Finance Digest for Week of October 10, 2005

THE QUALITIES OF A SUCCESSFUL TRADER

October begins major league baseball’s playoffs, an annual reminder that those ballplayers and teams who make it this far share two common traits: discipline and coolness under pressure. The Roger Clemenses(star pitcher for the Houston Astros) of the world did not make it with a casual attitude about work. Clemens has had the discipline to pitch successfully in the major leagues since 1984, and the mental toughness to win the post-season games that count – as he did on national television Sunday afternoon, coming into pitch relief in the last innings of the 18-inning marathon against the Atlanta Braves. Traders and investors may not perform in public, but they still need to possess discipline and mental toughness to succeed. In this excerpt from Bob Prechter’s question-and-answer book, Prechter’s Perspective, he talks about the qualities of a successful investor.

“Well, my best advice to the average investor is stop being an average investor. You cannot survive as an average investor. The pros will beat the pants off of you, and the markets will, too, because what seems logical is exactly what will not happen. That is one of the first keys to understanding how not to lose money in markets. So step one is: stop being the average guy or the average gal. Get a foundation. And the only way to do that is to start reading.”

TRANSITION CURSE

The end of an era is nearly at hand. After nearly 18 1/2 years on the job, Alan Greenspan is required under law to step down at the end of his full term as Fed governor on January 31, 2006. Akin to the election of a new pope, the changing of the guard at the Fed is a rare and important event for the U.S. and world financial system. In the past 27 years, it has happened only three times. In each of those instances, the transition did not go well – financial markets quickly seized up, eager to test the mettle of the new central banker. My suspicion is that the curse of the Fed transition is likely to be in play again – with potentially profound implications for increasingly vulnerable financial markets.

The last transition occurred in August 1987, when Alan Greenspan assumed the reins of power. A little more than two months later, the U.S. stock market crashed. Paul Volcker became Chairman in August 1979 – a transition that that was quickly followed by a wrenching sell-off in the bond market. And the U.S. dollar was in serious trouble from the very start of G. William Miller’s brief term as Fed chairman, which commenced in March 1978. It is not that new Fed chairman typically fail to meet the immediate test of financial markets. In each of these instances, the incoming central banker inherited very tough macro conditions.

Alas, that is very much the case today. Saddled with a record current account deficit, the U.S. is more dependent than ever on the confidence of foreign investors to fund ongoing economic growth. When Greenspan hands over the reins to his successor in early 2006, the current account deficit will be at least 6.5% of GDP. That is more than four times the average external shortfall of 1.5% that prevailed during the three most recent transition points – 1978, 1979, and 1987. Moreover, in a post-Katrina, energy-shocked climate, there is good reason to expect additional reductions in personal and government saving in the months ahead – actually, deeper dis-saving (deficits) on both counts. As a result, already-depressed national saving should move even lower, prompting further deterioration in America’s already massive current account deficit. In other words, America’s dependence on the “kindness of strangers” is likely to increase significantly at precisely the point of an historically-delicate transition to a new Fed chairman.

And that brings me to the most controversial point of all – the selection process, itself. With the consent of the U.S. Senate, the choice of selecting a new Fed chairman falls to the President. Generalizing on the basis of George W. Bush’s most recent senior appointments, I suspect the President will look for three key traits in a new Fed chairman – familiarity, loyalty, and a pro-growth bias. In the case of a Fed Chairman, those criteria imply that President Bush will probably not select the next Paul Volcker – a tough, independent policy maker who might be predisposed toward “tight money”. This could well pose a serious problem for US financial markets. With America’s external financing critically dependent on the foreign confidence factor, any doubts over central bank independence will not go over well. It leads me to believe that the curse of the Fed transition is about to strike again.

HOT HOUSING MARKET CROSSES THE BORDER

Lured by 300-plus days of sunshine and “good, fun waves”, Greg Leach is tapping the equity from his 3-bedroom Mountain View, California home to build a vacation getaway near the small Mexican resort town of San Jose del Cabo. Leach, 52, who is splitting the estimated $100,000 investment with a surfing buddy, could pocket a sizable profit if he wanted to. Realtors estimate their house could fetch close to $400,000 in Baja’s sizzling market, which has shot up at least 10% to 15% a year for the last two years. Buyers have been snapping up homes in the southern half of the Baja Peninsula, usually in all-cash deals. Like Leach, most of the newcomers are Americans, many from California, leveraging the equity in their increasingly valuable U.S. homes.

