Wealth International, Limited

Finance Digest for Week of April 18, 2005

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


Speculators and more cautious investors alike are feeding a boom in gold, oil and other commodities, leading some analysts to talk of an extended bull run in raw material prices. Fundamental demand for metals and soft commodities like grains, especially in Asia, has spurred speculative hedge funds to chase higher returns than they earn from traditional assets like equities and bonds.

While a weaker US currency has also helped by making dollar-denominated products cheaper for overseas investors, other analysts caution that no bull run can last forever. Hype surrounding price spikes has seen the term “supercycle” crop up in some quarters, as the current run higher has outlasted classical commodity bull markets of around two years. An influx of fund cash has fanned several resources to multi-year peaks this month, copper hitting a record $3,305 a ton and oil reaching an all-time high of $57.60 a barrel. The Reuters CRB index of 17 commodities futures earlier this month hit its highest since the commodities boom of the early 1980s.

At the end of 2001, worldwide manufacturing demand started to tick higher, and China's industrial revolution began. Analysts expect its voracious appetite for raw materials in the urbanisation process to continue. But doubts have emerged on the sustainability of current hefty raw material consumption rates from China in particular as markets ponder a soft or hard landing for the fast emerging economic giant. Exxon Mobil Chief Executive Lee Raymond took a sceptical view earlier this month.

GFMS analyst Neil Buxton noted the current commodity cycle did differ from previous ones because the bull trend had arrived at a fairly early stage in the broader economic cycle. UBS Investment Bank analyst John Reade said metal prices would be in an uptrend over the next decade or two – mostly due to urbanization rates and intensive use in China and potentially other emerging market countries.

Link here.


There seems to be no end in sight to the widening of America’s gaping external imbalance. A record $61 billion trade deficit for February is only the latest in a long string of warning signs for an unbalanced US and global economy. The rebalancing required to temper these deficits requires significant adjustments in macro policies. Yet with America’s fiscal and monetary authorities basically frozen at the switch, politicians are asserting greater control over the adjustment process – firing one protectionist salvo after another. The tradeoff between policy adjustments and political actions lies at the heart of the sustainability debate for ever-mounting global imbalances. A tipping point could be close at hand.

There is really no other way to put it: the latest trade numbers in the U.S. were simply terrible. In macro terms, trade and current-account deficits are emblematic of an economy that is living beyond its means. Over the past six years, growth in domestic demand (technically, gross domestic purchases) has exceeded overall GDP growth by about 0.6 percentage point per year. America’s widening external deficit is the functional equivalent of an “income leakage” of roughly the same magnitude – that portion of internal demand that is sourced by foreign production. Yet even in the face of this income leakage, domestic demand has barely flinched. Nor has the weakening of the dollar made even the slightest of dents in the external imbalance. On the contrary, since the dollar peaked in early 2002, the trade deficit has widened from 3.6% of GDP to 6.0% at present. Dollar depreciation simply cannot address an excess import problem of the current magnitude.

Which takes us to the heart of the problem – America’s consumption binge. Imports very much a by-product of growth in domestic demand, especially private consumption. And if there is anyone in the U.S. guilty of living beyond his means, the American consumer certainly gets the prize. Central banks, in my view, are the real culprits behind the excesses on the import side of the trade equation. The Asset Economy has long been a levered play on unsustainably low real interest rates in the U.S. The Fed has anchored the short end of the yield curve with its post-bubble tactics – holding the real federal funds rate in negative territory or near the zero threshold for most of the past four years. And foreign central banks have capped U.S. real rates at the long end of the curve – aggressively recycling rapidly rising foreign-exchange reserves into dollar-denominated assets in order to limit currency appreciation and maintain export competitiveness. In an income-short economy, asset-led consumption binges virtually guarantee ever-widening current-account and trade deficits. That means that the only way America will ever come to grips with its massive foreign trade deficit would be to bite the bullet and accept the pain of significantly higher real interest rates. Try telling that to the Fed or Asian central banks.

It is simply unprecedented for the world’s leading economic power to be running chronic trade deficits that have now turned America into the largest foreign debtor in history. This stands in sharp contrast with the experience in the first “golden era” of globalization in the years leading up to World War I. The developing world has seen its role change from users to providers of capital. This reverse foreign aid program is not a sustainable outcome for the global economy either. The only way it can continue is if the capital providers of the world – especially Japan and China – continue to suppress domestic consumption and recycle surplus saving into dollar-denominated assets. Yet that outcome is a recipe for instability in saving-led economies like China – it leads to an investment overhang that can only end in tears. With China’s investment ratio likely to exceed 50% of its GDP this year – unheard of even in the annals of other Asian development miracles in places like Japan and Korea – the need to draw down surplus saving and boost private consumption is increasingly compelling. If the world puts its excess saving to work at home rather than in the United States, U.S. real interest rates will finally adjust – as will the spending and import dynamic of the American consumer.

As the great powers gather for another G-7 meeting this weekend, one hopes there will be an active debate on these matters. Unfortunately, if past performance is any guide, that is unlikely to be the case. There is no popular outcry for change. America’s latest disturbing news on its trade and current-account deficits was greeted with a yawn in financial markets and by threats of protectionist actions from politicians rather than calls for a restoration of sanity to fiscal and monetary policy. There is one exception: Paul Volcker. The former Fed chairman has finally gone public with a plea for action in dealing with the perils of ever-rising U.S. current-account and trade deficits. The problem, in his view, is painfully simple – a lack of fiscal and monetary discipline. For a U.S. economy that is living dangerously beyond its means, the tough love of fiscal and monetary discipline is the only way America will ever make lasting progress on the road to rebalancing. A further decline in the dollar is needed, as is a meaningful increase in real U.S. interest rates. The longer we wait, the more treacherous the endgame.

Link here.


An unbalanced global economy is at risk of becoming unhinged. Beset by record imbalances between current account deficits and surpluses, it does not take much to derail a system that is already in serious disequilibrium. Such a possibility now seems less remote in the face of a confluence of powerful blows – an energy shock, threats to European unity, an outbreak of overt hostility between China and Japan, and the rising tide of U.S.-led protectionist sentiment. Meanwhile, steeped in denial, global policymakers are asleep at the switch. With an unbalanced world lacking the inherent resilience needed to overcome these mounting tensions, the global expansion is now at risk. That conclusion does not seem to be lost on stretched and still overvalued financial markets.

It is always easy to get swept away by the emotions of the markets, and last week’s sell-off in global equity markets offers many temptations in that regard. The markets are understandably unnerved over the possibility of another growth disappointment. And, on the surface, the March data flow certainly supports these concerns. The softness was global in scope – not just for the usual suspects like Europe and Japan but also for the two stalwarts in the global growth chain, the United States and China. The U.S. labor market data were lousy (again) and the latest retail sales reports were especially disconcerting. Even in China, import demand has tailed off in the first three months of this year – expanding at just a 12.2% y-o-y rate in 1Q05, literally one-third the 36% growth pace of 2004. Sure, this could be noise as well, but a softening of import demand is also a classic warning sign of a slowdown in Chinese domestic demand. Of course, weak incoming data could be just an excuse for the markets’ latest spasm. There’s always a lot of noise in the numbers – especially with this year’s early Easter.

A reversal of the recent energy price spike could turn the current global slowdown into nothing more than another temporary soft patch. If that is the case, equities should rebound and bonds sell off. Any such market reversal could be short lived, however, if political risks continue to mount. What is particularly disconcerting, of course, about the recent equity market sell-off is that it has been concentrated in a period when oil prices have been falling – not rising. That is a hint there could be a deeper meaning to all this. That deeper meaning, in my view, is tied to very worrisome signs of a potential failure in the global policy architecture. Around the world, politicians and policy makers have become a source of increased instability.

