a “nude model”.

The job situation in Germany is appalling in more ways than one. But our desire is to decipher how it may affect the direction of the German stock market. Well, German stocks were unfazed by the shocking jobs number. The DAX rallied all day and closed 16 points higher. In fact, an absolute majority of European indexes closed up. The British FTSE 100 has even managed to remain above 4,900 -- the level it has not visited since 2002. The DAX has seen plenty of negative economic reports lately, yet it has been rallying defiantly since last August. When the stock market ploughs ahead “despite the bad news”, that speaks volumes of the underlying mood.

THREE GREAT INVESTORS SQUARE OFF AT THE ORLANDO MONEY SHOW

“Who here in the audience likes small caps?” James Boric, editor of Penny Stock Fortunes, polled the attendees of the World Money Show. Nearly every conference attendee raised a hand. (One guy seated close to your New York editor raised both hands). “Wow!” said James, “That’s the most enthusiastic response to small caps I ever seen at a conference!”

Throughout the panel discussion -- which featured Boric and Chris Mayer, editor of the Fleet Street Letter, as well as Strategic Investments editor, Dan Denning, and part-time Daily Reckoning editor Addison Wiggin as moderator -- Boric trumpeted the achievements and virtues of small-cap stocks. At the conclusion of the panel discussion, attendees swarmed around Boric. The value-investing Mayer, by contrast, departed the conference hall completely unmolested. Hmmm ... your New York editor surmised, maybe small caps ARE a bit too popular for their own good. Boric admits the small-cap sector has become a bit pricier than it used to be but he still finds plenty of small-cap stocks worth buying. “Small caps have led the stock market out of EVERY bear market,” Boric emphasized. “And they just did it again.” But it is also true that small caps are pretty good at powering bear markets. They may not lead bear markets very often, but they follow with a vengeance.

Boric’s impassioned argument failed to convert Denning. Denning advised discretion rather than valor. “It is myopic to focus on U.S. small caps at the exclusion of all macroeconomic influences,” he said. “Sure small caps have been rallying, but so has just about everything else -- large caps, emerging market stocks, real estate, gold, oil ... everything. As I see it, small caps are just one of the many beneficiaries of a U.S.-centric asset inflation. Assets here in the states have been inflating for so long that there’s little value left in any of them.”

“Well I don’t completely agree,” countered Chris Mayer. “I am still finding some very attractive stocks that are well positioned to benefit from China’s long-term economic boom.” At this point, the three editors’ seemingly disparate philosophies converged around a central, unifying theme: China. “I like BHP Billiton [NYSE: BHP], the big Australian mining company,” said Denning. Mayer continued the China theme by recommending Agrium [NYSE: AGU], a diversified fertilizer company. Even Boric played the China card, when offering up his recommendations to the audience. “I like J-A-D-E. That’s the symbol. This is a U.S.-based jewelry retailer with big expansion plans in China.”

On the short side of the market, Boric deferred to his slightly-more-bearish colleagues. Mayer named Fannie Mae [NYSE: FNM] and Countrywide Financial [NYSE: CFC] as two of the stock markets least attractive names. Denning zeroed in on the REITS as attractive shorts, specifically “ICF”, the iShares Cohen & Steers Realty Majors. “’qve been negative on this group for about two years now ... and therefore wrong for about two years. But ’m not changing my view.”

INVESTORS IGNORE RISK, REACH FOR RETURN

If markets climb a wall of worry, as the old adage goes, they collapse on a crevice of complacency. From my perch, the complacency in a wide variety of names, many of which show up in this column, has not been this pronounced since 1999 to 2000. There is simply little in the way of respect for risk, which is why I call this the no-fear phase of this market’s cycle. I am still numb over how investors in the for-profit education stocks, for example, seem ambivalent about possible risks inherent in those companies after last week’s 60-Minutes investigation raised serious questions about the way Career Education does business. (The report on Career Education, which was backed by interviews with dozens of sources, was nothing less than exceptional.) Bulls say the risks are already priced into the stock. As if they know what will really happen if the government ever finds enough wrong-doing to yank government-sponsored loans from the industry. But don’t worry, it is just a risk and right now risk is a four-letter word. This, too, shall pass. (Always does, but usually not before someone gets blind-sided.)

