Wealth International, Limited

Finance Digest for Week of February 14, 2005

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


Can any property stock seriously be called a bargain? When Forbes kicked off this annual REIT rating list in January 2002 the stocks were cheap at 12 times trailing earnings. Now they go for 19 times. In the past three years the category has handily outperformed the stock market with a 21% annualized total return to the market’s 5.1%. There are still reasonable buys out there but no screaming ones. You cannot expect the next three years to be as thrilling.

Green Street Advisors came up with price/earnings ratios using a definition of earnings peculiar to the real estate industry. It is net income (excluding capital gains) with depreciation added back and capital outlays for building maintenance subtracted. This earnings measure, called “adjusted funds from operations”, or AFFO, gives the best picture of the income that a landlord can live on. Green Street says that AFFO has been climbing at a 3.6% pace annually over the past ten years. For the 61 trusts it covers (a good chunk of the REIT universe), AFFO will rise a satisfying 7% this year, the firm predicts.

Most trusts are paying out virtually all their AFFO to shareholders in the form of dividends. With the stock run-up the REIT dividend yield has shrunk a bit, from 6.9% in early 2002 to 5.5% today. And unlike most other dividends REITs are taxed as ordinary income, up to 35% on the federal level, and do not get the new 15% dividend tax rate. Still, that 5.5% dividend yield eclipses the S&P 500’s paltry 1.8%.

There are REITs and there are REITs. To help you decide which ones to buy, our REIT grades cover two things: performance and value. The performance grade shows how well a manager has delivered portfolio results as measured by dividends paid, growth in estimated liquidating value and growth in AFFO. The value grade measures something entirely different: whether or not the stock is a bargain.

Link here.


JohnsonFamily International Value is a pip-squeak in assets, but a giant in performance. Over the past three years this $77 million fund has delivered an annualized return of 16.9%, compared with 13.6% for the Morgan Stanley Capital International world stock index that excludes the U.S. Manager Wendell Perkins, 41, has 90% of assets in big companies from developed markets. Among them: BP and Mitsubishi Tokyo Finance (both of which trade in New York as ADRs). The remaining 10% of Perkins’s investments are in emerging markets, but he buys such stocks only when they seem grossly undervalued relative to counterparts in developed markets. To play it safe, he focuses on the largest and best-known emerging-market companies, such as Mexico’s Cemex, the world’s 3rd-largest cement company. Cemex shares are up 35% over the past 12 months and sell for 11 times estimated 2005 earnings.

Another pick: Brazil’s Companhia Vale do Rio Doce, the world’s largest producer of iron ore, with $6.3 billion in annual sales. Its shares have risen 58% in the past 12 months and trade at 10 times estimated 2005 earnings. That is not dirt cheap for a mining company, but Perkins believes that Asia’s voracious demand for ore will keep the share price rising. Perkins has owned shares in Teléfonos de México, Mexico’s leading nationwide provider of fixed-line telephony, since 2002, when Latin America suffered the backwash of the U.S. economy going into recession the previous year. Telmex then traded at four times cash flow (in the sense of net income plus depreciation), a relatively cheap valuation reflecting the fact that, as in the U.S., fixed-line phone service is not a growth business and Telmex faces stiff competition from cellular providers such as América Móvil. “You own them for some stability and yield,” says Perkins about Telmex. Telmex has appreciated 10% since he bought it; the stock yields 3.1%.

The fund’s Latin American holdings delivered a 35% return in 2004, but Perkins sees slower growth in 2005. “At some point we’ll make the decision [for Latin America], much like we have in our Chinese holdings, that we’ve seen the bulk of the return and it’s time to go elsewhere,” he says. Chinese stocks now represent just 5% of Perkins’s holdings, down from 9% in 2003. JohnsonFamily International Value is a no-load fund whose annual expenses run $1.70 for every $100 invested. The average international market fund charges $1.76. Do-it-yourself investors might consider the equities listed below.

Link here.


Last month I promised to explain why I expect stocks to be up 25% this year. Well, they sure have not started out robustly. But I am not throwing out my rose-tinted glasses. My reasoning: First, forecasters have a very tight and strong consensus for low-single-digit stock returns this year, yet historically the consensus has almost always been wrong. So stock returns should be either into double digits or else negative. Now, the first year of a President’s term has almost always been sort of 50-50, either negative or up a lot -- nothing in between. Since I do not expect a negative year, I expect the market to go up a lot.

Link here.


The tube is filled with ads featuring financial advisers making charming toasts at a client’s family wedding or wildly cheering his kid on the soccer field. No question, many financial advisers and brokers care for their clients and give good advice to go along with the neighborly bonhomie. But some widely offered counsel will hurt your portfolio’s performance. Be careful if an adviser is pushing these ideas:

1.) Team management. A lot of mutual funds use an array of in-house managers or farm out pieces of a fund to outside talent. Such a fund is not likely to do as well as a fund with a single stock picker whose past record is excellent. 2.) Three-year fund records. Look at 10- or 15-year numbers. 3.) Beta as a mantra. Professors Eugene Fama and Kenneth French concluded in a famous 1992 study that there was no correlation between beta and return. 4.) Sporty new performance measurement techniques. 5.) Popular trends. If you follow them, odds are you are buying near the peak, and the lovely outperformance will end soon. Today hedge funds are hot, as are foreign securities, gold and natural resources.

Am I being too hard on financial advisers? According to the sage John Bogle, Vanguard’s founder, the vast majority of portfolio managers have fallen short of the S&P’s returns since the 1970s. That includes managers of pensions, charities and mutual funds. Money management has to be approached with a certain amount of humility. If the adviser seems to think that he has the keys to the kingdom, walk away fast.

Link here.


In the wake of the Asian financial meltdown, experts predicted that China would devalue the renminbi. So did traders: Currency forwards priced in a significant devaluation. I did not jump on that bandwagon. And the right call it was. The exchange rate of 8.28 renminbi to the dollar has not budged since 1995.

That fixed exchange rate does not suit everyone, however. Led by the U.S., a chorus of countries is loudly demanding that China ratchet up the value of its currency against the dollar. Such a revaluation is intended to make Chinese exports more expensive and less competitive. The Chinese authorities have politely demurred, but most experts think they will eventually succumb to international pressure. The markets agree. Once again, I think the experts and the markets will be caught wrong-footed.

In the Chinese authorities’ eyes a fixed exchange rate, economic growth and stability are all tightly linked together. And in Beijing, stability might not be everything, but without it, everything is nothing. For this reason alone, it is hard to fathom a renminbi revaluation. There is plenty of local and regional history to reinforce Beijing’s views about the dangers of meddling with an exchange rate.

Link here.


The Federal Reserve keeps thorough records of U.S. consumer credit, and most of the data goes back 30 years or longer. They put it all on the Internet, too. Scroll through the numbers, and before long you will have what amounts to a crash course in how rapidly the debt levels have grown during just one generation. New car loans, for instance: In June 1971, the total amount financed averaged $3045 for 35 months. Fast forward to Nov. 2004, and the amount financed averaged $23,984 over 60.5 months. But that is just for starters. To see what real growth in the debt levels looks like, “revolving credit” (also known as credit card debt) is the place to look.

The Fed began keeping records on revolving credit in January 1968; the outstanding amount in that month was $1.4 billion. Jump a little more than five years ahead and you come to the first month that revolving credit exceeded $10 billion -- $10.2 in June 1973. Barely eleven years later came the $100 billion threshold, $106.26 in December 1984. Near the end of 2004 (November), revolving credit stood at $782.15 billion. That is a whole lotta credit card debt. As you scroll the data, you do occasionally notice a marginal decrease in the monthly debt figures, but “more” and “bigger” is the rule...

... until November’s number, that is. As large as $782 billion sounds, it is actually an 11% annual rate decline from October, the single largest one-month drop since the Fed began keeping records in 1968. Now, this data is always subject to “revision”, and one month does not a trend make. December’s number was well below the usual increase for that month. Credit card debt can keep growing explosively for years or even decades... until it doesn’t. And “doesn’t” is exactly what no one expects, let alone prepares for.

Link here.