The stewards of globalization are nowhere in any of this. Another G-7 meeting has come and gone, and I ask myself, Why do they even bother? The 16 April communiqué was as vacuous as ever. The U.S. succeeded in having any references stricken regarding its rapidly exploding current account deficit. The Wise Men appear to be smitten with Fed Governor Ben Bernanke’s recent whitewash of this problem, explaining away America’s external imbalance as an innocent outgrowth of a global saving glut. A G-7 having its head in the sand says it all – the managers of globalization don’t have a clue as to how to cope with the real-time problems of globalization.

Little wonder world financial markets are reeling. An unbalanced global economy is not in great shape. The global growth engine – the U.S. – continues to derive its sustenance from asset markets and the unsustainably low real interest rates that support a wealth-driven impetus to aggregate demand. The Bernanke thesis conveniently celebrates the result without looking in the mirror and acknowledging the bubble-prone Fed’s culpability in creating this moral hazard. In the absence of another global consumer, I guess the rest of the world is willing to put up with a lot in order to keep the music going. Policy blunders are bad enough. History warns us that political risks are always the most destabilizing force of all. Those risks are now rising around the world. Beset by record imbalances and mounting political perils, a precarious global economy does not have much to fall back on.

Link here.

How the Fed is doing China a favor.

The co-dependent relationship between the U.S. and Chinese economies is about to take a new twist. As the U.S. Federal Reserve finally gets serious about monetary tightening, an export-led Chinese economy could come under pressure. China can ill afford to ignore this risk. America’s central bank has only begun to turn the screws. Despite nine months of measured hikes in interest rates, the federal funds rate currently stands at just 2.75%. That is less than the annualized increase in headline CPI (3.1%) and only slightly above the core CPI inflation rate (2.3%). There can be no mistaking the persistence of extraordinary monetary accommodation.

The Fed can ill afford to play it cute and seek a “neutral” policy stance. The combination of accelerating inflation – highlighted by figures this week showing the march CPI at a 31-month high – a runaway current-account deficit, and an emerging property bubble implies that the federal funds rate may need to be pushed into the restrictive zone, possibly as high as 5.5%. This next phase of Fed tightening will impose internal costs on the domestic U.S. economy and external costs on the rest of the world. For the U.S., the burden will be felt most by the asset-dependent American consumer. To the extent that the interest-rate underpinnings of asset markets deteriorate – especially for property – a shift from asset- to income-based saving can be expected from U.S. households. The reversal of nearly a decade of excess consumption growth should then follow.

That is where the Chinese economy enters the equation. An externally dependent Chinese economy is very much in the cross hairs of a Fed tightening aimed at the American consumer. Unlike the U.S., a consumer-driven spending machine, in China, the name of the game remains exports and export-led investment. Chinese exports have grown from 20% of GDP in 1999 to 35% in 2004, while the investment share has hit an astonishing 50%. China’s biggest export market is the U.S., absorbing fully one-third of its overseas shipments in 2004. With the coming Fed tightening likely to squeeze U.S. consumption, Chinese policymakers would be wise to resist imposing a new round of tightening measures even though the economy was still growing at a 9.5% rate in the first quarter of 2005. Recent signs suggest Beijing has gotten the word. Apart from focusing on property, no new major tightening efforts appear to be in the cards.

But new flaws are starting to show up in China’s policy strategy. Because of the renminbi peg and its linkage to a still-accommodative Fed, China continues to receive large speculative capital inflows, which may well overwhelm the impacts of administrative tightening measures. That is what appears to be happening: China’s latest efforts to slow property markets are not having much effect. The more China pursues a pattern of unbalanced growth, the tougher it seems to break the habit. The strategy that worked so well in the early stages of development may be in need of an overhaul as China comes of age and faces its own imbalances. In that important respect, by going after the asset-dependent American consumer, the Fed may be doing China a real favor.

Link here.


Last week’s stock losses all but wiped out the gains investors booked in the huge relief rally that followed the 2004 election. For the year, the Dow and the S&P 500 are down by about 6%. Double those losses for the Nasdaq. Perhaps more troubling is that for the first time in three years, stocks lost ground in the face of falling interest rates and oil prices. The message is clear: This time, the economic slowdown could be so severe that low interest rates will not bail the country out.

As Martin Barnes, economist at the Bank Credit Analyst research firm noted, “Ominously, the drop in oil prices and bond yields in the past week or so has not lifted equity prices.” His advice is to steer clear of equities for now because the Federal Reserve is not finished raising interest rates and the economy appears to be skidding into something more meaningful than a soft patch. There is one thing the stock market fears more than a Fed that keeps on raising rates, and that is a Fed that stops raising rates. Further excesses will only set us up for a future that makes us wish for something as tame as a recession.

Link here.


Last week’s stock market action showed no signs of panic. Go look at a three or five day S&P 500 chart. Selling was heavy but it was also very orderly. The so-called reasons “why” are as scatter-brained as the descriptions – one day it is the trade deficit, another day’s it is concerns about slow growth, then we are told it is poor earnings at IBM (though nobody explains why this matters more than rich earnings at GE). The context of the (thus far) orderly selling is a change in psychology that began in March.

Throughout 2004 investors showed an insatiable appetite for risk, which was visible in everything from low junk bond yields to the parabolic explosion higher in emerging stock markets like Pakistan. Now, however, that appetite appears to have had all the extra helpings it can stand – and when you have eaten too much you do not rush away from the table. You push back s-l-o-w-l-y. And if you have REALLY overdone it – and I mean big-time gluttony, using both hands – other things WILL follow, no matter how slowly you move.

Link here.


A free lunch can be the most expensive meal in the world. For living proof, look at General Motors. A big reason that GM has gotten into such trouble is that the pension and health care commitments it made to employees decades ago seemed to be a free lunch. The United Autoworkers placed a high value on these benefits, but the accounting rules of the time placed no cost on GM’s risk of providing them. So the UAW and GM made deals that were heavy on benefits, relatively light on wages.

Lower salaries meant that GM reported higher profits, which translated into higher stock prices – and higher bonuses for executives. Commitments for pensions and “other post-employment benefits” – known as OPEB in the accounting biz – had little initial impact on GM’s profit statement and did not count as obligations on its balance sheet. So why not keep employees happy with generous benefits? It was a free lunch. Besides, GM’s only major competitors at the time, Ford and Chrysler, were making similar deals. Now, as we all can see, pension and health care obligations are eating GM alive. The bill for the “free” lunch has come in – and GM is having trouble paying the tab. In the past two years, GM has put almost $30 billion into its pension funds and a trust to cover its OPEB obligations. Yet these accounts are still a combined $54 billion underwater.

“Any market economist would tell you that things that are ‘free’ are overconsumed,” says Greg Taxin, chief executive of Glass, Lewis & Co. “That’s true of pensions, it’s true of OPEB, and it’s true of stock options in the ‘90s.” That is a lesson the SEC seems to have ignored, given last week’s decision to let companies delay counting the value of options as an expense. But that is a topic for another day. Now, unless GM starts making money on vehicles or gets a break from the UAW or the federal government, things are going to get really ugly. I hope that does not happen, but it easily could. The bottom line: Whenever you offer someone a free lunch, make sure that you will be able to pay the bill when it comes in.

Link here.


