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THE FUTURE OF THE WORLD ECONOMY
Last year, the world economy grew by 5%, its fastest rate for many years, led by the extraordinary boom in China and very high growth in most other third world countries too. America and Japan also had fairly strong growth, although Western Europe had a more dismal performance. Can the good times last? Or is the world economy heading for a crisis?
The world economic boom has been driven by two factors. In part it has been driven by a gradual liberalization of world trade and a liberalization of major third world economies like China and India. The average tariff level in a country like China has been lowered from 41% in 1992 to 6% in 2004. The increased liberalization of world trade has increased the scope of international division of labor and permanently helped raise growth in the world as a whole and in particular in third-world countries. Particularly if trade is freed even more, this factor should continue to help the world economy to prosper. Another reason for the increased growth in emerging economies is the free market reforms implemented there with a country like China transforming itself from one of the most destructive communist systems in the history of mankind to a virtual “capitalist paradise” with a seemingly endless supply of cheap but competent labor and with no welfare state and no unions and with many other emerging economies also undertaking free market reforms of varying radicalism.
But there is also a darker side to the current boom. It is to a high degree driven by the cheap-money policy of the Federal Reserve. And it is not just the American economy which rests on this shaky foundation. Most other economies in the world are also dependent upon the cheap money policies of the Fed. This is partly because the rest of the world has grown increasingly dependent upon the rising trade surplus with America created by the excess demand in America spawned by Fed policy and partly this is because the downward pressure on the dollar created by the low interest rates has made other central banks emulate the cheap money policy of the Fed in order to prevent their currencies from rising too rapidly in value against the dollar. Moreover, world economic growth is also dragged down by structural problems in Europe and Japan.
To better understand the prospects for the world economy, we should analyze in more detail the strengths and weaknesses of the four main economic powerhouses of the world: the U.S., the EU, Japan, and China. As they are the main driving forces behind overall movements in the world economy, it makes sense to focus on them. There are some other fairly large emerging economies like India, Brazil, and Russia which will also be briefly discussed.
For the world economy as a whole, we should in the short-term outlook expect the current boom to continue but at the price of aggravating the global economic imbalances. America’s debt burden will continue to rise while the rest of the world will grow increasingly dependent upon exports to America. In the medium term, a strong rise in real interest rates and/or falling confidence in America will trigger a recession there which will spread throughout the world in the form of falling exports to America, both because of the direct reduction in demand created by the recession and the indirect effects of a falling dollar and possibly outright protectionist measures. This will add to and aggravate the domestic problems in the rest of the world.
In the longer term, we will likely see a great shift in the world economy with China and other emerging economies increasing in importance while Europe and Japan gradually decline in importance. Because of the problems in the European economy, it seems unlikely that the euro will replace the dollar as the world’s reserve currency. However, in a longer term perspective (meaning a few decades from now) the Chinese yuan might take over that role when the yuan becomes fully convertible and when China becomes the world’s largest economy.Link here.
INFLATION FEAR BUILDS WITH RISING COST OF COMMODITIES
It is not just gasoline. Prices for many other commodities – including roofing lumber, copper and coffee beans – are surging, many to levels not seen in decades. And demand is more global than ever. Increases of a dime or a quarter collectively add up to inflation. Usually, price increases in some sectors of the economy are offset by decreases in others. But the almost across-the-board rise in commodity prices makes it more expensive to make and deliver products. That is fueling fears of inflation and of higher interest rates to curb it. Higher lending rates slow consumption and thus the economy.
The boom in commodities grew quietly and steadily over the three years that the global economy has been growing. Copper is trading on mercantile exchanges at its highest levels in 16 years, aluminum prices hit a 10-year high in March and iron-ore producers this month raised the price they charge many steel mills, which use the ore to make steel, by 71.5%. Economists and commodities traders are asking whether the boom is a supercycle, a traditional business cycle that is stronger than usual. If so, commodity prices eventually will return to normal. Some economists, though, think the boom reflects a change in commodity consumption worldwide. “It’s the nature of commodities,” said Allan Hubbard, the director of President Bush’s National Economic Council. He said he thinks the high commodity prices reflect a normal business cycle. But some economists think toda’qs commodities boom reflects new forces, mainly the emergence of China and, to some extent, India as global consumers rivaling the U.S. and Europe. With three major economies competing for the same industrial resources, the demand for commodities could become permanently higher, along with their prices.
Traditionally, as prices rise, factories increase production to meet demand. But it takes years to dig mines and extract ores in commercial quantities or to find new oil fields, dig wells and start pumping. That is why some experts expect commodity prices to remain high in coming years. Even a cup of coffee costs more because of the commodities boom. Last month, Procter & Gamble’s 13-ounce cans of Folger’s coffee and Kraft’s cans of Maxwell House each rose by 28 cents. Coffee brewers have raised their prices by at least a dime a cup. The reason: The price of green coffee beans has recovered from record lows in 2001, when big producers flooded the market. Many farmers went out of business, which reduced the supply and drove prices higher.Link here.
SELLOFFS SUGGEST A LOOMING CREDIT CRUNCH
The credit boom is still on schedule to collapse in early 2006, taking the economy and the stock market down with it. What is more, the stock market is starting to see that scenario as increasingly likely. Many expected 2005 to be the year when the economy turned in a robust performance, finally putting the destabilizing factors of the past five years – overpriced assets, erratic demand, whipsawing consumer confidence and a gaping trade deficit – in the rearview mirror. But for the economy to escape those things, it has to ditch its addiction to easy money in the very near future. And there is no sign of that happening as we approach the middle of this pivotal year. In fact, just the opposite has occurred. As hard as it may be to believe, nearly every key indicator shows that the dependence on credit has gotten markedly worse. And the stock market is obtaining an increasing distaste for the credit bubble, even though it has helped shore it up since 2001. The lackluster performance of market indices (the S&P 500 is down 4% so far) needs to be explained.
Given how sensitive the credit market is to changes in rates, there does not have to be a big catalyst to floor the U.S. economy. The Fed will of course try to forestall the inevitable by pushing the theory that the economy can grow its way out of its overleveraged state. But the only way the Fed thinks the economy can sustain its growth is by keeping rates low. What that does, however, is blow more air into the credit bubble, making the ultimate crunch much worse. When the history books get written, the corporate crooks of the 1990s will have a certain lasting notoriety – and deservedly so. But the villain of our era will most certainly be the man who created and then sustained the biggest bubble the U.S. economy has ever had to deal with – Detox’s old friend, Fed Chairman Alan Greenspan.Link here.
SHOULD YOU SELL YOUR HOME?
Whenever I write a report on residential real estate, I get a bunch of e-mails. It is the same question: “Should I sell my house?” I am always amused at these letters. First, the person writing is always a male. This means that he has no authority to sell the house. His wife does. Wives buy houses; husbands, at best, retain only the right of veto. The wife has not sent the e-mail. Thus, the poor schnook has not a snowball’s chance in Death Valley of selling his house. It is not his house. He merely makes the mortgage payments.
Second, the noun is always “house”. Should he sell the house? But wives do not live in houses. They live in homes. Their homes. Homes that reflect their tastes, their dreams, their sense of the social pecking order, and their ability to wheedle their husbands into signing 30-year mortgages. What I do not get is this letter. My wife and I are concerned that this may be the top of the residential real estate market in our area. We have talked this over, and we think the equity in our home may be at a peak. We are both willing to rent. In fact, we have talked about moving to a region that has a much lower cost of housing. What do you think?
Such a letter reflects a joint decision – which buying and selling a house ought to be. It reflects an awareness of economic options. If a wife sees the options as “owning my own home” vs. “renting”, she will take “owning my own home”. If, on the other hand, it is a question of where to own her own home, and how nice a home, that is a different matter. Recently, I received a note from a specialist in real estate construction financing. He lives in northern California. He and his wife recently sold their house. Their decision process is quite illuminating. It offers a case study in how to make the decision.Link here.
Irrational Exuberance moves home.
Buying a home, if the price is right, is often the best investment most people could make. However, the recent spectacular rise in home prices may turn today’s home purchase into a speculation that will engender eventual losses. National home prices, adjusted for inflation, have appreciated about 40% since 1995 and many areas are up more than 160% in that same time. “If you go back to the 1980s, during that cycle, adjusted for inflation, total price appreciation was 18%. In the prior boom in the 1970s, it was 15%,” cites David Stiff, an analyst with esteemed real estate research firm Fiserv CSW. He continues, “It’s alarming… I am surprised that it’s that high.”