“These aren’t commonsense rules. That’s why we call them preferred sense rules.” The subject of that Wall Street joke is the incredibly arcane accounting rules that govern how corporate and public pension plans report their financial condition. Ron Ryan ought to know. As chairman and founder of Ryan ALM, a pension-consulting firm, Ryan has been keeping a pension asset/liability scoreboard for years. Corporate pensions were fully funded in 1999, but his index shows that pension liabilities have outpaced pension assets by 50% over the last five years. Many readers will be surprised to see that two years of stock market recovery have done little to dig pension plans out of the hole they were in at the end of 2002. Indeed, Secretary of Labor Elaine Chao told the National Press Club in January that private pension funds were underfunded by an estimated $450 billion. A separate study by Morgan Stanley estimates the nation’s public pension funds are now underfunded by $1 trillion.

Few understand that pension liabilities, the money pensions are committed to pay to current and future retirees, are a major part of the problem, Ryan added. When interest rates go down, as they did during the bear market and in response to 9/11, it means that pension liabilities go up. So the same Federal Reserve actions that were meant to buoy the economy also caused a massive increase in pension liabilities. By his estimate, each 50-basis-point change in interest rates (1/2 of 1 percent) will cause pension liabilities to rise or fall by 6 to 7.5%.

Link here.


Washington is caught up in a housing bubble affecting a couple of dozen urban areas nationwide, characterized by soaring home prices and increasing speculative activity in local real estate. As people learned with the stock market bubble in 2000, the ride up may be exhilarating for investors and homeowners, providing an opportunity to make big money, but the ride down -- if the bubble bursts -- can be devastating to people’s finances and crippling to the economy.

Washington area home prices surged 24% last year, twice the national rate and the 4th straight year of double-digit gains, according to the Office of Federal Housing Enterprise Oversight. Since the late 1990s, home prices have doubled in northern Virginia and many other parts of the region. Richard DeKaser, chief economist with National City Corp., estimates that Washington is one of 28 U.S. cities where houses are 10% or more overvalued, based on income levels and other factors, and could be in a bubble. “There is a growing risk of ‘bubblettes’ in certain places,” although the U.S. market overall does not appear overpriced, he said. Standard and Poor’s has placed Washington among a group of major U.S. cities where it expects home prices to retreat because of unsustainably large gains characteristic of a bubble in recent years.

Link here.


I started getting edgy about international funds when a young grandmother told me she wanted to set aside money for her girl’s baby girl. The spot? Well, she is thinking about going international. Oh, brother. Betting on Latin America or some exotic spot to pick up the tab for college tuition? I would not recommend it. Yet lately, it sounds like international funds are the new hot spot where novice investors could get burned.

“We’re seeing signs of a possible mania,” said Carl Wittnebert, director of research for TrimTabs.com, a Web site that tracks money flows in and out of the market. Me too: Out of the blue, two people started chatting with me about international mutual funds this year. It is not a topic that crops up often -- or frankly at all -- in everyday yapping. Wittnebert’s evidence: Lots of cash has been flying off to international funds.

Why the rush to invest overseas? Why else? Look at past returns. World equity funds, which include gold funds, were up 17.8% in 2004, Lipper reports. By contrast, U.S. diversified equities did well but not nearly as well. They were up on average 12.0%. Latin America was super hot. Mutual funds that invest mainly in Latin American companies were up 38.4%. Over two years, world equity funds gained an average 28.4%. Latin American funds were up 49.9% in two years. And you are seeing plenty of ads for value-oriented, international stock funds. They were up 40% or so in 2003 and up 20% in 2004.

We are also hearing talk about how the falling dollar makes foreign stocks tempting. Yet it is still possible to lose money in these funds, even if the dollar drops further. And it is not really a good idea to invest in anything on a hunch where the dollar is headed. To be sure, many financial planners have long advised people saving for long-term goals to consider having a little money invested outside of the U.S. It is a way to diversify. But it is never smart to fall in love with a fund group because you cannot get your eyes off last year’s great returns.

Foreign funds once lost money, too. Many big winners of last year, including Latin American funds, posted losses in 2001 and 2002. Some international funds that invest in growth-oriented stocks lost roughly 20% in 2001 and again in 2002. “When you start hearing everybody say ‘It’s the place you ought to be,’ the warning lights should come on,” said Tom Roseen, senior research analyst for Lipper. Consider this a warning.

Link here.


If $225 million was sitting in a restitution fund for wronged shareholders and you were entitled to some of it, would you agitate to get your fair share? Silly question, right? Not, it seems, if you are an institutional shareholder. Last September, Computer Associates International, the Long Island software company that has been plagued by scandal, agreed to put $225 million into just such a restitution fund. The idea was to compensate shareholders injured by the company’s bad behavior, which came to light after an investigation by the Justice Department and the S.E.C. So far, not one shareholder has come forward with ideas about how to dispense the money in the fairest and most appropriate way.

To some degree, this example of investor passivity is understandable, since the courts typically decide shareholder compensation in securities fraud cases. Indeed, some suits against the company were handled by the courts. Institutional investors are not accustomed to negotiating for their fair share in such cases; unfortunately, they are used to seeing the lawyers get most of the money. But because the Computer Associates case presents such a fine opportunity for shareholders to design a fair and proper restitution fund -- and because many more of these funds are likely to be set up in the future -- their inaction is troubling. It is precisely such shareholder inertia that has allowed corporate malfeasance to thrive in this country in the first place.

Link here.


The club of the world’s wealthiest nations has punted on the big issues facing the global economy -- namely, unprecedented current-account imbalances, currency misalignments, mounting trade tensions, and the liquidity-prone biases of central banks. The G-7’s latest communiqué is emblematic of the increasingly vacuous rhetoric of globalization. This is a perilous course of inaction for a global economy beset with record imbalances.

Meanwhile, there is no stopping the process of globalization itself -- especially insofar as the cross-border integration of the global economy and world financial markets is concerned. World trade now stands at a record 28% of world GDP -- up nine percentage points alone from the share of the early 1990s. Turnover in foreign exchange markets is approaching $2 trillion per day. Courtesy of the Internet, the dissemination of information and technological breakthroughs is both instantaneous and ubiquitous. Cross-border connectivity of labor markets, product markets, and even so-called non-tradable services is occurring at a sharply accelerating rate.

The hard wiring of globalization is largely in place. Yet very little progress has been made on the soft-wiring front, namely, the globalization of collective actions by national governments and policy makers. When push comes to shove, the so-called global village is still reluctant to pull together and accept the shared responsibilities of globalization. Significantly, this reflects inherent flaws in the policy architecture -- with a Euro-centric G-7 (four of the seven votes going to the UK, Germany, France, and Italy) ill equipped to cope with the imbalances of a U.S.-centric global economy. But it also reflects the resistance to tackling the big issues of globalization.

So it is back to the well for another spate of U.S.-centric global growth. That would represent a disappointing reversal following two years of progress on the road to global rebalancing. It was a currency realignment that drove the rebalancing of the last two years -- a broad trade-weighted dollar that by the end of 2004 had fallen 16% in real terms since peaking in early 2002. But it was progress nonetheless. That progress is now at risk. It now appears that the heavy lifting is being put off for another day. For this latest growth gambit to work, financial markets will need to acquiesce -- containing interest rate pressures on the upside and dollar pressures on the downside. The risk remains, in my view, that some external event will crack the denial, leading to a weaker dollar and higher U.S. real interest rates. Recent market action makes those risks seem all the more remote. A new mindset has taken hold: Close your eyes, hold your breath, and watch an unbalanced world up the ante with another growth gambit.

Link here.


News is virtually irrelevant to explaining and forecasting market trends. I say “virtually”, because there is a relationship, in that social news lags market trends. There is some forecasting utility in that fact, but only if you have a trading method that recognizes degree, such as the Wave Principle or time cycles. Then certain types of news can be a confirming indicator. In fact, some of the best analysts I know use certain types of media reports as market indicators. Paul Montgomery and Ned Davis use magazine covers, for instance. When a national general news magazine finds a trend so exciting that it makes the cover, the trend is generally one to three months from ending.

News sometimes appears to affect the market for a few minutes, maybe up to an hour. When it moves the market in the direction you expected, it is irrelevant. If it moves it in the other direction, you can use it to your advantage by quickly increasing your position. Otherwise, news is irrelevant to trends.

Link here.


According to a new Morgan Stanley poll, 86% of European money managers continue to predict that the stock market is the place to put your money in 2005. While no one ever really expects professional money managers to turn bearish on stocks, they have been right so far this year. January was a good month for European bourses, and February is shaping up nicely, too. In fact,, the British FTSE 100 briefly poked above 5,000 -- the level the index has been trying to regain for over two years. All other major European indexes have been climbing just as strongly.