A detailed account, superbly researched and documented, of the Enron debacle under the title “A Conspiracy of Fools” by Kurt Eichenwald, recently read, is the inspiration for the question above. There is, at least, a workable hypothesis that the Enron rise and collapse is a possible microcosm of the global bubble ongoing, stoked by massive credit emanation currently believed to be the New Wave of Economic Growth. In its time, Enron was believed to be the new model of corporate growth, expanding exponentially more rapidly than prosaic forebears, incorporating marketing and financial genius, transforming industries and economies and enriching vast constituencies. It was, in fact, a gigantic scam and sham able to deceive with aplomb virtually all areas of expertise in understanding and analyzing risk and reward. A combination of fraud, greed, obliviousness, unbridled ego, unquestioned belief in growth, and fascinated obsession with financial innovation catalogues the “E” debacle. Virtually all these elements are in plentiful supply in global financial markets and the players therein as the world “reflates” with a vengeance in every nook and cranny having a medium of exchange and the means to exchange it.

There is no question of the criminality of many of the players in the Houston company’s demise, however, there is also clear proof that the complexities of modern finance are beyond the comprehension and understanding of many extremely intelligent and supposedly well informed “leaders” of the mammoth organizations now proliferating at excessively rapid growth rates across the global economy. In the abbreviated mini-downturn of 2000-2002, abruptly terminated by plummeting Fed rate cuts and massive liquidity injections, there were quite a few Enron-like disasters such as the two currently in the trial headlines, Worldcom and Tyco. Again, there is criminality aplenty but also plentiful further evidence of inability of supposedly astute “leaders” and observers to unravel what seemingly are relatively complex but not insuperably difficult frauds and misuses. More recently, the burgeoning AIG scandal, the shocking GM cash flow reversal and the ongoing flow of announcements from the Citi’s and B of A’s confirm the following thesis: Market and corporate growth have expanded beyond the ability of those in charge to be aware of and comprehend the incredibly rapidly growing risks, both business and ethical/integrity, assumed in this growth!

This growth, unprecedented during the 1990’s, although marred by episodic blow-ups easily quelled by Fed/Central Bank/GSE liquidity emanation, has expanded exponentially globally since the Greenspan demotion of interest rates below 0%, inflation adjusted, in 2002 and the maintenance at that level until succeeded by, in effect, a guaranteed “contract” between the Fed and the Brobdingnagian financial colossus labeled the “Leveraged Speculative Community” by Doug Noland, of a “measured” policy enabling ongoing profitable speculation. The “policy/contract” even produced a “conundrum” for the redoubted Sir Alan when long rates fell as he “measuredly” raised the short end.

Our thesis is that the global financial system has unwittingly and/or greedily gone past any safe exit from a humongous global credit bubble. While malfeasance and fraud will emerge in the aftermath a la Lincoln Savings and Penn Square; much of the damage will have been done by a corporate/bank/central bank leadership overwhelmed by a new, complex breakneck, financially engineered credit explosion a la LTCM. History and forensic accounting will judge what leaders were larcenous, which fraudulent, whom willfully blind and, finally, those of the ego-driven oblivious persuasion. The courts and public opinion will sort them out!

Link here.


U.S. bonds and the dollar would the main losers from a revaluation of the Chinese currency being sought by leading industrial nations, a poll of investors showed. In a regular monthly investor survey, Merrill Lynch asked fund managers across the world what short-term impact a 10% revaluation of the yuan against the dollar would have on various assets. Although there were a large number of “don’t knows”, a negative impact was seen on U.S. fixed income and the greenback. Some 51% of respondents said U.S. bonds would suffer, compared with just 13% expecting a positive impact. David Bowers, Merrill Lynch’s chief investment strategist, said one reason was that a stronger yuan would export inflation to the U.S., making U.S. debt less attractive. Similarly, China and other Asian countries have been keeping their currencies pegged to the dollar by buying Treasury bonds. This would presumably diminish if the Chinese currency were to rise.

The biggest beneficiaries of a revaluation were seen as U.S. equities and the Japanese yen. The biggest question mark, however, hung over the impact of a stronger yuan on commodities – 34% of respondents said commodities would benefit while 34 said they would suffer. 14% said there would be no impact and 18% did not know.

Link here.

Golden opportunity for China.

Under the best circumstances, a transition from a fixed exchange regime to a flexible one is not easy. Within the context of China’s unique political and economic environment, its top leaders face an especially difficult set of challenges that continue to conspire against a feasible exit plan for the yuan’s de facto peg to the U.S. dollar. Authorities have exacerbated this dilemma by repeatedly promising not to adjust the currency under pressure by foreign powers (read: the U.S.) or by currency speculators (read: illegal hot money inflows). The record U.S. trade deficit in November and China’s record foreign exchange accumulation through the end of last year suggest such pressures are unlikely to evaporate in the foreseeable future. Fortunately for mainland policy-makers, a conventional currency adjustment is not their only available path; a yuan peg to gold shines the way to a face-saving alternative.

Lest anyone get the wrong idea, this is not to imply China’s leaders ought to ignore the failed history of the gold standard by adopting one of their own. The idea is simply that China temporarily pegs its currency to gold to facilitate an exit from the insidious clutches of a de facto fixed currency regime and lay the foundation for an eventual transition to a fully floating one. Gold is often dismissed as a potential monetary anchor for developing economies like China because of the pre-eminent role the U.S. dollar plays in global trade and financing. A peg to the dollar minimizes currency risks for foreign lenders and direct investors, and facilitates capital inflows that are so essential for economic development in capital-poor countries.

This old shoe no longer fits, however, as reflected in China’s bulging balance of payment surpluses and exploding foreign exchange reserves, which grew by $206 billion last year alone. China’s use of band-aid administrative measures has provided a temporary respite from the continuing deluge of hard currency inflows. But a flexible currency is the only long-term solution for dampening dangerous foreign capital inflows, nearly half of which is illegal hot money breaching China’s porous capital controls. Meanwhile, the clock is ticking.

A peg to gold would immediately inject flexible market dynamics into the yuan’s exchange rate with the dollar without risking the political and practical repercussions of conventional currency adjustment alternatives. All that is required is for policy-makers to choose a yuan ratio that equals the current exchange rate of 8.28 against the dollar at the prevailing gold price. For argument’s sake, let us assume gold is $420. In that case, a ratio of 3,478 yuan to an ounce of gold, would result in an exchange rate that exactly matches the current pegged rate of 8.28. Starting from the current exchange rate would help policy-makers avoid the political and practical risks of choosing the ultimate size of any direct revaluation of the yuan versus the dollar. From such a neutral starting point, the yuan/dollar exchange rate would adjust automatically based on the gold price. As the gold price rises, the yuan/dollar exchange rate will appreciate, and vice versa.

Such exchange rate flexibility provided automatically by gold would serve an invaluable stabilizing function for the economy. When the gold price falls over some weeks or months, this is commonly interpreted as a sign of a relatively tighter U.S. monetary policy, i.e., fewer U.S. dollars are available for a given global supply of gold. In response to changing global liquidity conditions, therefore, the gold price would produce exactly what the doctor ordered in the form of the required currency depreciation or appreciation versus the U.S. dollar.

If China had fixed the yuan to gold before the Asian financial crisis, the resulting currency depreciation would have offset the painful deflationary pressures that rocked China’s economy and forced policy-makers to implement such administrative measures as export tax rebates that still remain more or less in place today. And China would have been insulated from the ire of trading partners, as any yuan depreciation resulting from a gold peg would have been the direct result of U.S. monetary policy, as reflected in a gold price that went from a high of $415 on February 5, 1996, to a low of $252.80 on July 20, 1999.