There are several reasons for the recent rapid rise in home prices including but not limited to the stock market decline, low interest rates, lax mortgage lending standards and speculation in homes by both American and foreign buyers hoping to resell soon for a quick profit. As we witnessed with the stock market boom of the last 1990s, rising prices temporarily obscured countless problems that were lurking beneath the euphoric surface. Today’s manic real estate market resembles the stock market of a few years ago when individuals purchased stocks simply because their prices were rising. With home prices spiraling higher, the classic bubble characteristics of euphoric greed (the intense desire to participate in a rising market) and the fear of being left out of the market cast a spell over investors.
This emotionality should remind you of the recent stock market bubble. Yet more similarities between the stock and housing markets exist. The share prices of the major homebuilders have risen meteorically during the past few years. Insider sales in this industry escalate as share prices climb. Notably, the CEO of Toll Brothers, Robert Toll, sold 20% of his stock in the last few months. This would not have caught our attention – and scorn – had he not gone on CNBC to tout his company’s stock while he was selling it. “The shorts are gonna get crushed,” he boasted. “You ain’t seen nothing yet.” This “pump and dump” technique is a page ripped out of the playbook of the tech executives from the great tech bubble.
There are signs that the bubble is beginning to burst. Whether or not this is true at this precise time can only be judged in retrospect. However, it is clear that due to a variety of reasons, home prices will need to come down. And, because there are now so many possible causes to force prices lower, rising interest rates – which have been known to force home prices lower – are not even needed to pop this bubble. The eventual decline in home prices will follow an all too familiar pattern, and the same reinforcing mechanism which propelled prices higher will then work in reverse to orchestrate their decline. (Witness the recent example occurring in the manufactured housing industry after its implosion.)
The possibility of an unraveling is so great that John Templeton currently believes that the risk of a 50% decline in U.S. home prices is “quite possible”. He notes that the Japanese real estate market, which peaked in 1990, has fallen by roughly 75% over the ensuing 14 years. Robert Shiller shares Templeton’s pessimism but will not predict how far prices could fall. What he does say will certainly come as a surprise to many home buyers today: “I don’t think housing prices will be higher five to ten years from now.” It is important to note that individuals will avoid adverse effects of a sizable downturn in home prices if they have no need or desire to sell, can afford their mortgage payments in any event and do not increase their debt by using their home equity to borrow for consumption purposes. We are not as optimistic for homeowners who are overleveraged or for the many speculators in the housing market.Link here.
Pay cannot match California home prices.
A house painter dressed in coveralls walks toward me. We start to talk. I learn the house behind me is his, that he bought it nearly 30 years ago for $17,500, and that he has improved it by adding a family room. Like its landscaping and small lawn, the house is in perfect condition. In much of America it would sell for about $150,000. How much is the house worth? “Prices are crazy here,” he says. “About $900,000.” A day later, I describe the house and neighborhood to a Realtor and she is a bit more conservative. “It’s more likely worth about $800,000,” she says.
Visit a Web site like bankrate.com and you can play with one of the many “How much house can you afford?” calculators. Its calculator tells me that if you have a 20% down payment (an impressive $160,000 on an $800,000 home) and can get a 30-year mortgage at 5%, you will need an income of about $13,000 a month to qualify for the necessary mortgage – assuming that real estate taxes are only 0.5% of value, that insurance is relatively cheap, and that you have no consumer debt that might reduce the amount you can borrow. So you would need an income of $156,000 a year to buy that house for $800,000.
How much would you bet the owner does not earn that much? While some painting contractors do very well, I have never met a painter who earns $156,000 a year. Indeed, fewer than 5% of all income tax returns report that much. Most get there by having two earners. Basically, California is a state where few of the homeowners would qualify to buy the houses they already own. This is good for them – if they have plans to sell their homes and move out of the state. But it makes you wonder who, and where, the next buyer is.Link here.
The number of areas in U.S. with real estate booms grew to 55 in 2004.
The number of areas across the U.S. with real estate booms grew nearly two-thirds last year to 55, the Federal Deposit Insurance Corp. said, warning that these booms may be followed by busts. The boom areas represent 15% of the 362 metropolitan areas the Office of Federal Housing Enterprise Oversight analyzes, the highest proportion of boom markets in 30 years of price data and more than twice the peak of the late-1980s booms. Boom areas were defined as having inflation-adjusted prices at the end of 2004 that were up 30% or more in three years.
Adding recent data and analysis to a study released in February, FDIC economists Cynthia Angell and Norman Williams repeated their view that credit market conditions may make current housing market booms different than past ones, which have tended to taper off rather than bust. “To the extent that credit conditions are driving home price trends, the implication would be that a reversal in mortgage market conditions – where interest rates rise and lenders tighten their standards – could contribute to the end of the housing boom,” they say. The FDIC economists found that only 17% of local U.S. housing booms in the 1978-1998 period ended in busts, defined as a 15% or greater drop in nominal home prices over five years.Links here and here.
Investors fed up with stocks are scooping up property.
On Valentine’s Day, the first of about 600 hopefuls began to line up for a three-day vigil outside the sales tent of a Boynton Beach, Florida, developer, to try to nail a condo. Among them were a couple of stand-ins for real-estate agent Peter Celnicker, whose investor clients were clamoring for units. Celnicker was elated when they snagged two – priced at $390,000 and $465,000 – and plopped down two $15,000 certified checks to reserve the unbuilt units. “Fabulous deal,” the Delray Beach, Florida, agent pronounced. “Fabulous.” Two days later, a woman who had not fared so fabulously offered Celnicker’s clients $50,000 for each reservation at the sold-out development. Celnicker said they turned her down flat, expecting to flip their deals for sweeter profits down the road.
Flipping is the practice of buying properties to quickly sell them, an investment strategy that has become wildly popular across the country. Disappointed with the stock market and dazzled by double-digit property-appreciation rates, amateur investors – apparently of every income stripe – are investing in real estate in droves. They are snapping up everything from condo conversions in Chicago suburbs to new three-bedroom ranch homes in the Arizona desert. Nationwide, ordinary people – armed with bargain mortgages, pooled family savings and cashed-out home equity – are investing at levels that are starting to worry economic analysts.
Their numbers are hard to track. But by one count, investors bought nearly 8.5% of all homes sold in last year’s record U.S. market, according to Loan Performance, a California housing-data firm. In 2000, the company estimated investor buyers were 5.8% of the market. Their effects on rising home prices, not to mention what might happen in a real-estate “bubble”, are being noticed. In December, Federal Reserve officials warned they were concerned about speculative demand affecting housing prices and said they were watching some regions’ activity closely. Last year, speculators went into overdrive in Las Vegas, Phoenix, many parts of California and southern Florida, buying perhaps 15% or more of homes sold. In those areas, people who were buying a home as a residence complained loudly that they were being pushed out of the market. Besides driving up housing prices and assessments, a flood of investor-owned houses can depress prices when a market loses its sizzle. If price-appreciation rates slow – or worse, decline – speculators have more freedom to cut their asking price, sell quickly and get out. Left behind are occupant homeowners, who often must realize a certain profit to buy their next house. In Phoenix, homebuilders have announced speculators are no longer welcome.
In South Florida, they generally still are. “We’re seeing three times as many buyers as there are units,” said Jack McCabe, a Deerfield Beach, Florida, development consultant, who says exuberant investors create artificial demand. “300- and 400-unit buildings sell out in a weekend. In my very, very conservative estimate, 40% of these sales are speculator-driven, and in some projects, it’s as high as 80%.” At least developer shuns investors. “Speculators are also our competition [when they resell], while I still may be trying to sell in my building,” said Alan Lev, president of the Belgravia Group, a Chicago-area developer whose sales contracts require buyers to live in its buildings. “Besides, our construction lenders are starting to look at [investor buyers] and say those are not good sales,” he said. Overall, the speculation picture is muddy because there is no single definition of “investor”.Link here.
Economist frets over bubble.
So when is it going to happen? People across the nation continue to buy houses at highly inflated prices, even though economists have warned for months that the bubble is going to burst. But it has not. University of Houston economics professor Barton Smith believes the bubble is bound to pop, but the severity and timing depend on how long and how high the Federal Reserve keeps raising interest rates. There is another big unknown looming, said Smith, who presented his annual real estate symposium to more than 1,000 real estate developers, bankers and other business leaders. “It’s psychological, it’s psychological,” he said.
At some point, people are going to realize that the gains of 10 to 20% a year are not sustainable, he said. In 2004, for example, average home prices increased 47% in Las Vegas, 27% in Washington, D.C., and 25% in Miami. When the realization strikes, prices will start to fall. A dip of only 20 to 25% in cities just on the East and West coasts could end up creating a nationwide recession. And that would hurt even affordable-housing cities like Houston that are closely tied into the national economy. “The Fed has to try to take the gusto out of the market without creaming it,” Smith said.