The small print at the bottom of every money-management contract always says that relying on past performance for future results -- also known as “trend-following” -- is risky business. But sometimes, this approach works. European stocks may just continue rising for a third year in a row, and clearly that is what most professionals are betting on. What is interesting, though, is that at least in Britain, much of the investing public does not trust this bullish view of stocks. Cash inflows to the UK’s investment funds were down 40% in 2004. Contributions to the U.K.’s Individual Savings Accounts (similar to the U.S. IRAs) fell last year to their lowest level ever.

In short, there does not seem to be a consensus in Europe towards equities these days: you have “smart money” bullish -- correctly -- for the past two years, and an absence of a broad public participation, a necessary ingredient for a healthy bull market. Could this lack of consensus be good for European stocks, then? After all, they have been rallying in this ambiguous environment for two years now. The good news is that the wave patterns are in consensus.

Link here.

Ban, ban, ban!

After Britain’s Prince Harry showed up at a party wearing a Nazi costume last month, all hell broke loose. And not just for Harry personally, but all across Europe. German members of the European Parliament were so outraged with Harry’s stunt, they proposed to expand the existing ban on Nazi symbols from Germany and Austria to all of Europe. Another group of European parliamentarians then added that if we are going to ban extremist emblems, we have to go all the way and ban the old Soviet red star and hammer and sickle across Europe, too. After all, Nazis “incited racial hatred,” and communists “incited social hatred,” so they are both bad. Why stop there, said some of the German government members. If we are going to ban extremism, let’s go to the source and ban right-wing parties altogether! We can start with Germany’s NDP, and then see where that takes us. Wait a minute, said the EU Justice Minister on Tuesday. A European ban on extremist symbols is nothing but “stupid”.

While the debates rage on, a recurrent new “theme” across Europe these days is “ban”. The desire to “ban” has been brewing since long before Harry made his (very) poor choice for a party costume. The real culprit for all the “banning” proposals is bear market psychology. In our research, we have long observed that in bear markets, prohibitive actions escalate. The bear market squeeze on European collective psyche is also showing up in the proposed restrictions on smoking across Europe, in a crackdown on email spam, and the proposed speed limits on German autobahns.

You may be surprised to hear the words “bear market” when European stocks have been rallying for over two years. They have indeed, but is this the return of a long-term bull market? While many economists say that it is, the fundamental indicators are very conflicting So, how do you reconcile the rising stock market with a bearish social mood? You have to step back and take a look at a larger picture. A larger wave pattern, to be exact.

Link here.


I confess to understanding the curmudgeon’s attitude: Once you have lived long enough your patience for BS runs out. When you speak you get to the point; heaven help the soul who does not do likewise when they speak to you. Perhaps all this is true of the 76-year old gentleman who recently published a book that goes by the title, On Bull****. If you are wondering what sort of publishing house would take such a work, I will let the name speak for itself: Princeton University Press. And, yes, the author himself is affiliated with this prestigious school. He is a professor emeritus, and, according to the New York Times, “a moral philosopher of international repute”.

His book begins this way (the asterisks above and below are mine, not his): “One of the most salient features of our culture is that there is so much bull****. Everyone knows this. Each of us contributes his share. But we tend to take the situation for granted. Most people are rather confident of their ability to recognize bull**** and to avoid being taken in by it. So the phenomenon has not aroused much deliberate concern, nor attracted much sustained inquiry.” Nicely put -- I do not detect even a faint whiff of his chosen topic.

What has all this to do with investing? Well, much of what passes for market analysis these days is indeed BS, and as for media coverage, do not even think about getting me started. Why this is so is the question, and our Princeton curmudgeon appears grouchy over not hearing such queries more often: “Even the most basic and preliminary questions about bull*** remain, after all, not only unanswered but unasked.” Well, in my opinion too many “experts”, “analysts”, and “economists” spout BS because: 1.) They can, and 2.) People believe it.

Link here.


We are this week provided a few moments of central bank sanity from our old favorite ECB Chief Economist, Mr. Otmar Issing. It is refreshing to read central banking philosophy from the well-grounded ECB perspective. What a contrast to that espoused by the Greenspan Federal Reserve. The ECB recognizes the necessity for adopting a long-term focus, while the Fed’s realm is the short-term and zealous activism. Mr. Issing exhorts that “central banks should certainly avoid contributing to unsustainable collective euphoria.” Mr. Greenspan has over recent years become a proponent of “the New Economy”, derivatives, structured finance, and even the liquidity and “flexibility” benefits of an expansive hedge fund community. Indeed, the activist Fed specifically targeted leveraged speculation and mortgage borrowings as the key reflating mechanisms in the post-technology Bubble environment. With short-term expedients come long-term costs and uncertainties. There is today -- in The Intoxicating Global Liquidity Bubble World -- little appreciation that Mr. Greenspan’s short-term activism is coming home to roost.

I strongly argue that the confluence of Bubble dynamics, central bank warnings, system-wide hedging, and acute “economic sphere” distortions creates the perfect backdrop for major market dislocations. While some participants do effectively use derivatives, it is impossible for a large portion of the market to successfully hedge against a major market decline. I assert that the circumstance of a major share of the marketplace hedging market exposure during the late-stage of Bubbles greatly increases the probability of one of two scenarios:

1.) The market commences a downward spiral, overwhelmed by self-reinforcing “dynamic” derivative-related selling pressure. 2.) I argue passionately that Bubble dynamics increase the likelihood of this outcome -- a final “classic” spectacular marketplace blow-off occurs: the animated crowd recognizes that the game is nearing its end and puts in place its bearish bets and hedges, only to get run over by the final short-squeeze and buyer’s panic “melt-up” (including the throngs of attentive speculators buying -- on margin -- in front of those caught short). Marketplace dynamics virtually assure that the crowd and their derivative counterparties will be forced to unwind hedges in the final dislocation. Not only does this lead to heightened marketplace volatility and indecision, it also exacerbates the widening chasm between current market prices and prospective economic values.

One other key aspect of the final short covering/derivative unwind/speculator euphoria melee is not as obvious: This process creates a veritable liquidity explosion that perpetuates and exacerbates the attendant boom in the real economy (“economic sphere”). The financial sphere will have over time expanded and evolved to over-finance the Bubble, while the most aggressive risk-takers (“proved right”) will have been elevated to top decision-making positions. Support from the political establishment also reaches full bloom. Importantly, this final destabilizing liquidity onslaught fosters the most egregious excesses throughout the real economy. These include misallocation of resources and -- certainly as we saw throughout the tech/telecom sectors in the late-1990’s -- over and mal-investment that ensures the collapse of industry profits as soon as the unsustainable liquidity bulge runs its course.

This brings us to the current environment. Despite Mr. Greenspan’s warnings and six Fed rate increases, the U.S. Credit system’s liquidity bulge has at this point anything but run its course. The homebuilding and consumption boom runs full steam ahead. Should we have expected anything less? It is my view that interest-rate markets succumbed to a marketplace dislocation not unlike NASDAQ in that fateful period, second-half 1999 to early 2000. I would assert that the Fed’s warnings of higher rates and the market’s rational reaction (large-scale hedging and bearish speculating) has resulted in an unfolding major “squeeze”, derivative unwind and destabilizing drop in rates.

The ongoing liquidity onslaught throughout the U.S. and global Credit system, echoing NASDAQ 1999, has wreaked distortion havoc on both the economic and financial spheres. Conspicuously, over-consumption, massive Current Account Deficits and unprecedented central bank dollar security purchases have taken center stage. The greater the U.S. lending and spending excesses, the greater the force of foreign central bank recycling operations back to the Treasury and agency markets. And talk of a paradigm shift to permanently low market rates (all too reminiscent of “blow-off” notions of enduring tech multiples) grows louder. Bubble distortions -- foremost liquidity excess -- under the façade of amazing fundamentals have played a major role in inciting a short-squeeze and unwind of interest-rate hedges throughout the Credit market.

And while on the surface not as spectacular as the technology stock melt-up, we do have the homebuilders. Further evidence of blow-off excess can be found in paltry corporate, junk, ABS, and MBS spreads. Globally, emerging bond spreads are extraordinarily narrow, while equity markets remain red hot. Basically, liquidity excess and multi-year low risk premiums have become the norm throughout global finance. The system is poised for another Trillion plus year of Mortgage Credit growth. And no discussion of Bubble distortions and potential dislocation in the interest-rate markets would be complete without some mention of GSE balance sheets. We can only hope that the GSEs are more adept at derivative hedging than they are accounting. But one can look at the current yield curve environment and see plenty of potential for error. Am I suffering from a wild imagination when I ponder the possibility that their operations could incite destabilizing yield curve gyrations and derivative hedging tumult?