After gold bounced around below $300 for a couple of years from 1999-2000, an equally dramatic and inexorable rise in the gold price beginning in 2001 brought gold back above $400 in 2003 and eventually to a high of $454 on December 2, 2004, before settling back down in the range of $420 recently. This rise in the gold price, reflecting an enormous reflation of global dollar liquidity, would have resulted in an appreciating yuan, thus counteracting the pernicious effects of the speculative pressures that have fueled, and continue to fuel, a deluge of foreign capital inflows into the economy.

Link here.


Some of the best investments for the remainder of this decade lie overseas. Marked by faster-growing economies, stronger currencies, superior earnings and generally more fiscal conservatism, foreign markets have outpaced Wall Street since 2000. In the 1990s, the S&P 500 Index averaged a 15.6% annualized return. That was better than any other 10-year period for U.S. common stocks since the high-flying 1920s. But so far in the 2000s, the S&P 500 Index has lost a cumulative 7%. Some of the most compelling opportunities for 2005 and beyond lie in the oversold and undervalued health care, biotechnology and insurance sectors. Plus, the best earnings growth remain in commodities, driven by booming natural resource prices and growing profit margins for energy and mining companies. But to invest in most of these companies, you must invest overseas. That is where the big values are as we begin 2005. One of the easiest ways to do so is by purchasing ADRs, or American Depository Receipts.

Essentially, an ADR is a foreign stock traded in the United States, in U.S. dollars. By investing in an ADR, you participate in the profits or losses for that foreign company, including any foreign currency gains or losses. ADRs are not new. Nearly 80 years ago, the first ADR was a British company listed on the NYSE. Today, ADRs total over 2,000 issues representing over 70 countries. Tracking your ADRs is easy with two great websites providing daily information plus in-depth ADR research: The Bank of New York and J.P. Morgan. Yahoo Finance also can track most ADR prices.

Link here.


This is the most important economic question in and for the world: Has the U.S. economy’s rebound since 2001 been aborted, or is it only delayed? Our rigorous disagreement with the global optimistic consensus over this question begins with four observations that we regard as crucial:

  1. In the past four years, the U.S. economy has received the most prodigious monetary and fiscal stimulus in history. Yet by any measure, its rebound from the 2001 recession is by far the weakest on record in the post-World War II period.
  2. Record-low interest rates boosted asset prices and, in their wake, an unprecedented debt-and-spending binge on the part of the consumer.
  3. What resulted was a badly structured economic recovery, which – due to grossly lacking growth in capital investment, employment and wage and salary income – never gained the necessary traction to become self-sustainable.
  4. Sustained and sufficiently strong economic growth implicitly requires a return to strong business fixed capital spending. We see no chance of this happening. Above all, the outlook for business profits is dismal from the macro perspective.

This takes us to the enormous structural changes that the Fed’s new monetary “bubble policy” has imparted to the U.S. economy over the years. While consumption, residential building and government spending soared, unprecedented imbalances developed in the economy – record-low saving; a record-high trade deficit; a vertical surge of household indebtedness; anemic employment and income growth from wages and salaries; outsized government deficits; and protracted, unusual weakness in business fixed investment. None of these shortfalls is a typical feature of the business cycle. Instead, they are all of unusual structural nature. Yet the bullish U.S. consensus simply ignores them, bragging instead about the U.S. economy’s resilience and its ability to outperform most industrialized countries.

To be sure, all these structural deformations tend to impede economic growth. Some, like the trade deficit and slumping investment, do so with immediate effect; others become repressive only gradually and in the longer run. Budget deficits stimulate demand as long as they rise. An existing budget deficit, however large, loses this effect. Rather, it tends to become a drag on the economy. In the past few years, clearly, the massive monetary and fiscal pump-priming policies have more than offset all these growth-impairing influences.

Measured by real GDP growth, the demand-pull driven by the housing bubble has, so far, overpowered the structural drags, provided you believe in the accuracy of the GDP numbers. We do not. Yet even by this measure it is actually by far the U.S. economy’s weakest recovery on record in the postwar period. In fact, measuring the growth of employment and wage and salary income, there has been no recovery at all. Our stance has always been and remains simple. Asset bubbles and their demand effects invariably fade over time; structural effects invariably worsen over time if not attended to. It is our strong assumption that the negative structural effects are overtaking the positive bubble effects.

We come to another feature of economic recoveries that American policymakers and economists flatly ignore. That is its pattern or composition. Past cyclical recoveries were spearheaded by three demand components: durable consumer goods, residential building and business fixed investment, regularly following prior sharp downturns caused by tight money during the recession. Importantly, the tight money had always created pent-up demand in these three categories, which promptly catapulted the economy upward when monetary policy eased. With its rapid and drastic rate cuts, the Fed rewrote the rules of the traditional business cycle and related policies. It managed a seamless transition from equity bubble to housing bubble. Consumer spending on durable goods continued to forge ahead during the 2001 recession at an annual rate of 4.3%. Residential building never retreated, while business fixed investment took an unusual plunge.

Thanks to the sharp decline in interest rates over the last few years, sharply inflating house prices have been a rather common feature around the world. But only in some countries have the rising house prices fueled borrowing-and-spending binges by private households – typically all the Anglo-Saxon countries, whereas the pattern is absent in most eurozone countries. Even among the borrowing-and-spending sprees coountries, the U.S. is a unique case, being the one and only country in the world where monetary policy was systematically designed toward the goal of inflating the market value of assets – stocks, houses and bonds – virtually making wealth creation through inflating asset prices their explicit goal. Central bankers who celebrate this as “wealth creation” and even explicitly animate people to exploit the possibilities of easy credit to lift their spending on consumption are unique to America.

For generations of economists, it used to be a truism that “wealth creation” implies capital formation in terms of generating income-creating assets. To indiscriminately put this label of “wealth creation” on rising asset prices in the absence of any income creation is plainly a novel usurpation of this concept. It is in essence wealth creation through a stroke of the pen. Lured by artificially low interest rates and easily available credit, private households have stampeded as never before into the purchase of homes, boosting their prices. Artificially low interest rates and easily available credit are, actually, the key features that specifically qualify an asset bubble.

The growth of home mortgages exploded from an annual rate of $368.3 billion in 2000 to an annual rate of $884.9 billion in 2004, compared with a simultaneous increase in residential building from $446.9 billion to $662.3 billion. Altogether, the U.S. experienced a credit expansion of close to $10 trillion during these four years. This equates with simultaneous nominal GDP growth of $1.9 trillion. America’s financial system is really one gigantic credit-and-debt bubble.

Our general misgivings about “wealth creation” simply through rising house prices has still another reason, however, and that is the way housing values are calculated. The conventional practice in America is to treat the whole existing housing stock as being worth the last trade. We do not think this makes sense, considering that current sales are always marginal to the whole capital stock. This way of calculating wealth creation naturally explains the extraordinary rapidity with which it can deluge an economy, creating trillions of dollars of such wealth in no time. For sure, this contrasts wondrously with the tedious process of generating prosperity through saving, investment and production.

In earlier studies published by the IMF about asset bubbles in general, and Japan’s bubble economy in particular, the authors repeatedly asked why policymakers failed to recognize the rising prices in the asset markets as asset inflation. Their general answer was that the absence of conventional inflation in consumer and producer prices confused most people, traditionally accustomed to taking rises in the CPI as the decisive token for inflation. It seems to us that today this very same confusion is blinding policymakers and citizens in the U.S. and other bubble economies. Thinking about inflation, it is necessary to separate its cause and its effects or symptoms. There is always one and the same cause, and that is credit creation in excess of current saving leading to demand growth in excess of output. But the pattern of effects is entirely contingent upon the use of the credit excess – whether it primarily finances consumption, investment, imports or asset purchases.