Fortunately, Houston’s market is not overpriced compared to the rest of the nation. For a four-bedroom, two-and-a-half-bath house, it costs on average $79 a square foot in Houston, compared with the national average of $117. Area employers are adding jobs faster than they did a year ago, though manufacturing and construction will continue to be weak spots. Assuming employers will keep their January-to-April hiring pace going for the entire year, Houston should end 2005 with an extra 33,000 jobs, a 1.6% increase. But ominous signs are looming, Smith said. Foreclosures, for example, are as high today as they were in 1991. And builders in Houston are putting up single-family homes faster than they can be sold. In the past year, 42,000 single-family home permits were issued, but the area gained only 15,000 households.
“It’s an environment in which builders should be cautious,” Smith said. Developers have been focusing lately on starter homes, which sell for $80,000 to $160,000. But that will be the weakest part of the market because those lower-priced homes are most sensitive to interest rate hikes, he said. Not only are developers overbuilding, but they are building the wrong houses, Smith said. When the economy improves and people start moving to Houston with money from selling their costly houses on the West or East coasts, they will be looking for upscale properties, not starter homes.Link here.
Greenspan warns on Fannie, Freddie again.
Alan Greenspan issued a fresh call for Congress to limit the multibillion-dollar holdings of the mortgage giants Fannie Mae and Freddie Mac, warning that their huge debt could hurt U.S. financial markets. Greenspan’s comments came in a speech that focused on the broader issue of the growing use of complex financial instruments, known as derivatives. The Fed chief, as he has done in the past, saw problems with the use of derivatives but also warned against increased government regulation in this area. Concerns about potential market disruptions posed by the two mortgage giants “will remain valid until the vast leveraged portfolios of mortgage assets held by Fannie and Freddie are reduced and the associated concentrations of market risk and risk-management responsibilities are correspondingly diminished,” Greenspan said.
Congress created Fannie Mae and Freddie Mac to inject money into the home-loan market. They buy mortgages and bundle them into securities for sale to investors worldwide. During a question-and-answer period, Greenspan said the two mortgage companies “should hold only the minimum level of assets needed to accomplish the primary missions mandated by their charter.” Shrinking their holdings, he said, could be accomplished “over the course of several years.” He also said limiting the size of Fannie’s and Freddie’s portfolio holdings probably would not affect mortgage rates for homeowners because so many big banks and other lenders compete with them in the home-loan market.
On the broader issue of derivatives, Greenspan said that banks, hedge funds and other big financial players that use derivatives must always assess whether they are effectively managing their risk. “The rapid proliferation of derivatives products inevitably means that some will not have been adequately tested by market stress,” Greenspan said. Financial players, he said, “must be aware of the risk-management challenges associated with the use of derivatives … and they must take steps to ensure that those challenges are addressed.” Derivatives essentially are contracts whose value depends on an underlying asset such as the value of a currency or a bushel of wheat. They are used by financial companies to guard against losses from unexpected market movements.Link here.
Stock-Trading ban for Fannie Mae employees.
Fannie Mae’s 5,000 employees were told they cannot buy or sell their company’s shares for the foreseeable future, according to the Washington Post, citing an email sent by to employees. The paper said that spokesman Charles V. Greener confirmed the message’s authenticity and said Fannie Mae took the step because it “felt it was the prudent course of action.” He provided no further comment.
Fannie Mae told its rank and file that it blacked out trading in the stock so that the employees do not accidentally trade illegally on material, non-public information, reported the Post. The newspaper added that according to the email, the reason for the trading ban is Fannie Mae’s “inability to make public filings with the Securities and Exchange Commission, the increasing number of employees supporting our restatement effort, and the continuing progress of internal and external reviews and investigations.” According to the Post, the email also instructed recipients to “cancel any outstanding instructions you have given your broker to purchase or sell shares in the future” and set forth restrictions for exercising stock options.Link here.
ASIA’S ONLY HOPE
Here in Asia (again), they have only one question for me: How is the American consumer? For a region lacking in self-sustaining internal demand, this concern is understandable. More than ever, externally led Asian economies remain a levered play on U.S. consumption. Therein lies Asia’s biggest pitfall: If the American consumer ever fades, Asia could be headed for serious trouble. The coming U.S. current account adjustment offers good reason to worry about just such a possibility.
The good news is that Asia has learned many of the painful lessons of the wrenching 1997-98 financial crisis. In general, the region has done a very good job of repairing its balance sheets and reorienting some of its most misguided policies. The bad news is that the next crisis is never like the last one. Particularly worrisome in that regard is the region’s unbalanced growth model – an externally led macro dynamic that is still lacking in meaningful support from internal private consumption. Should the U.S. consumer cave – a distinct possibility in the event of a long overdue current account adjustment – Asia would be toast. Little wonder Asians now have a new edge in their voices when they ask me about the fate of the American consumer.
Needles to say, my message has not been received with open arms as I travel through this region. Most Asians react with sheer disbelief when I even dare to mention the possible demise of the American consumer. Believe it or not, one client out here was so angry with me he actually tore my chart of the vanishing personal saving rate into tiny little pieces. Asians want to believe that the income-short, saving-short, overly indebted, asset-dependent American consumer will never stop spending. Lacking in domestic consumption, Asia’s only hope may be nothing more than wishful thinking.Link here.
TROUBLE AHEAD FOR THE CANADIAN DOLLAR?
Although Canadian politics seldom crosses the radar screen of international investors, the Canadian currency by contrast does matter as the country has become an increasingly significant repository for global capital flows over the past few years. During this period, Canada’s dollar, popularly known as the loonie, has been one of the world’s strongest performers, notably against its American counterpart, where it rose some 35% from its lows to the end of 2004. As recently as 1995, Canada was perceived as a country with boring first world politics melded to a third world economy destined for an IMF stabilization program. But now the reverse appears to be the case: Canada’s increasingly murky politics are threatening to impinge on a great economic story.
The loonie’s appreciation over the past couple of years has been predicated on three factors: 1.) the country getting its fiscal house in order against a backdrop of a stable majority government commanding a significant national support (thereby providing the necessary political backdrop required for large, unpopular cuts in public expenditures), 2.) a corresponding reduction in political risk premiums associated with the diminution of separatist sentiment in Quebec (as evidenced by the dominant position of the federalist Liberal Party on both the national level and in Quebec’s own provincial assembly), and 3.) an improving balance of payments surplus on the back of a commodities boom, and a revitalized, restructured corporate sector thriving against the backdrop of a vastly expanded free trade zone afforded by the North American Free Trade Agreement. All three of these factors now appear to be somewhat at risk with attendant negative implications for the currency, which has declined around 4% against the greenback so far this year. Let us consider each in turn.Link here.
WHY DO CORPORATE INSIDERS SELL STOCK?
When it comes to “why” a corporate executive would sell shares of his company’s stock, well … who knows? The need may arise for tax purposes, a second home, a private island, you name it. Barron’s magazine last week reported that a top exec at a real estate investment trust sold his shares for $18.3 million. Go for it, dude. This particular stock sale was actually one of several that Barron’s described in a piece that published on April 18 – near the lows for this decidedly bearish month in the market. The article contrasted the large volume of insider stock sales selling vs. a much smaller volume of insider buying, which the facts clearly bear out. Yet the headline of the story was “Insiders Are Selling With the Crowd” – even though facts which show that the “crowd” of investors is indeed “selling” are harder to come by, if such facts exist at all.
There is no question that insiders are selling; during this past March insiders sold 60 times more company shares than they purchased (60:1), close to the most extreme ratio ever. How extreme is this? Historically speaking, a 20:1 selling to buying ratio is considered a bearish indicator. But as for what the “crowd” of investors is doing, AAII’s survey shows that “67% of the individual investor’q portfolios remain invested in stocks.” Another recent survey shows that a near record 57.4% of U.S. households own equities.
Still, is it possible that this building series of extremes really means nothing to the market? Perhaps not. Maybe history means nothing. Valuations mean nothing. Record high stock holdings? Big deal. There never was a bubble. This time it’s different. “New Economy”. “The only real risk is not being in stocks.” Needless to say, we have heard (and seen) nonsense like this before. History DOES matter, especially in the stock market: Investor behavior is patterned, and the patterns repeat themselves – sometimes in a very big way.Link here.
THE HEALTH BENEFITS OF SLASHER FLICKS?
Many folks who love a good movie will choose to draw the line at the horror genre. The stresses of life in the real world being what they are, getting scared into cardiac arrest probably does not meet their common-sense definition of “entertainment”. Well, we all know that common sense can be overrated. What is more, you needn’t be scared of being scared. In fact, to stay away from horror flicks is to deny yourself a couple of hours that are not just “comforting”, but downright “soothing”! – at least according to a psychiatrist from the NYU Medical Center: “[Horror movies] allow you to engage in an experience that is, more or less, under your control. It follows, then, that the viewing of a horror movie can act as a kind of soothing factor.” (Reuters)
Now, in order to relax you, Hollywood studios “are releasing no fewer than 12 scary flicks during the summer movie season. … The tally is roughly double last year’s and far above any season in recent years, according to box office trackers.” This weekend’s New York Times likewise took note of the growth in scary movies, reporting that major studios (Warner Bros.) are pushing the trend, and that “top-tier” stars (Hilary Swank) now actively seek and receive roles in horror flicks.