A very fascinating dichotomy is developing in the marketplace. After beginning the year with a hiccup, global bond and equity markets have generally regained their strong momentum (U.S. equities are lagging). And we see this week continued price gains in the energy markets, as well as the resurgent commodity markets. While I appreciate that many are calling for the demise of the “reflation trade” -- long commodities, commodity currencies, and emerging markets, while short the dollar -- recent weakness may prove only a pause that refreshes. It is also worth noting that economists have begun to revise U.S. growth higher, and there are signs the global economy is demonstrating similar resiliency (not surprising considering the interest-rate and liquidity backdrop).

So if reflation retains its vigor; economies their resiliency; and the Global Liquidity Bubble its tenacity; what the devil is the 10-year Treasury yield doing at 4.09%? Are we in the midst of the best of times for the bond market or, instead, an environment characterized by instability and dislocation? How exposed has the marketplace become to an abrupt reversal of fortunes? I suspect that short covering and the unwinding of derivative hedges is placing the marketplace in an increasingly vulnerable position. And it is always these abrupt market “V’s” that cause the derivative players the most grief. As was the case with NASDAQ, one day derivative traders can be panic buyers only to have a market reversal hastily transform them into aggressive sellers.

Link here (scroll down to Mr. Otmar Issing article).


With the government and external deficits both so large and the private sector so heavily indebted, it is said that satisfactory growth in the U.S. cannot be achieved without a large, sustained and discontinuous increase in net export demand. After perusing the trade data from last year, it is doubtful whether this will happen spontaneously through a continuous fall in the external value of the dollar, and it certainly will not happen without a cut in domestic absorption of goods and services by the U.S. which would impart a deflationary impulse to the rest of the world.

The truth of the matter is this: Across three decades, only one economic event has been guaranteed to produce balanced U.S. trade: a recession. When the economy is contracting, people naturally buy less of everything, including imports. The scope of the global imbalances and the potential for crisis makes piecemeal, orthodox solutions to the global imbalance problem unworkable and far too slow. The U.S. service-based economy, with more limited economies of scale than those of newly industrializing economies such as China, will not be able to export its way out of the problem.

As we have noted many times before, there is a danger that over time, the U.S. economy will find itself in a “debt trap”, with an accelerating deterioration in its net foreign asset position and its overall current balance of payments (as net income paid abroad begins to explode). So the problem is likely to get worse, which could ultimately lead to “solutions” that prove highly disruptive to the existing system of multilateral trade and cooperation which has developed over the past several generations. If a full-blown crisis does occur, the macroeconomic challenge would be unlike anything the U.S. has faced in more than half a century. While this would be a time of wrenching, painful change, the new adverse circumstances might also inspire a great shift toward radically different political solutions than have hitherto been considered within the realm of acceptability.

Link here.


One new study shows half of all personal bankruptcies are caused by medical expenses. “The middle class is in trouble in the health care system in this country. It’s not just the uninsured,” said Harvard Medical School professor Dr. David Himmelstein, a cofounder of Physicians for a National Health Program and lead author of the study. Escalating health care costs impoverish families, hurt the economy, and force government into agonizing choices. Since 1990, medical spending soared from $696 billion to a projected $1.7 trillion dollars last year. That is 15% of the GDP.

“Health care is going up at such a rate, that it’s going to reach the point -- and we think it’s already reached the point -- where it’s an unsustainable situation,” Patricia Schoeni, executive director of the National Coalition on Health Care. The new Medicare prescription drug benefit will cost close to $1 trillion -- far more than the Bush administration originally predicted. And Medicaid, the federal-state health program for 50 million impoverished Americans, has already decimated state budgets.

Behind the increases: advances in medical technology, new drugs, and an aging population requiring more care.

Link here.


Two “Dogs Playing Poker” paintings cleaned house at Doyle New York’s annual Dogs in Art Auction, fetching a staggering $590,400, the auction house said. Before the sale it was estimated that the two rare paintings from Cassius Marcellus Coolidg’qs 1903 series of dogs playing poker would fetch $30,000 to $50,000, Doyle said in a statement after the auction. “A Bold Bluff” and “Waterloo: Two” sold to a private collector from New York City. The buyer was not identified.

Comedian Caroline Rhea of Manhattan, who attended the auction, told the New York Daily News that the Coolidge paintings were the highlight of the event. “It’s not the Mona Lisa -- we were joking it’s the ‘Bona Lisa’,” she told the paper.

Link here.


Japan’s economy shrank for a third straight quarter in the last three months of 2004 as export growth and personal consumption weakened, marking the country’s 4th recession in less than a decade. GDP fell 0.1% in real, or price-adjusted, terms from October to December, missing a forecast for 0.1% growth. The GDP figure also confirmed that the strength of Japan’s latest recovery has waned since it started two years ago. “There are three quarters now of negative growth, so Japan is really struggling in this recovery,” said Paul Sheard, chief economist at Lehman Brothers Japan. Two of the world’s biggest economies are now in or close to recession, with Germany saying this week its economy shrank by 0.2% in the fourth quarter.

Link here.

U.S. retail sales -- the WHOLE story.

One of the Tuesday’s top headlines claimed that “Retail Sales Are Weakest in Five Month”q -- as usual, neither the headline nor the news article told the full story. It is true that “a big drop in demand for cars” accounted for much of the overall 0.3 percent decline in January. Much more significant, however, was the fact that “spending was powered mostly by consumers anxious to use holiday gift cards.” In other words, gift cards extended the holiday shopping season by a full month. Consumer spending accounts for two-thirds of total U.S. economic activity, thus retail sales data is telling indeed. So let us look at the monthly percentage change in retail sales not just for the past five months, but the past 12 (chart here).

The chart shows that, yes, January was weaker than the past five months, but those months were nothing to write home about. Overall retail sales were up in 2004, yet the trend cannot be described as steady, much less growing. All the evidence says the economy is dramatically out of step with the normal cycle of recovery and expansion that has characterized post-recession periods in the U.S. since WWII. Do not expect to hear this uncomfortable truth from conventional economists and the media, much less an explanation why.

Link here.


My economic, financial and political outlooks have spawned six investment themes for this year. Three are likely to happen, while the other three are in the “maybe” category -- they will probably unfold at some point, but their timing is less clear. First, a rally in the dollar is likely, especially vs. the euro. And in the longer run, America’s commanding lead in new tech should ensure the buck’s dominance for at least a decade. Historically, the country with the fastest productivity growth had the strongest currency.

Secondly, consumer deflationary expectations will spread: When deflation is widely accepted, buyers anticipate it by waiting for lower prices before buying. This creates excess inventories and idle productive capacity, forcing sellers to cut prices in order to move goods and services. These cuts, in turn, confirm buyer suspicions, so they wait even further for even-lower prices and, in the process, generate a self-feeding deflationary cycle. This is already evident in autos. This last Christmas season showed that consumer deflationary expectations have spread from autos to general merchandise, especially Christmas gifts.

Thirdly, the yield curve will probably continue to flatten: The Treasury yield curve has flattened since the Fed started raising the short- term rates it controls last June. There is not much question that the Fed plans to continue its rate-raising campaign, which started when Federal funds was at 1% and at the current 2.5% target is still considered by the Fed to be below equilibrium. Will we go all the way to inversion, with short rates above long rates? In this era of low and, I believe, declining inflation, I look for a further flattening, but not an inversion of the yield curve in the quarters ahead. If I am wrong and the yield curve does invert, look for a recession. That has always been the case in the post-World War II years. No exceptions.

A flat yield curve would damage many less speculative investments. Financial stocks have done well in recent years and the earnings of those in the S&P 500 index account for about 40% of the total. This is not surprising since, at heart, many financial institutions are spread lenders, borrowing short term and lending long term. The steep yield curve in recent years has been their bread and butter. Further flattening in the Treasury yield curve would compress these spreads-and the earnings of financial institutions-considerably.