A credit expansion in the U.S. of close to $10 trillion – in relation to nominal GDP growth of barely $2 trillion over the last four years since 2000 – definitely represents more than the usual dose of inflationary credit excess. This is really hyperinflation in terms of credit creation. In other words, there is tremendous inflationary pressure at work, but it has impacted the economy and the price system very unevenly. The credit deluge has three obvious main outlets: imports, housing and the carry trade in bonds. On the other hand, the absence of strong consumer price inflation is taken as evidence that inflationary pressures are generally absent. Everybody feels comfortable with this (mis)judgment.

Link here.


Modern economic theory rests on the insight that what takes place between a buyer and a seller at the margin – one of these in exchange for two of that – is the central economic fact of pricing. The price of some item at the margin is imputed to all other goods of the same class. Every mania is therefore an imputed-price mania. It cannot be sustained beyond the ability and willingness of the last marginal buyer to pay an equity-raising price to the last marginal seller.

At the tail end of any asset bubble, people who have watched the bubble grow from its inception kick themselves for having missed out. While it may be true that for them, they stayed on the sidelines too long in a truly once-in-a-lifetime opportunity, they do not shrug it off and say, “Lots of other people missed out, too. So what? Something else will come along.” Instead, they climb aboard on what they think is the last train out. In manias, a few people buy in at the top. They buy an asset that will fall like a stone from astronomical levels. People who would not normally have been willing to roll the dice on such a high-risk venture buy in and gratefully sign the mortgage papers. Normally, no lender would have loaned to them. But the mania affects lenders, too. Both participants make a once-in-a-lifetime contract. Both will pay a heavy price when the mania ends. It is a once-in-a-lifetime opportunity to lose money.

This is true of all housing manias. We see these manias from time to time. The sign that the end is near is when people line up to bid, auction fashion, on properties that, five years earlier, would have been on the market for six months. The mania is revealed by the presence of above-asking-price prices. People bid frantically against each other to buy a property that they would not have considered buying two years before, or even a year earlier. There are never many of these people. At the top or the bottom of any asset market’s big move, there are few participants. Every mania ends when the last remaining group of potential buyers is finally unable to afford to buy. Then the market turns down.

The people who were the last ones to buy are left holding the bag. They committed themselves to huge monthly payments. They bought in at no money down or close to it. A month later, they are owners of a depreciating asset that may be worth 20% less after the sales commission than the day they bought it. But they owe full sticker price to the mortgage company. The once-in-a-lifetime boom was not used by most owners as a way to sell at a huge profit. Why not? Because most families do not want to move out of the mania region. Also, wives do not want to rent. The nesting instinct is ownership-biased among humans. So, most people hang onto their homes. Then come the property tax hikes, which are based loosely on market value, which has risen. The mania giveth. The tax man taketh away.

People in the last stage of a mania are impatient. Waiting is what they wish they had not done earlier. Meanwhile, the lenders are offering them deals. Renters want to become owners. Why? Because they want to be part of a never-ending boom. Because they forget about rising property taxes. Because they want to know that they will not suffer rent increases – as if property tax hikes were not rent increases.

Serfs in the Middle Ages were locked into their family’s land. They could not leave. They were immobile. They owned their land, but the land-owner owned their services. They were owners, but, in effect, the land owned them. A person who lives in a mortgaged home that he cannot afford to sell because he owes too much on the loan is like that serf. The home owns him. The mortgage company owns him. Yet, unlike the serf, he can lose the home. He can be evicted if he misses payments. He can lose his property if he cannot pay his taxes. Yet he thinks of himself as way ahead of renters, who can shop for lower rents, and move at any time, and do not have their credit rating at risk for mortgage payments.

Housing prices have been driven up to manic levels in California, Las Vegas, and east coast urban centers. Where brains congregate, where the division of labor is high, and where businesses pay for talent, housing prices are astronomical. I define “astronomical” as follows: “Whenever the monthly payments on a no-money-down home are twice or more than the rental price of a comparable home.” The recent first-time buyer in mania regions is now at great risk. He stayed out of the market. He may have bought in at the top – way above rental costs. He is locked into the loan contract. He is stuck. The equity in his home – if any – is dependent on a stream of buyers: other late-comers whose credit ratings are so low that they would not have been eligible for mortgage loans five years ago. But credit standards have dropped as long-term rates have fallen. In short, late-comers’ net worth is dependent on even poorer credit risks than they are. This is not the basis of long-term capital gains. Today, as always, it is the marginal buyer who determines the price of housing. Today’s buyers are more marginal than at any time in history.

I cannot get the words of Groucho Marx out of my mind. In The Coconuts, the first Marx Brothers movie, Groucho is selling Florida real estate. He tells a crowd of mania-driven buyers about the homes available. “You can have any kind of home you want. You can even get stucco. Oh, how you can get stucco.”

It keeps getting worse. We would expect lenders to come to their senses. They do not. The Federal Reserve regularly queries banks whether they are tightening or loosening credit standards for home mortgages. In four of the last five quarters, standards were loosened. The combined drop was the biggest in more than a decade. Meanwhile, the range of home mortgage products keeps expanding. Some lenders offer mortgages that are spread over four decades rather than three. Others extend the interest-only period to 10 or 15 years. The interest-only loan is being matched by the adjustable rate loan.

There is nothing wrong with renting. It is wiser to buy with a fixed-rate loan than an ARM. It is wiser to buy where rental income will pay for mortgage/taxes/upkeep. But there is nothing wrong with renting. In a mania, it is the wise thing to do. The day is coming when there will be motivated sellers. When you are an investor, always buy from a motivated seller. Buy the other guy’s disaster. I refer to the foreclosing lender. The overextended buyer is long gone. There is nothing like a house sitting empty for six months to motivate a lending institution.

Link here.

Is the real estate market cooling?

With housing starts posting their biggest monthly decline in 14 years last month, many are wondering if slowdown in the nation’s red-hot housing market is now emerging. One part of the country showing some signs of cooling is California. The Golden State’s sizzling real estate market has seen double-digit appreciation rates in most of its metropolitan areas in recent years, and some economists have even warned that the state’s housing market is a bubble waiting to burst, although such an event remains a matter of debate. Bubble or not, while growth rates in some areas of the state remain strong, recent data show other parts of California are beginning to see their strong growth rates subside.

Link here.

California real estate panel says the market is still hot, downplays concerns about a bust.

Speaking at the annual Milken Institute Global Conference, executives of KB Home, M.D.C. Holdings, and Starwood Hotels & Resorts Worldwide and Equity Group Investments discussed the real estate market as one of the greatest property booms ever. Executives said the real estate market remained awash in liquidity, with easy financing available and a weak dollar to deliver foreign investors. They also said despite the run-up in prices, gains have not been uniform and prices in major U.S. cities remained affordable compared to Europe and Asia. The executives agreed that there has never been a better time to be a seller in U.S. real estate. “The housing bubble has been created more by the business press than reality,” said Sam Zell, chairman of Equity Office Properties Trust and Equity Group Investments LLC. “You can’t have a crash without oversupply.”

Link here.

Still not convinced there is a real estate bubble?