FANNIE, FREDDIE REGULATOR SEEKS POWER TO CLOSE COMPANIES

The federal office that regulates Fannie Mae and Freddie Mac is seeking authority to close the giant mortgage finance companies in the event of a financial crisis, as legislation toughening rules on the firms begins to make its way through Congress. Lawmakers and the Bush administration have their sights set on both Fannie and Freddie as the legislative year begins. Both companies, which pump millions of dollars into the mortgage market, have weathered accounting scandals recently, with two of Fannie’s top executives resigning over a massive earnings restatement.

Meanwhile, a coalition of 37 federal, state and local groups urged the federal government and Congress to cut ties with Fannie and Freddie Thursday. Warning that Americans are threatened by a potential taxpayer bailout of the two companies, the groups recommended privatizing both.

CONDO FEVER TURNS BUYERS INTO EARLY BIRDS

Angelina Umansky, a 39-year-old spa owner from San Francisco, was visiting a friend in Miami two weeks ago when she heard about a new condo development downtown. Hoping to find a vacation home, but worried that others were interested, too, Ms. Umansky arrived at the sales office at 8 a.m. the day after seeing some model units. About 50 other buyers were already in line. Two hours later, a sales agent summoned her and said she had four minutes to decide which unit to buy. She acted fast, offering $350,000 for a two-bedroom, two-bathroom unit. Ms. Umansky thinks she got a bargain; when she called on behalf of a friend less than eight hours later, she was told the asking price on a unit like hers had climbed to $380,000, a nearly 9% price increase.

Just when it seemed as if the real estate market could not get any barmier, it has. With inventories lagging behind demand and prices for new homes rising seemingly by the hour in destination cities like New York and second-home markets like Miami and Orlando, home buyers are camping out overnight in front of sales offices, pestering brokers and developers and scooping up multiple units in the real estate version of scalping.

Across the country, according to the National Association of Home Builders, the number of new condos sold jumped 32% to an estimated 115,000 in 2004 compared with a year earlier. And in New York the number of condo sales in the three months through December 2004 increased 8.2% over the same period a year earlier, and average condo prices were up 11.1% to $1.29 million, according to Miller Samuel, a New York real estate appraiser. The gold rush mentality has some economists concerned. Some buyers of new condos and houses are behaving like day-traders before the dot-com crash, said John Vogel Jr., a real estate professor at the Tuck School of Business at Dartmouth College.

In some cases, developers are actually creating the frenzy. In central Florida, Transeastern Homes, which builds subdivisions, asks prospective buyers to put down a refundable deposit of $500 to $5,000 to reserve a time slot to buy a house that has yet to be built, sometimes without knowing more than the general location of the subdivision and a price range. Buyers review floor plans and maps first at a Web site or in a brochure. When they arrive at the sales “event”, typically at a hotel or a convention center, they spend five minutes looking at a map and choosing a home before the next buyer moves to the front of the line. Price increases -- up to 16 a day -- are announced over loudspeakers. “People get excited and get caught up in it,” said Joel Lazar, a Transeastern vice president. “Even if they weren’t planning on buying a home, they convince themselves to buy a home.”

What is lost in the giddiness is a sense of history. “People have a belief that’s not true: that you can’t lose money in real estate,” said Joseph Gyourko, a real estate professor at Wharton. “We know from the late 80’s and early 90’s that you can.” In New York, for example, median sales prices peaked at $375,000 in 1987 before plunging 45% to a low of $205,000 in 1995. Median prices did not climb back up to their 1980’s levels again until 2000, according to Miller Samuel. In the Northeast, the National Association of Realtors said median sales prices fell 11% from 1988 to 1989, and did not return to 1988 levels until 2001.