Their purchases reflect a change in global real estate ownership: People no longer have to be super-rich to invest in homes in foreign locales. In fact, some economists are starting to worry whether places like Baja California, London and Canada’s British Columbia are part of a global housing bubble driven by the same combustible mix that has fueled American home prices: low interest rates, flexible financing and sluggish stock markets that have sent investors looking for better money-making opportunities. Official figures are not kept on how many Americans are buying residential real estate abroad or how many foreigners are investing in the U.S. But a survey by the National Assn. of Realtors revealed that 15% of home buyers in Florida last year were foreigners, mostly from Europe and Latin America. Three-quarters of those buyers said the properties were vacation homes or investments. Though a similar study has not been done in California, economists believe foreign buyers play a significant role in the state’s housing market.

TD Bank economist Carl Gomez said Americans make up as much as 10% of the home buyers in the British Columbia cities of Victoria and Vancouver, which have experienced double-digit price increases in recent years. Like most buyers of homes abroad, Mike Pariseau was not seeking riches when he bought his first four-bedroom house in Victoria in 1996. He and his wife, who is Canadian, had been going there for vacations and grew tired of borrowing beds from family and friends. That home proved to be such a good investment that they purchased a condominium last year where their daughter is living while attending college. Pariseau paid about $384,000 for his Canadian properties, tapping the equity in his Santa Barbara home, which has jumped in value from $210,000 to $1.2 million in the two decades since he purchased it. “As far as I’m concerned, real estate is the only way to be,” said Pariseau, a software consultant. “We’ve got some money in managed funds, but it doesn’t even come close.”

Although housing markets historically have been driven by local buyers and sellers, globalization – and the Internet – has made it easier for people in the fastest-growing markets to export their wealth. Some economists fear that if the U.S. economy hit a rough patch, heavily indebted Americans would be forced to sell their second homes or dump investment properties, triggering price drops in the U.S. as well as in places such as Baja that depend heavily on American money. Investment bank Morgan Stanley estimated this year that property prices in two-thirds of the world were either highly inflated or moving quickly in that direction. Morgan Stanley economist Andy Xie believes a global housing crash is a serious possibility.

Some worried governments are trying to cool their housing markets in hopes of engineering a soft landing. The Chinese government has raised taxes and tightened lending in an effort to tamp down prices that have doubled over the last two years in markets such as Shanghai. After the British and Australian governments hiked interest rates, housing prices in those markets started to slow. But even the threat of hurricanes, restrictions on foreign investment and soaring electricity and water bills have not damped America’s enthusiasm for Baja. Greenbacks have transformed this region into an American enclave, where English is the lingua franca, the U.S. dollar is the currency of choice and must-have accessories include a security guard, an infinity pool and high-speed Internet access.

Chris Snell, 44, president of Snell Real Estate, which handles 80% of southern Baja’s luxury properties, said his company had handled $270 million in sales since January, up from $120 million for all of last year. Snell is not worried about a housing bubble here. “When I go to Santa Barbara and I go to Napa and I see people wanting to buy homes with zero percent down, that scares me,” said the Realtor, who recently sold his own 3,200-square-foot Baja home for more than $3 million. “That is a bubble I see that can burst. When I see them coming to Cabo and buying homes with all cash and they’re involved in the deal, that doesn’t scare me.”

Much better now, thanks.

There is nothing like the wisdom of a great leader to comfort the rest of us in times of distress. Who could not have heard Winston Churchill prepare his country for the Battle of Britain without making darn sure that this was, in fact, about to be his finest hour? Likewise, who could not be filled with hope when Dr. Phil says, “Life is a marathon, not a sprint” particularly when going through airport security?

So when Ben Bernanke, one of the front runners to replace Alan Greenspan as Fed chairman was talking about housing prices on CNBC recently, no doubt many highly-leveraged Americans were hoping to hear a calming voice give them the courage to peek out from under the covers and face the implosion of the giant housing/mortgage bubble head on. “House prices have gone up a lot,” Bernanke said. In the interview, Bernanke also doubted that housing prices would ever go back down. “We’ve never had a decline in housing prices on a nationwide basis,” Bernanke said, intimating that a drop property values is about as likely as FOX stealing programming ideas from the History Channel. And that is exactly the no-nonsense kind of rhetoric we like to hear from a Fed Chairman-in-the-Running, and it is just the inspiration needed to persuade Americans with giant home equity loans that they can raise the blanket enough to let light in under the covers.