Is there a broader cultural import? Graphically violent and “slasher” style movies have been with us since the steady stream first began in the 1970s. In fact, violent/scary/spooky themes have been around since the early 1930s. The point is, the ‘70s and early ‘30s were memorable times in the stock market, AND important moments for violent/scary/spooky subject matter in the broader culture. Popular culture matters – it tells you a great deal about where we are in the larger trend that is driving social mood, and where we are headed next.Link here.
The scissors, the pencil, the SAT, and the stock market.
If you appreciate writing that does not waste a word, Hemingway and Capote are a delight, as are authors such as E.B. White, Orwell, and C.S. Lewis. I can also tell you where you will not find fat-free prose: among the highest-scoring SAT essays written by students who take the revised SAT exam. When asked how students should prepare for this essay, the professor who directs undergraduate writing at M.I.T. did not say a word about grammar, style, or accuracy: “I would advise writing as long as possible, and include lots of facts, even if they’re made up.”
“It’s exactly what we don’t want to teach our kids,” he said. But the New York Times reports that after the professor “looked at the 15 samples that the College Board distributed to schools nationwide, reviewed the 23 graded essays on the College Board Web site and the 16 ‘anchor’ samples the College Board used to train graders,” he bluntly concluded that the longer the essay the better the score: “I have never found a quantifiable predictor in 25 years of grading that was anywhere near as strong as this one.” What is more, after he saw that long essays could be rife with factual errors and still get a top score, he checked the official guide for scorers. It said, “You are scoring the writing, and not the correctness of facts.”
This revised approach to writing in the SAT exam began this year, though it was announced in 2003. What has this got to do with finance and investing? Put simply, “fuzziness” and “dullness of focus” come with the negative mood of a bear market, whereas clarity and sharp focus reflect a bull market. The psychology is real, and observable, and large enough to show up in countless places – from the stock market to student essays.Link here.
ARE WE RUNNING OUT OF OIL?
It is a complicated subject, but now I am familiar with the two theories of the origin of petroleum, the conventional one that assumes that oil is biogenic, originating as plant and animal matter and the other, that it is abiogenic, it or its raw material having been formed with the earth when it was formed 4.5 billion years ago. My learning curve began several years ago with a short article that described the oil field beneath the Eugene 330 oil platform in the Gulf of Mexico. I lost the clipping but did not forget the story of a dried up oil well that was refilling itself. This spring when I found a new discussion of Eugene 330, essentially describing the same conditions, my original conclusions of a mantle filled with or manufacturing petroleum were reinforced, leading to the conclusion that the world’s supply of oil was essentially limitless. But by now the Peak Oil people were out in force and desperate to prove that we are due to run out of oil soon, and must prepare ourselves for war and/or starvation.
One clincher in the debate is that Peak Oil writings are terribly muddled. The other is the suspicion that its adherents seem to fall into Professor Kuhn’s description of people who cannot accept anything outside their conventional world, people who cannot be scientifically critical, whose every belief must fit their current paradigm.Link here.
THE ORACLE SPEAKS
Warren Buffett and Charles Munger warn of real estate “bubble”, the risk of terrorist nukes.
Inside the Qwest Center arena in Omaha, Nebraska, roughly 20,000 shareholders gathered from around the world to hear Buffett and his vice chairman, Charles Munger, answer questions for nearly six hours. Not a single individual shareholder asked whether Berkshire might be implicated in the widening scandal about alleged earnings manipulations at American International Group – and even the money managers in the audience whose questions touched on the subject approached it gingerly. Buffett’s shareholders are true believers; to them, the idea that he could have done (or known about) anything wrong is absurd.
In his answers to shareholders’ questions, Buffett made it clear that he remains concerned about the trade deficit and the U.S. dollar, although he is bullish on the long-term strength of the U.S. economy. But he and Munger issued stern new warnings about the residential real estate “bubble”, the destabilizing effect of hedge funds on the financial markets, and the possibility of another terrorist strike against America. They also warned that they do not see a clear future for pharmaceutical stocks, that GM and Ford face severe trouble over pension and health costs, that hedge funds could wreak havoc in a market decline, and that the New York Stock Exchange is doing a disservice to investors by going public.
As always, Buffett spoke in elaborate paragraphs when replying to shareholders’ questions, while Munger spoke in terse, tart sentences. The two often disagree about political and social policy, but for much of this meeting they sounded like identical twins. What follows is an edited and approximate transcript of their remarks.Links here, here, and here (scroll down to piece by Sala Kannan).
DIGGING A LITTLE DEEPER INTO “FINANCIAL SPHERE” ANALYSIS
Listening to Larry Kudlow yesterday afternoon – lambasting “market analysts” for selling stocks based on a slightly weaker-than-expected GDP report – I thought to myself, “Financial Sphere Larry, Financial Sphere”. It is my contention that financial developments these days lead the economy and not vice versa. Those focused on the current generally robust and seemingly sound “Economic Sphere” (decent growth, strong profits, and relatively tame CPI) are these days at a decided analytical disadvantage when it comes to appreciating the many nuances of the financial market environment. The Financial Sphere is sputtering and convulsing, and if this situation is not rectified, the widening schism between the Financial and Economic Spheres will be resolved in favor of finance. But is it amenable to rectification?
It used to be that The Spheres were Kindred Spirits. Financing profitable investment in the Economic Sphere was the commanding source of expansion for the Financial Sphere. Economic profits and prudent lending were, in conjunction, self-adjusting mechanisms, not repealing the business cycle but at least suppressing boom and bust dynamics. Moreover, tight control over Financial Sphere expansion (implemented post 1930’s financial collapse) for some time nurtured both financial and economic stability. The Spheres shared common interests and growth dynamics. Sound economic investment was the key to financial stability; sound finance the lifeblood of balanced, sustainable economic growth.
But memories faded, historical revisionism prevailed and, over time, the Financial Sphere was set free and left to its own powerful devices. Once unleashed, it was an historic case of a progressive multi-decade bias to asset-based lending and securities speculation. The seeking of Financial Sphere “profits” became the commanding mechanism driving both lending and “investing” decisions, with real economic profits relegated to a fading and rather distorted second fiddle.
In contrast to the self-adjusting nature of economic profits (over- and mal-investment fostering eventual profit disappointment and retrenchment), unfettered Financial Sphere expansion is seductively self-reinforcing over protracted periods (decades). By its very nature, financial sector expansion generates unending “profits” as long as the inflation (creation of additional financial claims) is sustained. The ballooning Financial Sphere has for some time suppressed the downside of business cycles. However, an unrestrained Credit Cycle nurtures speculation, surreptitious boom and bust dynamics, and financial and economic vulnerability to any ebbing of credit and financial excess. Inflationary bubbles in the Financial Sphere – such as those that culminated with the “Roaring Twenties” or 1980’s Japan – are manifestly more dangerous than inflation in the Economic Sphere.
Today, the Financial Sphere is massively inflated with respect to the Economic Sphere. This excess finance – Monetary Disorder – has inflated financial returns, while destabilizing pricing mechanisms within the asset markets and real economy. The massive pool of finance is today faced with paltry opportunities for true economic returns, as well as a natural proclivity for over-investing at every opportunity. Speculative excess has gone to unprecedented extremes and there are, of late, initial indications that Bubbles are strained and possibly beginning to burst.
Importantly, these types of colossal inflations involve a profound redistribution of wealth. For awhile, the finance-induced boom and consequent asset inflations appear to provide at least some benefit to all. The fleeting notion of shared wealth enhancement, however, is replaced by increasing real disparities and animosities. We are seeing this today. While many in California, Florida, Manhattan and elsewhere enjoy a housing wealth bonanza, many less fortunate are being priced right out of home ownership. While the finance, housing and energy industries wallow in windfall “profits”, our nation’s auto and airline industries are left for financial ruin. As the U.S. and its inflationary partners in Asia boom, a more financially stable Europe stagnates. Its citizens are growing restless. Here at home, the American consumer enjoys an endless consumption windfall, while Asian societies accumulate massive and untenable holdings of dollar IOUs. Our creditors are growing impatient, while our lawmakers look for scapegoats. A seemingly wonderful reflation has turned – for the duration – problematic.
Today, careful observation identifies heightened stress on many levels. And to Mr. Greenspan and others than warn against protectionism, I can only say they are correct but offer specious reasoning. The scourge of protectionism is one predictable consequence of inflation’s unjust distribution and transfer of wealth between nations.