And to start on the “maybe” section ... maybe the housing bubble will break this year: I have warned about the expanding bubble in housing prices in recent years, and continue to forecast its burst. Prices, which normally rise in step with incomes and the CPI, have run well ahead in recent years. What might trigger a nosedive in American house prices? I can see four triggers: 1.) a spike in mortgage rates; 2.) loss of confidence in mortgage-backed securities in addition to faith in the obligations of government-sponsored housing enterprises; 3.) if the low-end, first-time homebuyers lost their jobs and consequently were frozen out of the market; or finally, 4.) house prices might simply fall of their own weight.

A significant nationwide fall in housing prices, the first since the 1930s, would wipe out the slender equity of many homeowners and cause much more national distress than the big 2000-2002 bear market in stocks. As a result, widespread or chronic house price weakness would almost certainly end the 20-year U.S. consumer borrowing and spending binge and touch off a frantic saving spree. A residential real estate collapse and a saving spree in this country, combined with its echoes and other negative economic consequences abroad, could create a big enough global financial and economic crisis to convert the good deflation of excess supply I foresee to the bad deflation of deficient demand.

Link here (scroll down to piece by Gary Shilling).

Grief for risky investments.

To continue with my “maybe” forecasts ... a renewed bear market in U.S. stocks, and grief for riskier investments, may commence this year: The October 2002 bottom in stocks may not have been the final lows that corrects the irrational exuberance of the 1990s. Massive monetary and fiscal stimuli, especially after 9/11, kept the 2001 recession brief and shallow, and provided the money to keep speculation alive. It simply shifted from dot.com and other new tech stocks to other vehicles like Treasury bonds, junk bonds, emerging market bonds and equities, commodities, currencies and hedge funds.

Recall that when speculation survived the big bear market, stocks fell substantially but never really got cheap. P/E ratios are still high, so higher P/Es, on average, are unlikely in the foreseeable future -- unless I am right and deflation drives long Treasury bond yields to 3%, but that would present another whole new set of problems for stocks. With no P/E expansion likely in coming quarters and dividends not even high enough to support current stock prices, earnings growth is all-important to stock performance. The stock market rally that commenced in late 2002 is now 27 months old and since 1954, they have averaged 40 months, by my reckoning. Also, bull markets tend to have limited life expectancies -- from one to 23 more months -- once the Fed starts to raise interest rates. The wide range of possibilities is another reason I regard a renewed bear market as a “maybe” for this year. And “maybe” stocks will decline this year, but not enough to suggest they are headed for new lows, with that likelihood remaining for later years.

Maybe China will experience a hard landing this year: China has been trying to cool her overheated economy, but with great difficulty. Her economy is still in transition from a command to a market structure; monetary and fiscal tools are crude; and her newly minted buccaneer capitalists, including many state and local officials, are hard to control. A recession in China would wreak havoc on the rest of Asia, even Japan, which is just emerging from over a decade of deflationary depression, and remains dependent on exports for growth. A serious recession in China would reveal the mountains of excess capacity that is now being built with the aid of direct foreign investment. A hard landing in China will also reveal the strength of her internal demand: I do not think that China has a big enough free spending middle class to do the job.

Coincident recessions in the U.S. and China would almost guarantee a global slump, given the dependence of most countries on exports to the U.S. for growth and the nearly-stagnant European economies. This, in turn, would no doubt reverse the rapid rise in commodity demand and prices in recent years. Furthermore, global economic weakness could well initiate the worldwide deflation I have been expecting -- the good deflation of excess supply, unless financial crises develop to the point of chronically retarding demand.

Link here.


The German government announced some gloomy news: The economy contracted by 0.2% in the fourth quarter of 2004. This follows flat growth in Q3, and together, these disappointing figures brought the final German GDP number to 1.6% last year. While this official new number is not too far below an earlier estimate of 1.7%, it still adds to the worries that the economy in 2005 may fair even worse. What is more, the conventional wisdom also holds true that “a worsening economy” is a “bad sign” for the stock market. If you buy that argument, Germany’s prospects for 2005 are dim, indeed.

However, things are not as bad as they seem. As our research has demonstrated many times before, the economy does not lead the stock market -- it lags it. This is worth repeating: The economy lags the stock market. To prove this point once again, let us compare the German GDP and the performance of the German DAX in 2004 from this perspective. The German GDP in Q3 of 2004 was flat, and in Q4 it shrank by 0.2%. Remember, the economy lags the stock market. So, if you were to look back at the months leading up to Q3 and Q4, you would expect to see declining stocks. That is exactly what happened. In March-August of 2004, the DAX was stair-stepping lower and lower, paving the way for the weak economic growth in the second half of 2004.

Both the stock market and the economy are product of social mood. When social mood recovers, first you see stocks rallying -- the stock market always reacts first -- and then the improving mood boosts the economy. Since mid-August 2004, the DAX has been in a strong uptrend. The index ended last year 7% higher and continued its rally in January and February, reflecting improving social mood. This is further confirmed by the just-released German investor confidence figures that “rose unexpectedly sharply” in February. Now, given everything you have just read, what would you forecast the German GDP to be in Q1 of 2005? ...

Link here.

How fast can an economy go from good to bad?

Mr. Greenspan delivered his semiannual Monetary Policy Report to the Congress on Wednesday, and for brevity’s sake I will condense his opinion about the U.S. economy into three words: All is well. I could offer a fact-filled and scathing rebuttal, but why be quarrelsome? Instead I would like to answer this simple question: “How quickly can a very large industrial economy go from good to bad?” My case-in-point is recent indeed -- up through this morning’s business news, no less. All the news reports come from the BBC -- note the dates.

1.) Japan’s economy grew at its fastest rate in 13 years in the last quarter of 2003, helped by a rise in exports to the United States and China (Feb. 18, 2004). 2.) Business confidence in Japan is at its highest level for seven years, the Japanese central bank’s latest quarterly survey has found (April 1, 2004). 3.) A surprise slowdown in industrial output growth has raised doubts about the strength of Japan’s recovery (June 29, 2004). 4.) The Japanese economy grew at a slower than expected rate during the quarter to June, according to new figures (Aug. 13, 2004). 5.) Growth in Japan evaporated in the three months to September, sparking renewed concern about an economy not long out of a decade-long trough (Nov. 12, 2004). 6.) The Japanese economy has officially gone back into recession for the fourth time in a decade (Feb. 16, 2005).

The reports of growth and optimism just one year ago in Japan looked convincing indeed. The Japanese economy and stock market had been through bouts of deflation and decline since 1990; the Nikkei index saw rallies of 48%, 34%, 56% and 62% before hitting a 20-year low in April 2003. Japan’s central bankers tried (and keep trying) every monetary policy trick in the book. And when those policies appeared to be working, they spoke with just as much confidence as Mr. Greenspan did today.

Link here.


The spark for the Panic of 1907 may have been a personal vendetta gone awry. As author C. G. Glasscock observed, “F. Augustus Heinze was to the Panic of 1907 as the Archduke Franz Ferdinand was to the World War.” Even so, the Panic of 1907 was like many of the crises that went before it and would happen after it. It was inevitable, because highly leveraged and overextended lenders and speculators lead to eventual ruin. The Panic of 1907 was not the worst financial crisis in American finance, but it was critically important because the forces in favor of creating a national bank -- the Federal Reserve Bank -- would gain strength, and the tide of public opinion increasingly supported the idea. As a lender of last resort, the Federal Reserve Bank would bail out failed banks and thereby stem future panics. The Federal Reserve Bank was established in 1913.

The real problem was that the banks had been allowed to renege on their obligations to redeem their deposits in gold. This allowed them to inflate, to pyramid deposits and loans on a smaller and smaller base of gold. The excess funds created fueled speculation in the market. Failure was unavoidable in such situations. Today, with a Federal Reserve Bank and deposit insurance, we seem to have done away with the quaint notion of a bank run. Instead, we suffer near-continuous debasement of our currency, a mostly gradual, but sure erosion in purchasing power. We suffer from debts and deficits that would be impossible under a strict gold standard. Who is the better for it?

The Panic of 1907 broke Heinze at the age of 37. He headed back to Butte, Montana where he was welcomed as a hero. His health, though, was failing. In 1914, only 44 years old, he suffered a hemorrhage of the stomach caused by cirrhosis of the liver, and he died. Stories such as that of Heinze are intriguing to me because I see in these events so many parallels with today’s markets. Timeless qualities of finance -- the constants of greed and speculation and easy money -- forge the familiar patterns of boom and bust. “Easy money makes a wild town,” Glasscock observes. It also makes for a wild stock market.