As the debate over the existence of a real estate bubble rages, the most persuasive case in favor continues to be made by those firmly committed to the opposite point of view. Such was the case with several recent articles that should give even the most ardent real estate bulls cause for concern.

A New York Times article of April 17, 2005 entitled “Seeking Nest Eggs Investors Buy Nests”, chronicles the recent deals of several New York actual, and wannabe, real estate moguls. Although the figures profiled varied largely in terms of wealth and experience, two threads that united them are their a.) confidence that real estate prices have no where to go but up, and b.) willingness to accept low rental returns, or even negative cash flows, as trade offs for expected appreciation. Several individuals admitted to being attracted to real estate because they had either lost money in the stock market, or knew of others who had. What these “investors” fail to realize is that they are making the same foolish mistakes with real estate that they or others made with stocks. Stocks per say are not bad investments. Neither is real estate. It is over paying for either that makes for a bad investment. In the 1990s investors over-paid for stocks by ignoring the fundamental measurement of a stock’s value, its dividend yield, simply because they expected its price to rise. By ignoring rents, today’s real estate “investors” are making exactly the same mistake.

Quotes taken directly from the Times article provide more evidence than any academic study could in support of the existence of a real estate bubble. One “expert” consulted commented that in the past real estate investors expected annual rental returns of 8% to 10%, and that such a “historical perspective” is actual a negative in today’s market, as it results in experienced investors passing on properties that investors with “fresh prospective” routinely buy. “They’re not being foolish; they’re looking at it differently than people who have been in the market for a long time.” In other words, this time it’s different, a new era. I have seen this movie before, and I know how it ends. Remember all the novice stock market day-traders ridiculing Warren Buffet for his failure to grasp the new reality. A second “expert” remarked that “A break even investment is O.K.,” but cautioned others to “never buy a negative return.” So even today’s supposed experts see nothing wrong with buying rental property that produces no net rental income.

Similarly, a local magazine in Connecticut recently featured a cover-story titled “Annual Real Estate Market Survey – How High Can It Go?” in which an expert commented “The only problem with real-estate investing in this area is when you approach it strictly as an investor.” – i.e., consider the fundamental investment value of the property. “Yes a house in Darien or New Canaan will appreciate, and turn a handsome profit when sold, but the greatest interim benefit comes from actually making your home there rather than renting it out and waiting for the optimal selling point.” (Not for my wife and me, who are enjoying the area along with the benefits of cheap rent while waiting for prices to collapse.) Notice how appreciation is seen as given, despite the low rental retunes available at today’s already high prices. Another agent commented that “Homes have been very difficult to rent. I’ve seen rental listings sit for numerous months.” A third added “Even transferees who are coming here for a year or two are buying and then selling after they leave. It’s great to buy a house for investing because the value will increase, but don’t expect to get an enormous amount of rent.”

Finally, an article which appeared in the April 10 New York Times, entitled “The Hunt, Becoming a Mogul Slowly”, which should have been entitled “A Bankruptcy in the Making”, chronicles the real estate deals of a 25 year old New Yorker, who began his investment career at the ripe age of 22, using money borrowed from his proud parents for the down-payment. This young man’s advice to those potential investors who might be worried about real estate is “What are you worried about? Take a risk with real estate, its less risky than the stock market.” It is! Well he is 25 years old, so I guess he should know. The young mogul also advises against shying away from bidding wars. “An apartment is more attractive to me when other people want it. While the price might seem expensive now, it might not be expensive six months to a year form now. We overbid to capture the opportunity.” Basically, his real estate wisdom boils down to the following: Don’t worry about the price you pay, just buy, because the price will be higher in six to twelve months.

I do not think there has ever been a greater “cannot lose” consensus than the one which exists among today’s real estate “investors”. Combine this “irrational exuberance” with unprecedented access to cheap credit, and its no wonder that the Fed has succeeded in creating the “mother of all bubbles”. In fact, it is the sheer size of this mega-bubble which makes it so hard to detect, as so many observers are themselves trapped within it. But the simple fact that a 25 year old kid, with three years of experience, is the subject of a series article about real estate investing in The New York Times, itself is perhaps the best anecdotal evidence that today’s real estate market is a bubble. When a self-described computer geek, proclaims real estate investing to be cool, you can bet the trend is nearing its end.

Link here.


The stock market is poised at one of those very scary inflection points. From here, it could fall another 3% on the Dow Jones Industrial Average or another 8% on the Nasdaq Composite. Or it could rally back to its March highs for a gain of 8% on the Dow or 13% on the Nasdaq. Which will it be? Lower prices and more gloom? Higher prices and smiles? News events that we cannot now predict will certainly have a big role in settling the question. But I think I can make a strong case that we have got a 3% to 8% decline ahead of us before we can start looking for an end to this punishment and the beginning of the next temporary rally. Let me lay out the case for believing that the stock market will fall further.

Maybe last week’s punishment was enough to shake out the weak hands and set up the next rally in what I still believe continues to be a range-bound stock market. For the week, the DJIA tumbled 3.6%, the Nasdaq Composite fell 4.6% and the S&P 500 dropped 3.3%. And the week did finish, after all, with three days of 100-point losses or more for the Dow. Volume picked up into the close on Friday, always a good sign on a down day if you are looking for the Big Washout that marks the end of a stock market decline. But my best guess is that we are not there yet. I think we will need at least another week with a failed rally – to suck in the last optimists – and then another stretch of a few down days – to spit them out again – before this market decline is ready to call it quits.

Link here.


A funny thing is happening in South Korea: Investors seem to be rediscovering the place. The Kospi index is up 7.8% this year. That compares with an 8.5% drop in the Dow Jones Industrial Average and a 9.4% decline in Nikkei 225 Stock Average stocks. Why might some investors be turning bullish on Korea? The possibility of 5% growth this year, for one thing. That seems paltry by Korean standards, yet it is a rate of which the U.S., Europe and Japan can only dream. It could provide a boost to corporate earnings amid slowing growth elsewhere, competition from China and rising energy costs.

Yet the bigger reason may be a calculated risk that after two years of backsliding, Korea is ready to reclaim its title as one of Asia’s most vibrant economies. There is reason to believe that is indeed occurring. Surveys show consumers in March were optimistic about their finances for the first time in 2 years. Even more important, though, this year’s recovery provides a rare window of opportunity to push through reforms that could raise living standards and attract investors in the long run. It is an opening for the government to see to it that households work their way out of debt taken on since the 1997-98 Asian crisis, and a chance to make sure more Koreans at the bottom end of the economy benefit from today’s growth.

Link here.


If it is true that “the stock market follows the economy”, then China should have been everyone’s investment locale of choice in recent years. China’s economy grew by 53% from 2000-2004, to become the 6th largest in the world (nominal GDP). If this growth rate holds for a few more years China’s economy will surpass the economies of France and the U.K. By one generous measure of GDP (purchasing power parity), China’s economy is already second only to the U.S. China’s foreign exchange reserves have more than doubled in the past two years (to $659 billion). Some estimates put China’s middle class at 100 million people; perhaps more impressive still is how many Chinese are now “retail investors” – 60 million, according to the Wall Street Journal. All that said, let us turn to China’s stock indexes. Have they followed the economy's blistering growth rates? As usual, a chart offers the best answer to a question like this.