For some time the U.S. Financial Sphere inflated largely in isolation. The backdrop is profoundly different today. There are myriad domestic Credit system inflations internationally, in what amounts to a major global Financial Sphere inflation. The distinguishing characteristic of the Greenspan/Bernanke 2002 reflation was its effect on global currencies, credit systems and speculation – the globalization of the U.S. credit bubble. I contend that the Fed will now face significant risk if it attempts to adjust the inflation throttle either up or down and has largely lost control of the inflationary process. For more than two years the perception held that the masterly Fed was in complete control. This was, however, only a deception made of inflating asset prices, narrowing risk premiums, and economic boom reemergence. Risk-taking was made incredibly profitable and it was done in self-reinforcing excess – with everyone confidently on the same side of the risk-taking boat. Everything became a “crowded trade” – from equities, to junk, to converts, to MBS, to manic homebuying. I contend that this reflation was of the “blow-off” “terminal phase” variety.
There has been a major dilemma associated with allowing the Financial Sphere to be commandeered by speculative market dynamics. Years of excess only culminated into a period of spectacular excess. Importantly, the amount of risk created during the credit system’s blow-off period grows exponentially as a huge increase in riskier credits (mortgages, junk) is financed by mushrooming speculative leveraging (“repos,” MBS, “spread trade”). At this point, there is no turning back, with the entire credit system succumbing to Minskian “Ponzi Finance” dynamics. Debt structures become increasingly fragile, reliant upon progressively inflated asset prices and only more aggressive financing methods. It becomes only a case of what precipitates the crisis.
At other times, I would argue that the recent blow would not prove deadly. But this is a “blow-off” period with unprecedented speculative and leveraging excess, with everyone crowded on the same side of the boat, and with the Financial Sphere inflationary bubble sustained only by continued massive credit inflation and speculation. And if the system does begin to seriously falter, the Fed will need to get everyone lined up to play yet another “reflation”, with unprecedented risk and uncertainty. Prices throughout the financial markets are now being whipped around and about, inflicting corrosive damage upon confidence and portfolio values. With all the derivative-related hedging and risk speculating, markets demonstrate increasing leverage both on the up and downside. The defining feature of the Financial Sphere at this time is a massive and destabilizing pool of “hot liquidity” seeking to make a decent return but increasingly fearful of getting run over. So, to proffer a response to the above question - Is it amenable to rectification? – I don’t think so. Could a crisis develop quickly or be delayed for awhile? I feebly answer “yes”.Link here (scroll down to last article on page).
INTERESTING WEB SITES FOR INVESTORS WITH AMPLE FREE CONTENT
Back when everything on the internet was free, it was easy to write a column recommending websites for investors. Even if you wanted to recommend a few fee-based sites they always had a simple subscription structure that made it easy to explain what users were paying for. Nowadays, it gets trickier. Media and research companies are desperate to turn online content into cash through subscriptions. This is fine. But many websites “ladder” the costs to access their site – a little bit for free, a basic subscription, a pricier premium subscription that offers exclusive content, a separate charge for newsletters, a super-premium subscription, and so on – that it makes investors wax nostalgic for cyberspace’s simpler days.
Take heart, investors. One of the few truths about investing that has not changed since the late-1990s is that the internet remains a trove of resources that do not cost a penny. Yes, much of the best content is now behind the subscription veil. Nonetheless, the savvy online investor will be pleased to learn that many of the best things on the web remain free. Here are the free sites I visit early and often. But browser beware: some are penned by bloggers or investors who have a particular viewpoint they are selling – in other words, they may be talking their book. While some of the domain names may not be immediately recognizable, they are worth bookmarking. Best of all, I assure you you will never click on a story only to read, “This article is premium content that requires a subscription to view.”
Prudent Bear accurately describes itself as “the one-stop shop for the bear case”, and its formidable content should be required reading for bears and, especially, bulls. Investopedia is the place to look if you want to make sure you understand the particulars of a straddled put or some derivative strategy, and offers daily articles on investing strategies such as tracking insider sales or cash flow analysis. Silicon Valley Watcher has become required reading for anyone interested in the long or short side of technology stocks.
Seeking Alpha is an entertaining site about the flurry of activity in the hedge fund world, and an entry point to the many blog sites of David Jackson, former Morgan Stanley analyst and current hedge fund manager. Among the best of his sites is the ETF Investor, which includes insights on the hugely popular exchange-traded funds from several different writers. Research Finance does one thing: it houses links to the latest academic finance articles and working papers either just published or set for publication. Bank Stocks affords its hedge fund manager/publisher the ability “to evangelize about the stocks we like”. The site includes updated insights on stocks in the financial services sector, making it required reading for anybody with a stake in financial services stocks.Link here.
HANKY-PANKY AT THE FEDERAL RESERVE BANKY?
Pardon my cynicism, folks, but today’s Fed “goof” was just a little too cute. I refer, of course, to the second or “corrected” statement (AKA, “Son of Statement”) issued by the Federal Open Market Committee after today’s policy meeting. Contained in the second press release accompanying Son of Statement was the explanation: “Note: Corrects previous release to add sentence in second paragraph, which was dropped inadvertently.” Has something like this ever happened before? I simply do not know. But I have been around almost 38 years in this business, and if something similar has happened before, I cannot remember it. My reaction to statement number one was to sell the rally in stocks that immediately ensued. After factoring in Son of Statement, as well as the circumstances surrounding it, my reaction is the same.Link here.
The Fed vs. “Oversized Opponents”
“Don’t fight the Fed” was the conventional wisdom in 2001, back when this snappy phrase was used to persuade people not to sell their stocks. The big central bank was cutting rates; little guy investors best go along with the program. That was bad advice. Stocks kept right on falling, long after the Fed’s first rate cut. Today the tables are turned. The Federal Reserve is in a fight of its own making, which it started nearly a year ago. Only now Mr. Greenspan & Co. are up against oversized opponents, namely the economy and the financial markets.
Tuesday afternoon’s announced 1/4-point rise in the fed funds rate is the latest in the campaign that began in June of 2004. Tuesday’s was hike #8. The Fed has moved the fed funds rate two full percentage points, to 3%. Yet the economy has conspicuously refused to follow. Mortgage rates have barely budged during the past year. As for the markets, 10-Year Treasury yields are below where they were last June; the Dow Industrials are down in 2005.
In truth, the Fed’s decision to begin raising rates was a forecast, and it anticipated healthy economic growth. Alas, as the Fed’s statement put it, “recent data suggest that the solid pace of spending growth has slowed somewhat…” That is a tad understated. The charts below put the facts more bluntly. “Slowed somewhat” indeed. The question is why Mr. Greenspan is raising rates at all. Could it be that the Fed dare not end their campaign, lest doing so would confirm what is so obvious in these charts – that the economic trend is going the wrong direction?Link here.
With America’s cyclical impetus now fading, post-bubble fault lines could deepen – making it all but impossible for the Federal Reserve to normalize real interest rates. This week could mark the Fed’s last rate hike of this cycle. With all due respect to the “soft-patch crowd”, maybe there is something else going on. I continue to see the macro debate through a very different lens. Sure, there may be some temporary aspects to this spring’s global growth scare. But, in my view, there could well be a far more powerful force at work – the ongoing post-bubble shakeout of the U.S. economy. By default, that means a U.S.-centric global economy could be trapped in the same quagmire.
I am not a chartist, but I continue to be struck by the eerie similarities between post-bubble patterns in Japan and America. Five years after the bursting of the U.S. equity bubble, the Nasdaq continues to track the post-bubble Nikkei very closely. Is this merely a coincidence or, in fact, a visible manifestation of the long and drawn out perils of a post-bubble shakeout? I fully realize the indelicate nature of this question. Everyone – from investors and recovering dotcomers to policymakers and politicians – seems united in their conviction to dismiss this possibility as nothing short of blasphemy. Federal Reserve Chairman Alan Greenspan summed up the consensus view on this critical issue over two years ago, when he famously declared that “…our strategy of addressing the bubble’s consequences rather than the bubble itself has been successful” (see his January 3, 2003, speech, “Risk and Uncertainty in Monetary Policy,” delivered to the annual meetings of the American Economic Association).
The risk, in my view, remains that the Chairman may have been premature in taking this victory lap. In large part, that is because history tells us that major asset bubbles have long and lasting consequences that are not easily remedied by conventional policies. While the painful experience of the 1930s is the most obvious example in modern times, Japan’s persistent deflation fully 15 years after the bursting of its bubble is hardly a lesson to take lightly. Nor, unfortunately, is the state of the U.S. economy as it faces what may well be yet another pitfall in its own post-bubble journey.