In Heinze, you see any number of beleaguered executives -- men who tasted early success, rode it to create brilliant fortunes, only to be forced to resign in disgrace, with much of their empires disintegrated. These tales are classic tragedies, told again and again in the dusty tomes of financial history, with new ones being written nearly every day.

Link here (scroll down to piece by Chris Mayer).


We Americans excel at producing waste ... lots and lots of waste. China buys some of it. The specific sort of “waste” that China buys is scrap metal. We probably cannot export enough of this stuff to plug our trade deficit ... but we might export enough of it to boost the fortunes of scrap metal companies. It is a perfect trade alliance: America is the world’s largest scrap metal exporter, while China -- no surprise -- has become the largest importer. In 2003, the Asian juggernaut became the first country ever to import over $1 billion of U.S. scrap metal. Thanks largely to China’s voracious appetite for scrap metal, prices are booming and scrap metals companies worldwide are feasting on the trend.

“Companies dealing in scrap have seen their prices soar,” reports Donald Straszheim of Straszheim Global Advisors, “But they are still relatively unknown ... and will continue to be a beneficiary of the China growth story.”

Link here.


The Hypomanic Edge: The Link Between (a Little) Craziness and (a Lot) of Success in America, by John D. Gartner concludes that, “many of the components of the archetypal American character-optimism, entrepreneurial energy, religious zeal-fit the hypomanic profile.” Gartner says writes that because America began as a nation of immigrants, Americans may be “culturally and genetically predisposed to economic risk.” Whether it is genetic or not, Americans are taking on more risk than ever. Here a risk, there a risk, everywhere we look we find a whole nation at risk. Investors, new homeowners, and would-be retirees take on big risks with Puritanical zeal.

What a moment in financial history we observe, dear reader. A quick scan of today’s headlines show all the large themes of globalization and history picking up speed and converging. Americans are getting older, and realizing they cannot pay for rising health care costs, or for the comfortable retirement of the Baby Boomers. How do stocks react to all the gloomy sociopolitical forecasting? They go up, of course.

Here is a question: at what point does a future inevitability become a clear and present force on asset prices? When will the lurking knowledge that the American government has made promises it cannot (and has no intention of keeping) propel U.S. bond yields into double digits? And when will the nervous struggle for the world’s oil, conducted politely and with fake smiles and behind the scenes deals for access, turn into an ugly public spectacle? Or are we already watching the opening act?

Link here (scroll down to piece by Dan Denning).


Can one identify a financial crisis before it occurs? Researchers at central banks and other official institutions around the world would have you believe that they can. They produce endless weighty reports on the sustainability of economic developments and their associated risks. Yet these official economists are generally conformist in their opinions and mealy-mouthed with their warnings. In my view, their work indicates both a desire not to rock the boat and a deep intellectual flaw in their economic analysis.

I arrive at this conclusion having ploughed through the Bank of England’s latest “Financial Stability Review” and the recently published “Financial Risk Outlook” from the Britain’s Financial Services Authority. Both documents are remarkably anodyne. They identify some obvious risks -- credit spreads may be too low, house prices too high, savings insufficient and property lending excessive. On the other hand, unemployment is low, borrowers are confident, lenders are profitable and well capitalised, mortgage arrears are virtually nonexistent and the ratio of household debt to net wealth is low.

Both reports draw comfort from indicators that are backward rather than forward-looking. Financial and economic crises are seldom anticipated by rising unemployment or soaring bad debts. In the calm before the storm, banks are generally profitable and well-capitalized, while consumers will normally be feeling confident. According to Claudio Borio and William White, economists at the Bank for International Settlements (an institution which does produce much interesting research), “indicators of risk perception tend to be lowest closest to the peak of the boom.” In other words, before a crisis appears one generally observes high asset prices, tight risk spreads and low levels of provisions for non-performing loans. Such confidence sows the seeds of future problems. Such confidence is also evident in the financial world today.

The most important leading indicator of financial crisis is a rapid growth in credit. In another research paper, Borio asserts that the existence of a large “credit gap”, i.e., the deviation of credit growth from its trend -- has predicted past financial crises with an 80% success rate. The second most reliable leading indicator of a crisis is the presence of an asset price boom. Speculative bubbles are invariably associated with the rapid growth of credit. Credit inflates the value of assets, providing collateral for further borrowing and enabling people to spend more and save less. Credit creates an illusion of prosperity without its substance.

Link here.


Indexes drift upward pulling predictions, expectations and your leg. It is high time to more profoundly question the wisdom being peddled by the Fed, administration and financial press. I strongly recommend that investors listen less and think more. If you follow this simple rule, your rose-colored goggles will fog over as your temperature rises, and you will be driven toward their removal. U.S. equities are not cheap and neither is the dollar. Thankfully, this is not very widely understood. Thus, the safety offered by the mob. To stay happily in the game, one need only ignore reality. Look no further than Greenspan for an impeccable role model.

Link here.


Before getting to the meat of the subject at hand, let’s take an inventory of where the current secular bear market stands, using the DJIA, the S&P 500 and the NASDAQ 100 as proxies. (It remains my view that we are still in a secular bear market, one that is drawing ever closer to reasserting itself with what will be unambiguous turbulence.) (1) As of 12/31/04, vs. respective year-2000 closing highs, the DJIA was down 8.0%, the S&P 500 was down 20.7%, and the NASDAQ 100 was down 65.5% -- and on a net basis, not a great deal has changed during 2005’s first six weeks. (2) The Dow has celebrated its 5th anniversary of a value below its 2000 closing high. Next month, the S&P and NDX will celebrate their 5th anniversaries of the same travail -- unless they experience rallies of 26.2% and 204.1%. Five years without taking out former highs is not a bad indication of the “secular” nature of the current episode.

How can one recognize the public’s stock-market capitulation? There are the traditional manifestations of capitulation, the most common being the old-fashioned “selling climax” -- a given day in what has been a bad market in which there is a very weak open, a reversal, a very strong close, all done on a volume spike. You need only go back less than three years, to 7/24/02, to examine a classic one of these.

But there also are other, far more subjective varieties. Say that in late March of 2000, you meet someone at a cocktail party. Eventually, the discussion comes around to the stock market. (Doesn’t it always?) Your new acquaintance cannot wait to tell you that he has just taken an initial position in Cisco Systems -- at 82 (the all-time high trade on CSCO, set on 3/27/00)! When pressed, you convey an impression that this gentleman may have made a timing and valuation mistake. In return, he assures you, in the most vociferous terms possible, that you simply do not understand the new paradigm, or John Chambers’s “vision”, or the extraordinary value that the tech sector continues to represent! Years later, the two of you meet again. After several drinks, he sheepishly confides that he simply could not take it anymore. Earlier in the week, he had sold his CSCO -- at 5!

The moral of this story or form of capitulation is this. In the really nasty market episodes throughout history, the people who help make the tops are often, if not usually, the same people who contribute mightily to making the bottoms. But the kind of public capitulation I have in mind would likely fit a different mold. And taken to an extreme, it would require years to play out. In this regard, the example I am thinking about occurred during the 1970’s. The public threw in the towel and, for a protracted period, stayed on the beach. For 10 consecutive years -- 1971 through 1980 -- the household sector generated net mutual fund redemptions. In nine of those years, mutual funds generated negative stock flows. Outside of mutual funds, the household sector disinvested in equities in all but two of the 17 years from 1966 to 1982. The two years of positive flows were 1975 and 1976, which helped fuel the cyclical bull immediately following the DJIA’s horrific 45.1% slide between January 1973 and December 1974.

It is important to look at some aggregate figures: As of 12/31/1965, total mutual fund assets stood at a mere $35.2 billion, of which $30.9 billion was invested in stocks. The total market value of all equities at the end of 1965 was about $735 billion. At the time, money market funds were a thing of the future: only $2.4 billion was invested in these vehicles. As of 9/30/2004, mutual fund assets totaled $4.9 trillion, with an additional $1.9 trillion invested in money market funds. Stock holdings of mutual funds stood at $3.3 trillion. The total market value of all equities was $15.6 trillion. Notwithstanding the household sector’s lack of support, the equity market, using the DJIA as the proxy, was able to muster 10 positive years in 1966-1982 -- but the DJIA’s cumulative principal return for the period was just under 8%, i.e., a horrific 0.5% per year on average. At the end of 1965, the household sector had total direct equity holdings of $616.1 billion -- 83.8% of total outstanding equity value. By the end of 1982, these figures had become $832.5 billion and 53.3%, respectively.