Oops. That is even uglier than a chart of the NASDAQ over the same period (trust me, I looked). Now, I need to note that equities in China remain subject to a heavy degree of state ownership and control, which in turn has led to rampant cronyism and corruption among state regulators. (Yes, there is something worse than the SEC.) But even widespread corruption should not keep a good stock market down THAT far – certainly not if it is supposed to “follow” an economy that is growing at a double-digit clip each year. In truth, of course, the conventional wisdom is mistaken. If anything, this chart of China’s stock markets should give deep pause to anyone with a stake in China’s economy. That is no less true for anyone with a stake in the U.S. stock market and economy, which very likely includes you.

Link here.


Wall Street analysts have a well-deserved reputation. They rate stocks a “Buy” with one hand, and – if necessary – use the other hand to hold their nose. So, when it comes to aroma, it would makes sense that the foulest stench of all would be the ever-so-rare stock that is actually labeled as a “Sell”. Yes, we all know that after the post-bubble scandals, a “Buy” rating was supposed to mean something: Wall Street analysis would stop being a sales brochure and start living up to the name “research report”. Still … is this not all the more reason to think that stocks which do get a “Sell” rating are about as untouchable as leprosy?

Think again: “Stocks with large proportions of ‘sell’ recommendations from Wall Street analysts have lately performed better than those with plenty of ‘buy’ or ‘hold’ ratings and no sell ratings at all, according to an analysis by Zacks Investment Research in Chicago, done for The Wall Street Journal. In fact, the stocks with sell recommendations have widened their lead since the stock bubble burst in 2000.” Those are the words, this is the picture. As fascinating & disturbing as this chart may be, I suspect that in a year or two the updated version will be far more so – perhaps the “01-02” spot on the graph provides a preview? If this much does not convince you that Wall Street is of no help to individual investors, I would rather not see what would.

Link here.


Seth Klarman is a value investor who has seemingly mastered the craft. Not only are his results strong – his Baupost partnerships have averaged returns of nearly 20% annually since their inception in 1983 – but he is also a graceful writer whose brilliance shines through in his annual letters to shareholders. Klarman stays out of the limelight and most investors have probably never heard of him. His annual letters are not widely distributed a la Berkshire Hathaway’s, and though he wrote a terrific book called Margin of Safety in 1991, it has long been out of print and is exceedingly rare (commanding prices north of $300). I was able to read his book for this issue, thanks to the kindness of a friend who loaned me a copy, and I also have his 2004 letter to shareholders. I would like to share with you some of Klarman’s insights.

Klarman’s own investment activities are shrouded in secrecy and his positions are not disclosed even in his letter. Categorically, he discloses the amounts he has invested in various asset classes. And one can see right away that Baupost is no run-of-the-mill value outfit. Baupost’s partnerships hold a wide array of investments. Their positions range from fairly traditional value stocks to more esoteric investments like distressed debt, liquidations, and foreign equities or bonds. Cash balances averaged 50% in 2004, reflecting Klarman’s inability to find what he considers reasonable values. “We are not seeking perfection in our investments,” he explains, “just acceptable return prospects for the risk incurred.” Klarman does not mind “doing nothing” on occasion. He is completely unperturbed by the idea of sitting on the sidelines holding cash whenever investment opportunities are scarce, though he recognizes that by doing so, his clients may be forced to accept lower returns. But Klarman is unrepentant about his recent inactivity. “Investors,” he observes, “confuse decisions with diligence, activity with insight, and a fully invested posture with a worthwhile portfolio.”

Investing, he cautions, is more than just producing absolute returns. Too often investors focus on that one easy number – return – and ignore the risks incurred to generate that number. Certainly, a 20% annual gain in a conservative value stock is a much better result than the same return generated by “naked” options trading. Part of the reason why investors focus so simplistically on return, Klarman thinks, is that risks are so hard to quantify. Some investors buy gold, for example, as a means of avoiding risk. But during some periods of time, owning gold can FEEL far riskier than owning tech stocks.

Also, Klarman feels that few investors are able to maintain a truly long-term focus and that the psychological pressure to generate near-term returns is great. We have all fallen victim to this, watching over our stocks, checking in on them several times a day. Klarman reminds us: “What matters is not who performs best during sequential short-term intervals, but the attainment of a successful long-term, risk-adjusted, cumulative result.” Returns are deceptive too, because some portion of it may be due to luck or short-term factors. Remember when Internet funds posted triple-digit annual returns?

The underlying methodology is a more important indicator of long-term success than the returns themselves. As Klarman writes, short-term results often belie the “absence of an investment philosophy that would suggest any replicability of results.” What does it take to succeed as an investor? According to Klarman, “analytical rigor, intellectual honesty, resolve, humility, sound judgment and a contrarian instinct.” Klarman also shares our preference for tangible assets. He writes in his book, “The problem with intangible assets, I believe, is that they hold little or no margin of safety. … Tangible assets, by contrast, are more precisely valued and therefore provide investors with greater protection from loss.”

Link here.


When the going gets tough, the tough weep in private … well hidden from public view. Prior to Thursday’s spectacular rally, your New York editor had been hearing of many “rugged”, seasoned hedge fund managers who had been crying into their vichyssoise … both about the stock market’s abysmal performance in 2005 and about the stock market’s abysmal prospects for the balance of 2005. We would love to offer some solace, but we would just be faking it … as we neither empathize with this well-heeled crowd, nor believe that the market will offer any continuing relief to investors.

As regular readers may recall, your New York editor had been anticipating a possible “springtime rally”. The rally finally arrived Thursday, as the Dow vaulted more than 200 points higher to 10,218. (To spare our dignity, we will ignore the fact that the Dow had tumbled about 400 points while we were awaiting the springtime rally). The pyrotechnics certainly broke up the monotony of steadily falling share prices, but we are reluctant to believe that a new, enduring bull trend is now underway. “After [last] week’s breakdown,” observes the seasoned market technician, John Murphy, “there can be little doubt that the cyclical bull market that started in October 2002 has ended. The question now is how far can the market drop … There’s a support level at [the stock market’s] late October low. But I think the S&P (and the other major averages) are headed all the way back to their August lows.”

We are inclined to believe him. We recant, therefore, our earlier faith in a springtime rally and now profess complete agnosticism – albeit an agnosticism tinged with skepticism. In other words, we do not know what to look for next. But if we were forced to choose, we would look for something bad. In short, we must admit that we are feeling more fear than greed. The current market environment, by virtue of its high volatility and erratic trading action, verily begs to be abandoned. Therefore, standing aside seems like a reasonable idea. Timorous investors (i.e., those who prefer keeping their money to losing it) do not lack for reasons to check out of the market and begin the summer vacations very early this year, like today, for example.

Link here.


You can make an enormous amount of money in small stocks. Gerry Tsai can tell you. … You may not know his name. But investors in Gerry’s fund made an absolutely ridiculous amount of money in small stocks – so much that people were actually willing to pay up to half of their first year’s investment, just to get a piece of Gerry’s fund. What was Gerry doing with people’s money to make it multiply so quickly? Gerry was known as a “gun-slinger”. He was the poster-child of an era of gun-slinging portfolio managers – managers who favored new issues, small fast-growing stocks, and “concept” stocks. Some of his big-name gun-slinging contemporaries performed even better. Fred Carr’s Enterprise Fund rose 118% in one year as he jockeyed in and out of various stocks. And Fred Mates’s fund was up 158% a year later.

These maverick young guns all did one thing: they avoided the big old blue chips – or the old “buggywhip companies”, as they joked. They wanted smaller, newer, higher-risk stocks. Why? Because they were convinced that small companies always beat the old companies. Gerry was the king of the 1960s. “Gerry Tsai is buying it!” That was all it took. For example, when Gerry Tsai bought 120,000 shares of National Student Marketing (NSMC) for $5 million, he put the company on the investment map. And NSMC was not the only stock. It happened over and over again.