The academic literature on bubbles is virtually unanimous in concluding that the central bank is the key actor in this story. Whereas bubbles are inevitably an outgrowth of excess liquidity, the post-bubble policy stance of the monetary authority is viewed as decisive for any recovery. Unfortunately, the success rate of post-bubble recovery operations is not high. Once the macroclimate enters the deflation-risk zone at low nominal interest rates, the escape path becomes exceedingly problematic. In my view, the jury is still out on America’s post-bubble travails. In large part, that is because the Fed has not been able to extricate itself – or the U.S. economy – from the low real interest rate policy it adopted in the aftermath of the burst equity bubble. Further rate hikes could well mean game over for the income-constrained, saving-short, asset-dependent, overly indebted American consumer.
It was a great ride on the U.S. growth front for a while. But post-bubble excesses have only been compounded during this cyclical respite. An unprecedented drawdown of saving and an ominous buildup of debt, in conjunction with a lasting shortfall of organic income generation, solidified the emergence of the Asset Economy. If the U.S. economy were truly healthy, the Fed should target the federal funds rate in the 5% to 5.5% zone. However, with America’s cyclical impetus fading, post-bubble fault lines could deepen – making it all but impossible for the Fed to normalize real interest rates. Under those circumstances, this week could mark the Fed’s last rate hike of this cycle.
Financial markets are unprepared for this possibility. In an extended soft patch, growth and earnings expectations are at risk – pointing to downside pressure on equity markets. Moreover, the inflation scare could be over – pointing to the possibility of another bullish run in the bond market. In the end, the post-bubble endgame always boils down to the central bank. Unfortunately, like the Bank of Japan, America’s Federal Reserve does not have a viable post-bubble exit strategy. Unlike Japan, however, the U.S. has the mother of all current account deficits – the pivotal excess of an unbalanced world. Watch out for the dollar: If U.S. real interest rates do not rise, rebalancing should swing to the currency axis and push the greenback sharply lower. Such are the perils of the post-bubble trap.Link here.
GREENSPAN OR BUFFETT? ASIA MULLS WHO IS RIGHT
Even though his bet against the dollar cost him $310 million in the first quarter alone, Warren Buffett is sticking with it. Alan Greenspan seems less worried about the world’s top currency. Who is Asia to trust when the two most revered U.S. gurus in this region are at odds? The issue is far from academic, something that is clear from the intense interest among policy makers in Istanbul for the annual Asian Development Bank meeting. Be it discussions about growth outlooks, poverty or infrastructure, the risk of a dollar crisis is sure to come up. It troubles many Asians that a man as admired as Berkshire Hathaway’s Buffett could so publicly bet on a plunging dollar. It is fine for George Soros to be down on the dollar given his distaste for the Bush administration; it is another to see the “Sage of Omaha” doing the same.
The sense of confusion is heightened by Federal Reserve Chairman Greenspan’s assurances that a scenario like the one Buffett fears is not likely. Admittedly, Greenspan’s view is highly nuanced. He warns U.S. deficits are unsustainable, yet tends to stress that in the age of globalization, capital markets are so large and flexible that economies can handle larger imbalances – ones that can be unwound with minimal disruption. Record U.S. current account and budget deficits do not seem to be getting many headlines in Washington, yet they are Topic A in a region that is highly vulnerable to a sliding dollar. There are myriad reasons why a dollar crisis would be dreadful news for Asia.Link here.
A $310 million loss in three months on a single trade?
What would you think of the investment skills of someone who lost $310 million in three months on a single trade? “Not much” would be the kindest answer that most folks could muster. That is, until they learned how $310 million represents “only” about 1.5% of the total size of the trade. Yes indeed, that is a $21 billion trade. Now you know that we must be discussing someone whose wealth is on the scale of, well, Warren Buffet. Of course, Warren Buffet is supposed to be the ultimate buy and hold investor, so his position against the dollar may well succeed in the longer term. Plus it is hard not to admire the fortitude and fortune of an individual who can hold his ground in the face of a $310 million loss, even if it is only 1.5% of the trade.
What is the real relevance of this story? Buffet’s position regarding the dollar has been well known, especially since late last year when the whole world was bearish the dollar. This broader sentiment alone was nearly enough for us to take the opposite view – the Elliott wave price patterns made it a virtually airtight case. The pattern we saw at the end of 2004 is the same pattern we see now: the Dollar Index has been unfolding as forecast. We continue to see a strong opportunity in the months ahead.Link here.
STOP USING STOPS
Bob Prechter has done a lot of thinking about how to trade successfully. One startling conclusion he has come to: traders should often avoid using stops. Here is why: If you analyze the market you are trading, you should not need a stop to tell you when to get out of the trade. In fact, the point of using Elliott wave analysis is to determine where the market is in a wave count, so that you are able to see where the trend is most likely to turn.
A stop takes only one aspect of analysis into account: price. There is much more to analysis than price. A stop also makes you lazy. If the market and your analysis turn against you, you are prone to think, “Well, if the market takes my stop, then I’m out.” But if you have already decided that your position is wrong, you should already be out! On the flip side, when you already have a stop in and decide it is in the wrong place, there is a psychological impediment to widening it. If you do not act, the stop is typically taken out, and then the market turns your way without you. So it can hurt you two ways.Link here.
A MINER CORRECTION
Gold mining stocks have had a rotten time of it lately. Since topping out at 257 in January 2004, the HUI index of unhedged gold miners has skidded 30%. Even more frustrating for the rattled resource investor, over the same time period, gold has actually RISEN (about $2 an ounce to $426) and so has the general stock market! If there is a logical explanation for this, we do not know it. Besides, we are only concerned with where these stocks go next. That is where Doug Casey and Steven Jon Kaplan come in. They are both seasoned investors in the resource arena and they both think gold stocks are going up. The rest of today’s issue explains why.…Link here.
CONTRA-CYCLICAL OPPORTUNITY FOR GOLD?
According to thorough technical analysis, the gold sector seems to have reached a significant low. This is complete with measurable signs of capitulation selling and rather bearish sentiment. The latter shows up as extreme lethargy in exploration stocks generally, despite good programs and, until recently, some good gold rallies. This is opposite to the condition in March-April, 2004. Quite likely, the condition offers much more than another trading opportunity out of an oversold market.
As outlined below, on the very long term the golds have set an important low in the Fall of the year (2000) that a great financial bubble climaxed and then enjoyed a cyclical bull market of 2 to 3 years as the big stock markets suffered the initial post-bubble bear market. At times, gold shares were set back during the hard phases of the stock bear market, but generally the golds gained as gold outperformed commodities. The recovery out of the panic for stocks and low grade bonds in late 2002 became a boom by mid-2003, with gold underperforming commodities as well as silver.
Our gold/commodities index declined from 255 in mid-2002 to 192 in March of this year. This is not too far off the key cyclical low of 187 in the Fall of 2000. From 82 in June, 2003, the gold/silver ratio took a long decline to 56.6 on December 1. Last week’s low of 58.4 seems to be testing both the December low and that of 57.2 on February 18. The next step of this study is to review the exploration side of the gold market, which offers opportunity possibly beyond what one would expect from a normal cyclical recovery in gold's price relative to commodities and most asset classes.
Every era of financial bubbles is eventually followed by a severe credit contraction. Since the advent of modern financial markets by around 1700, there have been five examples prior to the blowout in Q1 2000. Mother Nature needs to fill the post-bubble credit vacuum and, typically, gold’s real price has increased significantly and this resulted in equivalently increased production and exploration success. Also typically, the post-bubble rise in gold ran for 20+ years and, in a number of examples, a great gold rush occurred with gold’s highest real price at the end of the secular credit contraction. The discoveries in the 1840s and late 1890s are the best known gold rushes – “California” and the “Klondik”q. With varying degrees of intensity and success, the record is complete back to the 1690s’ depression bottom, which recorded the “Oro Preto” mania in Brazil.
Over the past year, the severe decline in the U.S. dollar and associated rallies in gold have not been as profitable as the goldbugs were counting on. However, as the more alert in the gold community are beginning to discover, a bunch of currencies suddenly jumping relative to the U.S. dollar does not translate to improving operating margins or soaring share prices in Australia or Canada, for example. For a real, rather than faux, bull market, gold needs to be rising relative to alternative assets such as stocks, bonds, and commodities. It also has to be rising relative to most currencies.
Recently, there has been a successful attempt to popularize the notion that from the lows of late 2002 commodities have started a long bull market that could run for about 18 years. Yes, there are long bull markets for commodities and they typically run for more than 20 years. They start from a depression bottom and end in the era of bubbles – never the other way around. Throughout the period under review, the behaviour of gold’s real price, or purchasing power, or mining profitability has been consistent. It has recorded a significant low during the bubble era and then, once completed, gold’s real price increased for some 20+ years.