But during this period, a major shift was in progress. As of 12/31/1965, the equity holdings of private pension funds combined with state and local employee retirement plans totaled a mere $43.3 billion -- 5.9% of total outstanding equity value. At the end of 1982, these figures had grown to $354.6 billion and 22.7%, respectively. Pension plans (private + state + local) had positive flows into equities in all of the 17 years, and were a major creator of equity-market flows during the great bear stock market of 1965 through 1982. During the period the public was placing a growing portion of its investment decisions about the stock market into the hands of pension plans, who were placing these funds in the hands of professional money managers, who almost entirely avoid mutual funds. Thus, the public’s generally more emotional attitude towards the market had been largely muted.

The proverbial worm has turned. And the mechanism for turning it has been the enormous growth of defined contribution pension plans. This has occurred vis a vis a major diminution in the relative importance of defined benefit plans, the latter vesting investment decisions in the hands of the plan sponsors or in the hands of the managers hired by the plan sponsors. In other words, a large and growing amount of the decision-making process is back in the hands of the public -- assets in private defined contribution plans first exceeded those in defined benefit plans in 1996. Unfortunately, the data do not break out the split between defined benefit and defined contribution numbers for the 1965-82 period. Many of the vehicles available today did not even exist during much of that period, e.g., as late as 1982, total IRA assets were a mere $51.7 billion.

Perhaps the transition of the last couple decades has changed the public’s historical behavior towards the stock market. Perhaps there will be no ultimate capitulation. If this is the case, “it is different this time”. Arguing in the other direction is that as of 9/30/2004, the public continued to have direct equity investments totaling $6.133 trillion. In addition, the public held another $3.243 trillion in mutual funds, much of which is invested in stocks. Therefore, if nothing else, the ingredients for a bear-market capitulation at some point in time are in place.

Link here.


Federal Reserve Chairman Alan Greenspan urged Congress to significantly cut the mortgage portfolios of the big mortgage firms Fannie Mae and Freddie Mac to avoid “almost inevitable” problems for the U.S. financial system. Greenspan has in the past expressed concern about the growth of the companies’ mortgage holdings, saying they could pose a risk if allowed to increase unchecked. The Fed chairman went farther this week, telling members of the House Financial Services Committee they should require the companies to slash their mortgage holdings. Congress is weighing tighter supervision of the mortgage finance companies after accounting controversies and senior management ousters at both firms in 2003 and 2004.

Fannie Mae and Freddie Mac buy home loans from lenders and repackage them as securities for investors, but they also retain mortgages and mortgage-backed securities for their portfolios. Congress chartered the shareholder-owned companies to ensure there are plenty of funds available for home buyers to take out mortgages. Greenspan said in response to lawmakers’ questions that the growth of those portfolios, which together top $1.5 trillion, primarily allows the companies to leverage their federal charters to generate substantial profits. Limits on the finance providers’ enormous mortgage portfolios, which reached a combined $1,500 billion in 2003, would hurt their profits. “It’s an earnings killer for them,” said Bert Ely, an independent financial consultant and longtime critic of the finance providers.

Links here and here.


Richard Morrow is a commodity futures broker and hedge fund manager who is very bullish on energy prices. However, unlike most of his commodity-trading peers, Morrow believes the equity markets provide the best way to capitalize on the rising crude oil prices he anticipates -- not the futures markets. This unique commodity trader is a big fan of oil stocks, especially big, boring integrated oil stocks like Exxon and Chevron. We, ourselves, do not own these stocks, but we are persuaded by his argument.

Richard earns a handsome living brokering futures trades and running a hedge fund devoted to trading agricultural commodities. Professionally, Richard never dabbles in stocks. But in his personal account, he does whatever he wishes. And lately, he wishes to own oil stocks. “Lately, I have had several customers who are bullish on energy,” Richard relates, “and they have asked me how to make money on the long side of crude. Most of them want to buy ‘way out’ month crude oil futures. The 2007-2010 crude contracts are trading around $40 which is a $6-$8 discount from the 2005 contracts. Obviously, it would be in my financial interest to shut up and let them buy the back month futures contracts. Instead, I have been advising my clients to buy the major integrated oil stocks, not back month futures.”

“It’s pretty simple,” he explained. “At the end of the day, I think being long the integrated oils makes more money -- or loses less -- that being long crude futures. Let’s consider three possible scenarios: Oil prices fall, they stay the same, or they rise...”

Link here.


Shell Canada Ltd. CEO Clive Mather says oil from his Athabasca project, where tar sands are boiled to produce crude, can cost twice as much as drilling in the North Sea. And it is worth every cent, he says. “If we had access to unlimited conventional oil, I guess the interest in Athabasca would diminish quite quickly, but that isn’t the case,” Mather said in a Feb. 3 interview in London. “This is high-cost oil, there’s no question about that. At current prices, it’s still very good business.”

A 15-year decline in oil reserves is spurring companies such as Royal Dutch/Shell Group, Exxon Mobil and ChevronTexaco to spend $76 billion in the next decade to boost supplies of oil from tar sands and diesel fuel from Qatari natural gas. Oil executives say they have no choice but to try alternatives to drilling because there is not much more crude to be found in their current fields. “We’re damn close” to the peak in conventional oil production, Boone Pickens, who oversees more than $1 billion in energy-related investments at his Dallas hedge fund firm, said in an interview. “I think we’re there.” Suncor Energy, the world’s second-biggest oil-sands miner, is his largest holding.

Companies will produce 10.1 million barrels/day by 2030 from projects in Canada and Qatar, more than Saudi Arabia does today, according to forecasts by the International Energy Agency -- 8% of the world’s total. Shell is spending $13.70 per barrel at its Athabasca project in Canada, higher than drilling projects, said Mather. Oil executives say that crude prices near $45 a barrel more than offset the extra cost. The oil industry needs to spend $3 trillion by 2030, or $105 billion a year, to meet an expected surge in demand, the IEA estimates.

“Pressure on supply will become sufficient for more money to be put into non-conventional oil,” said Peter Odell, an oil politics and economics professor emeritus at the Erasmus University in Rotterdam. “This is a natural development of a resource base from the lowest cost to the highest cost.” Oil-sand mining projects offer a rate of return of 13.6%, less than half the 33.4% at a deepwater Gulf of Mexico field such as BP’s Mad Dog project, said Scott Mitchell, an analyst at energy consultant Wood Mackenzie in Edinburgh. West Africa’s deep waters offer an 18.2% return, he said. The estimates are based on an average price of $21 per barrel.

Link here.

LNG terminal will be built off Louisiana.

The Royal Dutch-Shell Group of Companies won a U.S. permit to construct a LNG terminal in the Gulf of Mexico. The depot will be built in 55 feet of water 38 miles from Cameron, Louisiana. Oil and gas companies are racing to acquire the permits necessary to begin construction on terminals to import liquefied natural gas amid waning U.S. production and rising demand. More than 40 proposals have been announced, though just three have begun construction.

Link here.


More than 1,600 companies changed their outside accounting firm in 2004, up a whopping 78% from 2003, reported the The Wall Street Journal, citing date from proxy research firm Glass Lewis & Co. The 2,514 changes over the past two years represents more than one-fourth of all U.S. publicly traded companies. Smaller businesses were more likely to changes auditors. According to the study, 85% of the companies that did so rang up $100 million or less in revenues last year.

The most common reasons that companies switched auditors? Audit firms discontinuing public-client work because of extra regulatory demands; corporate mergers; and lower fees at the new firm, according to the report. Only 19 companies last year -- compared with 27 a year earlier -- switched auditors because of disagreements over accounting matters. The increased changes are “inconsistent with the arguments put forth in the past by the accounting firms, that changing auditors reduced audit quality,” Glass Lewis analyst Jason Williams reportedly asserted.

Link here.


The S.E.C. rule makes it harder to sell securities short when they are on what is called the threshold list. Two advertisements in The Washington Post, run by the National Coalition Against Naked Stock Shorting, denounced the S.E.C. for not forcing brokerage firms to buy stock to cover trades that failed to settle before the rule took effect. The ads say naked shorting is illegal, but in fact it is sometimes permitted in the name of orderly markets.

At the S.E.C., Annette Nazareth, the head of the division of market regulation, said the rule was aimed at assuring that new naked shorts would be cleaned up relatively quickly. Some people, she said, “are very disappointed that the impact of this rule was not to make these stocks go up.” There are 47 common stocks on Nasdaq or the NYSE that have been on the threshold lists regularly. As a group, they have underperformed the market this year although some, like Martha Stewart Living Omnimedia, have rallied nicely.