At the end of 1965, after making 50% for his investors that year in the Fidelity fund he ran, Gerry Tsai left Fidelity to start his own fund – the Manhattan Fund. Investors clamored to get in. He raised a quarter of a billion dollars from investors – an astonishing amount back then. In 1967, the Cult of Tsai and the other “go-go” managers rolled on as he earned investors a return of 40% that year. Everyone knew it. Small stocks simply had more upside potential than the big old dogs. Always have, always will. (Or will they?) “We are at least in a different – if not a new – era of traditional thinking, the standard approach to the market is no longer in sync with the real world… we have never really been here before, and therefore cannot be certain of what happens next.” – Forbes, October 15, 1968

With the benefit of hindsight, we know what happened next … there was no new era. And small stocks got obliterated. Shares of National Student Marketing are a perfect example. With Gerry Tsai’s stamp of approval, National Student Marketing had become THE stock to own. The stock had soared to $120 in February 1970. An international conference of institutional investors was held in New York in February of that year. The two thousand delegates were polled, and their favorite stock was National Student Marketing. Then, from a price of $120 a share, NSMC dropped 95% by July that year – in just five months!

The game was over. Investors who bought Tsai’s Manhattan Fund on its opening in 1966 lost over half their money by February 1973, not counting dividends, according to Time magazine (February 12, 1973). And then the terrible bear market came. … Losses in small stocks piled up. Small stocks lost 35% of their value in 1973. And then in 1974 they lost over 25% of their value once again. The great bull market in stocks peaked in 1968. Yet the real obliteration came five years later. Stocks in general lost half of their value between 1973 and 1974, and small stocks took it on the head even worse. Fast forward to today. The great bull market in stocks peaked in 2000. Is the real obliteration going to begin today – five years later? It sure looks like it.

While the NASDAQ has taken it on the chin since 2000, small stocks have hung in there remarkably well. The time has come for small stocks to pay the piper. Why do I think this? It all comes down to my three criteria. To enter into a new investment, ideally, I would like to see all three of these things: Extraordinary value, an opportunity that is hated, and the clear beginning of an uptrend. In the case of small stocks, we have exactly the opposite of all of these. Really, the timing is perfect. It is time to bet against small stocks.

Link here (scroll down to piece by Steve Sjuggerud).


I have never experienced an environment with so many major uncertainties. Is the U.S. Bubble Economy slumping or in the midst of an intransigent inflationary boom? Are general inflationary pressures gaining critical mass, or is “deflation” waiting patiently to make its appearance? Will heightened financial stress keep the Fed at bay, or are short-term rates on a methodical march to the much higher levels required to rein in destabilizing mortgage credit excess? Are historically low long-term U.S. (and global) rates a secular phenomenon, or is the bond market a bubble of historic proportions? Is the resolute marketplace conviction that the Greenspan Fed would never allow a bond bust precisely the psychology that ensures its inevitability? Are emerging economies – and the global financial system, generally – vulnerable to pneumonia when U.S. markets cough; or have three years of dollar weakness and global reflation buttressed individual Credit systems? Is the dollar poised for the much anticipated rally, or have we witnessed yet another pathetic dead cat bounce?

The “reflation trade” and the global pricing environment hang in the balance. Is tumult in credit default swaps (and auto bonds) the initial manifestation of acute financial fragility, or is it along with attendant equity market weakness just what the system needs to keep the Fed cautious and the mortgage finance liquidity spigot wide open? Have the mushrooming derivatives markets actually dispersed risk and strengthened financial underpinnings, or are they a case of speculative bubbles run precariously amok and ready to bust? Is a Chinese currency revaluation – breaking the dollar peg – a step toward rectifying massive global imbalances, or perhaps a blind leap forward with respect to global currency market dislocation and a U.S. inflationary shock?

There are myriad factors that continue to make bubble analysis challenging, at best. The unprecedented dimensions of both leveraged speculation and the derivative markets – as well as the system’s dependency on massive unending Credit creation – create fragility to recent market losses in CDS (credit default swaps), corporate bonds, and equities. For a system so leveraged and commanded by speculative finance, there is little room for error. And there is little doubt at this point that GM, Ford, and the airlines, among others, are today in serious financial trouble; bubble markets in their debt have dislocated. Two years of zealous “reflation” have done more bad than good for some key companies (throw in Fannie, Freddie and the FHLB). Importantly, key risk market bubbles have burst, heightened risk aversion is the order of the day, and the credit cycle has turned.

But I also believe a strong case can be made that the consequent decline in rates (and reduced fear of a yield spike) becomes a major development with respect to continued mortgage credit excess – the key source driving both the financial sphere and the economic sphere. Heightened risk aversion initially may incite lower market rates and even stimulate demand for mortgage loans and MBS. And perhaps the banking system’s desire to build commercial loan portfolios will for now largely counter flagging corporate credit availability in the securities markets. Perhaps, or perhaps bankers get rattled by financial market instability – major uncertainties.

The inescapable dilemma of asset inflation, leveraged speculation, and resulting asset price bubbles is that expectations based on extrapolating from past trends are badly distorted. The longer they are accommodated, the greater the distortions to market pricing mechanisms and the more confidently price gains are extrapolated. And it is the final extrapolation by the frenzied crowd in the midst of unsustainable “blow-off” excesses that fosters the greatest financial and economic distortions. Pricing, investing, speculating and spending patterns are distorted, creating vulnerability to abrupt changes in perceptions, speculative positions, and spending behavior. Much less apparent – but of vital importance – are distortions to both marketplace liquidity and the perception of ongoing liquidity abundance. It is during the “terminal phase” of excess when speculation and leveraging wildly distort marketplace liquidity and perceptions. Furthermore, the longer this problematic “blow-off” period continues, the greater the gap between current conditions/perceptions of over-liquidity and the unavoidable collapse of liquidity associated with the reversal of speculative bets and the unwind of leveraged positions.

Being in the depths of credit bubble “blow-off” excess has been for sometime a delirious, if tenuous, situation. Until quite recently, the massive liquidity effects were inflating prices throughout virtually all asset classes – treasuries, stocks, corporate bonds, junk, mortgage backed securities (MBS), emerging bonds & equities, houses, property, commodities, art, sport franchises, and so on and so forth (including collapsed credit default swaps premiums). Some argue that all these prices adjusted higher due to declining “real interest rates”. I will instead profess that they have risen because buyers had access to too much cheap credit/liquidity/finance, and the more asset prices inflated the greater the intensity of demand to acquire more. Synchronized bubbles were inflating in various markets which tended to create a false sense of reinforcing stability. To be sure, it has not been the conspicuous (but largely isolated) technology-style Bubble. Instead, we have witnessed a systemic inflation where a confluence of many marketplace bubbles created unprecedented system-wide liquidity excess and distortions. Such systemic asset and liquidity bubbles are as uncommon as they are dangerous.

It very well could be that the Treasury (including agency and MBS) market has the greatest affliction of distorted expectations. The marketplace is remarkably assured that heightened financial stress and instability are good; that the Fed is almost done; that the economy is slowing markedly; that inflationary pressures will abate; and that foreigners will provide unending demand. Well, each of these perceptions is today suspect, and as a whole they may be problematically unrealistic. There are today major uncertainties, including, I conjecture, the possibility for abrupt price adjustments in various markets including interest rates and currencies. If this week provided any indication, we have commenced a period of wild volatility that has in the past often proved a harbinger of financial accidents.

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