Some confusion in the goldbug ranks can be reduced. Over the past 300 years, there have only been two bull markets for gold in senior currency terms and that was when sterling and the dollar were not convertible into gold at a fixed price. The first one ran for some nine years in the early 1800s and ended when the great financial mania that blew out in 1825 got underway. The only other example ran for some nine years until 1980, from which collapse set up the era of bubbles, during which gold would be likely to set a significant low.
The following charts show two things. One is that our commodity index seems to be replicating the key top in the late 1980s. The other – the gold/commodities index – details the end of the tech bubble in 2000, which was similar to gold’s behavior through the climax of the two previous stock bubbles, in 1873 and 1929 – which both followed the pattern that was recorded with annual numbers at the bubble tops of 1825, 1772, and 1720. This recovery in stocks, business, and credit markets is showing some of the classic signs of topping at the same time as the gold side of the equation is indicating downside capitulation.
In which case, the second cyclical bull market whereby gold will outperform most commodities as well as most financial assets is about to get underway. The first one out of the collapse of the tech bubble launched a remarkable drive to acquire millions of ounces of gold. This one will launch an even more remarkable drive to discover millions of ounces of gold. Exploration companies with outstanding field abilities and portfolios of identified properties will be outstanding performers. Think about the small-cap tech stocks in 1994.Link here.
SINGAPORE HEDGE FUND “FACES BIG LOSSES”
One of Singapore’s biggest hedge funds is thought to be facing significant derivatives trading losses, following the resignation of one of its main fund managers. Aman Capital Management yesterday confirmed that its $242 million hedge fund had suffered “trading losses in April”, which have raised concerns about its internal risk controls. The company also confirmed the departure of Michael Syn, a former derivatives specialist at UBS, the Swiss banking group. A company official declined to comment on the likely cause and extent of the trading losses, pointing to an “independent review” launched by the fund’s administrator, or back-office services provider, at the end of last week.
However, industry experts believe the fund may have lost more than $43 million, or 18% of its assets, in April by investing in derivatives based on the Korea Composite Stock Price Index. Total losses since the beginning of the year – estimated at more than 20% – could make it difficult for the fund to earn a performance fee by the end of the year, depriving it of its main source of income. One Singapore-based industry expert said the company might decide to close the fund by returning the diminished assets to investors: “These losses have come as a big surprise, because of the calibre of the people who run the fund.”Link here.
According to Ben Stein, the fault lies not with Social Security but with ourselves. Stein is on a crusade to warn Americans about the coming retirement crisis. It has less to do with Social Security or its reform, and more to do with the dramatic decline in U.S. savings and the absence of individual retirement planning. “This is the greatest crisis facing the country that people can do something about,” Stein says. The crisis is that they are not. Stein, 60, is a paid spokesman for the National Retirement Planning Coalition, a group that includes nursing homes and sellers of annuities and other financial products. But he says his advocacy arises from his work as an author and journalist, and from the fate of people he knows, including some of his rich Hollywood pals, some of whom are now in financial deep water.
With less than 20% of U.S. workers now in employer pension plans (many of those plans are on shaky financial footing) and with Social Security typically replacing less than 40% of pre-retirement income, personal saving has never been more important. But savings rates have never been lower. In 1999, the national savings rate dipped below 3% for the first time since 1959, according to the U.S. Commerce Department. It has been declining further since then, and in 2004 it was at a mere 1%. The low savings rate, coupled with large deficit financing by Asian banks, is dangerous for the U.S. But it is more dangerous for individuals.
The nest eggs are cracked. Nearly 28 million U.S. households – 37% of the total – do not own a retirement savings account of any kind. Among the households who owned a retirement savings account of any kind as of 2001, according to a 2004 report by the Congressional Research Service, the average value of all such accounts was $95,943. That number was distorted by the relatively few large accounts, and the median value of all accounts was just $27,000. The median value of the retirement accounts held by households headed by a worker between the ages of 55 and 64 was $55,000 in 2001, the CRS says. To that, Stein adds that just 11% of all Americans have retirement savings of $250,000 or more. He figures that in order to replace an income of $100,000, most retirees would need savings of $1.5 million, and very few people have that. The median net worth of U.S. households where the head of the household is between 55 and 64 was just $181,500 as of 2001, the CRS reports. No, not everyone is a millionaire. The problem persists up and down the income scale.Link here.
Most economists are ivory tower academics who engage in abstract theorizing. Seldom are their ideas of any practical value. As Jean Baptiste-Say, the great French economists said, “They’re ideal dreamers who offer no practical value.” But more and more, economists are offering practical skills and techniques. Some have done a lot of research on the ability to do well in the financial market, and have found some very interesting things in their studies. One of the most important fields is called behavioral economics. It is a new area that has been going on for 20 or 30 years. Several Nobel Prize winning economists have studied the performance of top money managers and individual investors. What they find is individual investors often have a far better record than professional money managers. Basically, they are saying if you do your homework, and you go contrary to what the money managers and the establishment is doing you, have a better chance of beating the market.
Irving Fischer – the Milton Friedman of his day – was the premier monetarist economist of the 1920s, a Yale professor, and an inventor. He made one thing that is used every day in every business in America – the Rolodex. He sold his invention to Remington Rand and received stock that was worth $10 million at the peak of the stock market in 1929. He was known in the 1920’s as the oracle of Wall Street. He was what we call a perma-bull; he was always optimistic. He believed in the new era of the 1920’s, which was not unlike the 1990’s in many ways – all of these new inventions, the new technologies, and the new consumer products. Where did he go wrong? This is where we have the name of a man who died in infamy, even though he was a great economist and contributed what was known as the quantity theory of money. There was a fatal flaw in his macroeconomics: he failed to see the coming debacle, the Great Depression. If you do not foresee a major cataclysmic event in the world you are going to pay dearly. On the other hand if, you anticipate it you can profit amazingly well. The 1920s and 1930s were no different. Most people lost tremendously, but there were others who made money and survived.
Now, two of my favorite economists, who did predict the Great Depression, were Ludwig von Mises and Frederick Hayek. They worked together in the Austrian School at the University of Vienna. But I should point out that Mises predicted it would in 1925, which means he missed the bull market too. We would like to be able to foresee the bull market, and get out at the right time, but of course, that is difficult. Now there were the perma-bulls and the perma-bears. It is an exceptional person who gets in right before the bear market starts. You can count on one hand the number of economists and financial advisors who fit in that category. In the 1920s and 1930s there is only one person who got out at the top and bought in at the bottom in 1932, and that was Joe Kennedy. After he got out the stock market a little bit early in 1928, he feared that he got out too soon. And then the shoeshine boy gives him a stock tip. He decided right then and there that he was wise to be out, and he was right. All the great investors in many ways are contrarians. You have to be in the minority. It is very difficult.Link here (scroll down to piece by Mark Skousen).
The One-Arm Contrarian
I call John Maynard Keynes the one-armed contrarian. Keynes was a British Don, a Cambridge economist, and today we live in the “Age of Keynes”. It was his idea that we need to increase government spending to keep the economy growing. He is the father of the welfare state, and he argues for big government. He despised the Marxists and the Communists, but he was suspicious of laissez-faire and the invisible hand. He believed more in the visible hand of government. Keynes was fully invested in 1929, and failed to see the crash, just like Irving Fischer. He believed in the new era of the 1920s; he believed in the Federal Reserve, and the ability of government to protect us. And although he was wiped out in the 1929 crash, Keynes is still known as a speculator par excellence.
The fact of the matter is that he knew his limitations. He never had the ability to get out at the top. However, we call him a one-arm contrarian. He did have the unique ability to buy at the bottom. Some people just do not know where the top is, but they are really good at buying at the bottom and knowing that this is a bargain. And that was Keynes, so in 1932 he started buying stocks and utilities yielding 15%. He started buying gold stocks, even though he hated gold. But Keynes was smart enough to ignore his personal economic philosophy and bought what he knew were bargains in the 1930s. He bought gold stocks and managed money for insurance companies and became spectacularly wealthy as a result.
There was an issue of the American Economic Review, the premier publication by economists, and that had come out with a special study in the late 1980s. They reasoned that today we have all of these modern econometric methods to predict the future, so why not go back with the data from the 1920s to see if our modern methods could predict the 1929 crash and the Great Depression. When they ran the regression and did their analysis … and proclaimed that the Great Depression and the 1929 crash were “unforecastable” – their model could not predict the crash. This tells you that today the top economists who work for President Bush do not have a clue of any possible next Great Depression or crash. They cannot predict it and they are proud of that fact. Instead of saying they have the wrong model, they say there is no model that can predict a future depression or crash. Therefore, they gave Irving Fischer, John Maynard Keynes, and the Harvard Economic Service high marks, even though they failed miserably to predict the Crash and Great Depression. Amazing.Link here.