Too many investors are like students who think that good grades reflect their brilliance while bad grades prove teachers are unfair. It is too early to reach conclusions, but it may be that the new threshold lists will have the opposite effect of what some expected. Rather than displaying stocks that are sure to rise as shorts are squeezed, they may show stocks whose valuations are questionable. Investors who own such shares might do better to try to understand why some think the shares are overvalued, rather than simply rail about unfair short selling.

Link here.


Jerry A. Grundhofer, the chief executive of U.S. Bancorp, is playing a dangerous game. Rising interest rates are digging into the returns of mortgage bonds held by the Minneapolis bank, and Grundhofer is refusing to sell. His bet: Profits from corporate lending will pick up enough to compensate for what he hopes is a gradual drop in profits from the bonds.

By now you might have expected banks to have forsworn interest rate bets, given Fed Chairman Alan Greenspan’s ample warnings that the Fed would continue raising short-term rates from their 46-year low last year. But there is little sign of that. In fact, all manner of financial companies, speculators and hedge funds are playing the interest-rate game, borrowing short-term at low rates in order to lend the money long-term at higher rates. On Wall Street this speculative game is called the “carry trade”. It is a great way to coin money -- until short-term rates rise.

The potential hit to earnings caused by a rise in short-term rates could be more than a blip. Financial companies account for 30% of U.S. corporate profits now, up from 18% a decade ago. There is no way to know how much of that financial-sector profit comes from the spread between short- term and long-term rates; indeed, sometimes the companies themselves seem not to know how much of a rate bet is built into their bottom lines. (Witness the accounting mess at Fannie Mae.) The circumstantial evidence, though, is that yield spreads are crucial to corporate profitability. “We’ve never seen U.S. companies so dependent on the steepness of the yield curve,” says Leo M. Tilman, chief institutional strategist at Bear Stearns.

Link here.


No. 1 -- Get a Method

An objectively definable method, that is -- one you have thought out in its entirety, so that if someone asks how you make your decisions, you can explain it. And if that same person asks you again in six months, the answer will be essentially the same. The point is that it must be in place before you start trading. It does not typically “arrive” though. While a method has to reflect market reality, which is difficult enough, it also has to suit the user’s psychological makeup. To that extent, it must be built.

Link here.

No. 2 -- Be Disciplined, Be a Marine

You need the discipline to follow your method. Among the true professionals, this requirement is so widely understood that it is almost a cliché. Nevertheless, it is such an important cliché that it cannot be sidestepped, ignored or excepted. Any system with a decent track record will be profitable if you apply it rigorously and honestly. Using the 10-day advance/decline oscillator with reasonable parameters, you can make money seven times out of 10. But very few people have the discipline to do it. Discipline is much more difficult to obtain than a method.

Lots of workaholics fail at trading. What you need is the guts to do what is right when it feels wrong. That takes immense courage and discipline. It struck me one day that among a handful of consistently successful professional options and futures traders of my acquaintance, three of them are former Marines. Among my acquaintances anyway, this is a ratio way out of proportion to the ratio of former Marines as a percentage of the general population. This anomaly implies to me that discipline is extremely important. At some point in their lives, these guys volunteered to serve in an organization that requires discipline and stamina. Being “tough” in this context means having the ability to suppress a host of emotions in order to act in a manner that would cause most people to shrink back in fear.

Link here.


It seems an unlikely trend. In recent years the fund-management industry has been mauled for its excessive and opaque fees, deceptive marketing and rampant conflicts of interest. At the same time, however, not only has the industry flourished, but it has done so in its costliest, highest-leveraged and least transparent segment: hedge funds. Instead of shunning such unregulated funds, investors have been falling over themselves to grab a piece of the action. Whereas the size of the mutual-fund industry in terms of assets and offerings has merely returned to its level of 2000, hedge funds have doubled in size and number, according to Hedge Fund Research, a consultancy (see chart). In 2004 alone around 400 new hedge funds were created, bringing the known total (many others escape scrutiny) of 7,000 into rough parity with the number of mutual funds.

New funds begin daily, some in spare rooms in someone’s home, others in waterfront offices with parking for yachts. In Manhattan, midtown office towers serve as hedge-fund warehouses. While there have been numerous pronouncements that the tide will soon turn, nothing suggests this is imminent. Quite the opposite. Initially sold only to wealthy individuals, then the family offices of wealthy individuals, increasingly hedge funds are now being sought out by large institutions. If institutions merely make good on the amount they currently intend to invest in hedge funds, another $250 billion will be flowing into the industry, according to Greenwich Associates, a consultancy. What might hold them back is not desire, but capacity. Such is the popularity of hedge funds that many of the largest are closed or, as they say in the trade, “soft-closed”, meaning that entry requires special pleading -- and many plead.

Unable to get into established winners, investors are pouring money into managers with no track record but good pedigrees. Given the enthusiasm, at the very least it should be clear what all these customers are buying. In fact, that is a surprisingly hard question. Theoretically their audience is limited to sophisticated and affluent investors. In reality, clever lawyers, lots of money and astute marketing have expanded the exemption so that they can be sold to anyone, do almost anything and keep whatever they do, and who they do it for, a secret.

Hedge funds have some common characteristics. They are usually pooled investments (like mutual funds) structured as private partnerships (unlike mutual funds). Many carry substantial leverage and are quite rigid about the flow of money from clients. Initial “lock-ups” for as long as four or five years are not uncommon; rarely is money allowed to come in or go out more than monthly. This restriction allows hedge funds to take positions in the most illiquid corners of the market including options, futures, derivatives, and unusually structured securities. Increasingly, the large funds that have succeeded flit from one area to another. Since hedge funds can account for more than half the daily volume on the NYSE and can have an equally large presence in every other financial market, where they might be today is anyone’s guess.

Investors value this ability to embrace opportunities, magnify returns through leverage, and take difficult positions because of a stable base of assets. But they have not always been so keen. Mutual funds, if structured correctly, can have the same characteristics (though there are some liquidity restrictions). A big reason why mutual funds approach investing differently is that when they tried to take a flexible approach in the mid-1990s they were torn apart by consultants and customers for so-called “style drift”. Under pressure from the press and pension consultants, most (but not all) mutual funds began to follow narrow pre-designated benchmarks that were tightly limited to a class of investing, such as shares of companies included in the S&P 500 index, or an even narrower subset, for example a mid-cap benchmark. That helped performance in the soaring equity markets at the end of the last decade, but also contributed to their wretched results during the bear market of 2000 to 2002.

The bear market prompted many investors to think it might be good to have money with an investment manager who knows when to invest and, ideally, where to invest, and works within a format that allows him to do so. Relatively good returns, meaning better performance than the market, has become a bit less important than absolute returns (i.e., not losing money, especially when the market falls). A clever mutual-fund manager could, of course, pursue this approach in the new environment. But it has become much more sensible to start a hedge fund. Why? Because, to cite a phrase of the moment, a hedge fund is “a compensation scheme masquerading as an asset class”. Whereas the average mutual fund charges 1% or 2% of assets, and smart buyers can pay a fraction of that, hedge funds charge 1% or 2% plus a big slug of profits, typically 20%, but often more.

Institutional Investor’s obsessively read list of most-highly-paid hedge-fund managers starts with familiar names (George Soros: $750 million), but 16 others made at least $100m in 2003. And at a time when mutual and pension funds have become ever more reluctant to pay the traditional five cents a share for trades, hedge funds pay up to four times that amount if in the process they can receive good ideas or particularly effective execution. Trading is just the beginning for banks. Hedge funds want hot issues, structured derivatives, margin, stock-lending for short sales and the equivalent for fixed-income, clearing and settlement, customer support and marketing. The money coming from all these transactions and fees is enormous.

Oddly, given the spectacular wealth that hedge funds produce for their own managers and for investment firms, they do not, overall, seem to produce much wealth for clients. Certainly the highest-performing funds have produced breathtaking returns. But there are good reasons to believe that these are rare exceptions. Burton Malkiel, a professor at Princeton, concludes that for all their vaunted talent, hedge funds perform less well than cheaper mutual funds. The bigger it grows, the more the boundaries between hedge funds and traditional asset management are blurring. But on current trends, hedge funds’ second trillion dollars of assets will arrive even faster than the first.

Link here.
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