THE OUTER LIMITS OF NATIONAL DEBT
Sometimes, if you stand too close to a picture, you cannot tell what it shows. That can be a particular challenge for economists, who spend their days up to their elbows in data. Consider the budget deficit. As the U.S. runs large deficits year after year, the national debt increases. Some prominent analysts warn that debt levels are out of control and that an imminent, Argentina-like crisis is looming. Others say debt is simply not a problem. Shouldn’t economists be able to sort this one out? They could start with straightforward questions: How much can the federal government borrow, and how close is the nation to that limit?
It is a pretty simple concept for an individual. But who can tell what the limit is for the federal government? Most experts have been content to answer the question this way: At some point, lenders will stop lending, and that is when we know we have hit the limit. Not very satisfying, is it? Of course, it is not as if someone can call the bank to check. But with a few simple tools, one can establish a rough sense of where American borrowing stands and how much headroom is left.
One astounding example of national debt was that of Britain after World War II, when it owed debts representing about 250% of its GDP. It is worth noting that Britain later paid down the debts to a level near 50% of G.D.P.; in contrast, more recently, Argentina hit the wall at around 65%. According to Moritz Kraemer, a credit analyst at Standard & Poor’s in London and an expert on sovereign debt, it is not easy to exceed debt burdens of around 150% of GDP. Of course, as the leading economy in the world, the U.S. has certain advantages over a smaller country in handling its debt burdens. But at high debt levels, the risk of a lending crisis, perhaps prompted by recession or rising interest rates, becomes significant. And any Argentine will tell you that a lending crisis is worth avoiding.
So assume that debt of 150% of GDP is a sound limit for borrowing by the U.S. It could probably borrow more, but that does not seem prudent, given the experience of other countries. Based on America’s GDP today, that translates to an $18 trillion debt ceiling. HOW close is the nation to that limit? It depends on what you count as debt. The most simplistic view counts only what the Treasury calls “debt held by the public”. That amount is $4.6 trillion, about a quarter of our prudent limit. That does not sound too bad. Unfortunately, it is not the whole story. Add on estimates for future Social Security and Medicare obligations, and the aggregate debt is $40.6 trillion in present dollars, well over that prudent limit of $18 trillion.Link here.
FUND LETS RETAIL INVESTORS BET ON CREDIT DEFAULT SWAPS
The first credit derivatives fund aimed at retail investors has been launched, giving individual investors the chance to gain exposure to the potential rewards – and risks – of an investment product that is becoming a core part of markets. Trade in credit default swaps (CDS) – instruments offering insurance against the default of a borrower – have long been the domain of the large institutional investors and sophisticated fund managers, but a new fund aims to change that. “As a retail investor, you can’t really access the CDS market,” said Nicole Montoya of AXA Investment Managers, the fund manager, which launched the fund with ABN Amro, the investment bank. “In five to 10 years, there may be a pure retail market.” AXA, which will manage the portfolio, said it raised €50-100 million from retail investors in France and Monaco for the fund.Link here.
GM, FORD STUMBLED TO JUNK ON DESIGNS, UNIONS, JAPAN’S CHALLENGE
General Motors CEO Rick Wagoner did not think much of hybrid cars in 2002. After sales surged for Toyota’s Prius hybrid, Wagoner backtracked. GM and DaimlerChrysler AG said in December they would jointly develop a gasoline-electric power system for delivery by 2007 – 10 years after Toyota introduced the Prius. GM’s reversal is an example of decades of management miscues that led Standard & Poor’s yesterday to cut the credit ratings of both the world’s largest carmaker and Ford Motor to junk-bond status for the first time. GM and Ford, once icons of American manufacturing, have blundered over issues ranging from design, vehicle size and fuel economy to union contracts and meeting the challenge from rivals such as Japan’s Toyota.
“They have a pretty bad track record on guessing the market,” says Thomas Stallkamp, 58, who was president of Chrysler before it was acquired by Daimler-Benz AG in 1998 and is now a partner at the New York buyout firm Ripplewood Holdings LLC. “They went with the sure bet, and the market moved around them.” S&P cut GM two levels to BB from BBB-, while Ford was lowered one level to BB+ from BBB-. The move slashed the value of $375 billion in debt, about $200 billion of which is GM’s, and will raise the automakers’ borrowing costs. GM and Ford, with a combined market value of $36 billion, are the biggest companies ever to have their credit lowered to high-yield, high-risk ratings.
The roots of the downgrade date back to the early 1970s, a period when the two automakers together controlled 80% of the U.S. market. Then, three Japanese automakers – Toyota, Nissan Motor, and Honda Motor – began grabbing U.S. sales with reliable, fuel-efficient cars. GM and Ford tried to respond. First, they came out with ill-fated subcompacts such as the Chevy Vega and Ford Pinto and later designed cars such as GM’s Saturn that failed to draw buyers. The U.S. carmakers were hamstrung in part by one of the legacies of their success: Surging costs for employee and retiree health care that added more than $1,220 to the price of each new vehicle they sold in 2003, compared with just $450 for Asian and European companies, says the Washington-based Automotive Trade Policy Council, which lobbies on behalf of GM, Ford and Chrysler. While the Japanese automakers started with new factories – many of them built in southern U.S. states since the 1980s – GM and Ford had to close older plants and reduce their workforces. They did so partly by giving workers buyouts, which swelled the costs of retiree health care and pensions.Link here.
Still think Ford, General Motors cannot go bust?
Anyone who says it is unthinkable that either GM or Ford might seek Chapter 11 bankruptcy protection should call Francisco Landaez. After working 24 years at Petroleos de Venezuela SA, Landaez lost his job and decided to put his savings in “something secure”. He invested about $280,000 in General Motors bonds and shares. “I made an analysis about a year ago, asking myself what company is it almost impossible to see going bankrupt,” Landaez, 50, said in a telephone interview from his home in Caracas. “I decided to put my money into General Motors. When I looked at my account a month ago, it was down almost 30 percent.”
Landaez knows he is in for another nasty shock next time he checks his investment. Yesterday, Standard & Poor’s analyst Scott Sprinzen slashed his credit rating of GM to junk with a two-step cut that puts the world’s biggest automaker at BB. Nine minutes later, he whacked Ford to junk as well, with a BB+ grade. For good measure, Sprinzen strapped a “negative” outlook to his assessments of both companies, meaning their ratings are more likely to decline further than recover.
S&P highlighted its concern that both companies are too reliant on sport utility vehicles, which are likely to be less profitable in coming years. And while Sprinzen said in a television interview he is “not pointing to management”, chief executives Rick Wagoner at GM and William Clay Ford Jr. at Ford should be thinking about handing back the keys to the chief executive suites. “We will take whatever measures are necessary, and we will succeed,” Ford Jr. wrote in a letter to his employees, following the rating cuts.
Unfortunately, those measures may have to include seeking bankruptcy protection from creditors while Ford and GM come up with reorganization plans to address falling market share and crippling health care and pension costs. If it is good enough for the airline companies, there is no reason to rule it out for the automakers. There is no such thing as “too big to fail,” however tragic bankruptcy would be. Landaez in Caracas says he has decided to stick with his GM investment for now, figuring that it is not worth taking the hit, and praying that GM does not go bankrupt before it repays his bonds, which come due in 2014. “It’s pretty scary,” says Landaez. “The bottom line is, there’s nothing secure in this world any more.”Link here.
CHINA NEEDS A NEW ANCHOR
In China, stability is everything. Despite the extraordinary progress the nation has made on the road to reform over the last 27 years, the Chinese leadership does not take these accomplishments for granted and will not do anything to jeopardize economic, social, or political stability. But while China has managed the tradeoff between reforms and stability with great success, an important adjustment is now needed: The Chinese economy must find a new stability anchor. China’s fate is tied far too closely to that of the U.S. Its export-led growth is dependent on the American consumer; at least a third of all Chinese exports go to the U.S. Moreover, China’s currency, the renminbi, has been pegged to the U.S. dollar for over a decade. This means the monetary policies of the People’s Bank of China and the Federal Reserve are joined at the hip.
China needs to prepare for the coming U.S. current account adjustment. From the standpoint of stability, it is taking on unnecessary risk in tying itself to what could well be the most unstable major economy in the developed world. It is taking an equally serious risk linking its embryonic financial system to what could well be the most unstable currency in the world. The stability anchor that has served China so well for so long must now be hoisted out of the water and a new one found.
The great paradox of stability is that it is not carved in stone for any economy – it is a moving target. As China comes of age, it must constantly rethink its stability requirements. This will undoubtedly mean a different internal mix to its economy, as well as a new foreign exchange mechanism. These changes are all positive developments for China – visible manifestations of the extraordinary progress it has made on the road to reform and development. A new stability anchor will be yet another important milestone along this road.Link here.
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