Early this year, the FDIC published a paper titled “U.S. Home Prices: Does Bust Always Follow Boom?” The FDIC concludes that even regional housing busts are not all that common. They figure that in the 20 years prior to 1998, only 17% of cities that experienced a boom found themselves in a bust within five years. The inevitability of a bust-free existence is exactly the kind of comfort, no doubt, that Bernanke was trying to bestow upon the mortgage-laden during his interview. But more soothing words may one day be required. For example, the busts discussed in the FDIC study were rolling regional misfortunes. And while not all that common, the busts that did occur followed regional booms. But today’s boom is nationwide. There is not just a boom in New England or California or Florida. There is a boom in all those markets and up and down both coasts, as well as in Las Vegas, anywhere near a lake, inside any high rise, and on any ground that has just had a small house bulldozed off it.

And the boom is a big one. The FDIC has christened this housing boom as “historic” because their count of 33 boom markets (even as of 2003!) is the highest witnessed over the past 25 years. Likewise, Business Week recently quoted Dean Baker, economist at the Center for Economic & Policy Research, who marveled that, “We’ve never seen this sort of run-up in home prices in U.S. history.” Anytime one person says that the price of anything has gone up at its fastest rate in history, and another person says that the price of that same entity will not ever go down, most poker champions would bet on the first person, particularly if the second happens to be the same guy who thinks that dropping American currency from a helicopter is sound monetary policy.

Another reason that the leveraged classes may continue to sleep with the lights on despite Bernanke’s mellow assurances is because it is not really about the housing bubble. It is about the mortgage bubble. That is because easy borrowing has kept consumer spending alive. According to the Economist, after housing prices and credit in Holland climbed at double digit rates in the late ‘90s, home prices peaked, but did not plunge. Instead, they merely flat-lined. But flat prices were enough to restrict credit, which meant fewer economy-juicing home equity loans. And that meant slower consumer spending, and for the Dutch, that meant a severe recession.

The current Fed chairman recently completed some ground-breaking research into the relationship between economic growth and mortgage borrowing like a drunken-sailor. While he claims no certainty, Greenspan goes out on a limb to speculate how we got in this pickle: “If indeed this is the case, the implied increase over the past decade in consumption expenditures financed by home equity extraction, rather than by income and other assets, would account for much of the decline in the personal saving rate since 1995.” And he speculates on the repercussions, “… leaving aside the effect of equity prices on consumption, should mortgage interest rates rise or home affordability be further stretched, home turnover and mortgage refinancing cash-outs would decline as would equity extraction and, presumably, consumption expenditure growth.”

In other words, it can happen here. Maybe. Under certain conditions. Man, that’s not comforting at all.

The wealthy hear thud of lower housing values.

Last week, news hit that home prices had fallen – a lot – in Manhattan. This headline was not lost on this former New Yorker. I spent the majority of my 6 years there dumbfounded at the scorching real estate market that shut out so many of us. Prices have risen on that 36-square-mile island for so long now that the subject has become passé. At least it was when the subject was rising prices. Now, average prices have declined by 13% in the third quarter. And on the high end, homes with four or more bedrooms, the decline was 36%. It makes you wonder how it feels to have a for-sale sign in your window.

The story does not end in the East. In San Francisco, though prices still climbed at a healthy clip in August, you can bet plenty of owners there noticed that sales declined 10%. And in speculative San Diego, sales dropped 4%.

Sure, you may be saying, but these are just the “frothy” markets that Alan Greenspan has been talking about. They have no bearing on the economy at large. Oh yeah? Then why the audible swoon among the nation’s high-end retailers? It could have something to do with the disproportionate amount of spending power wielded by the “haves”. Look at it this way: The average 50- to 59-year-old in this country has saved less than $100,000 toward retirement. But the top 10% of income earners in the same age bracket have amassed 10 times that much. Something tells me the real estate boom has made the rich even richer, which makes sense – the highest-end properties have risen in value much more than middle- and low-end homes.

It stands to reason that while soaring energy prices will hit the lowest-income quartile the hardest, a decline in home prices will hurt the wealthiest among us the most. If nothing else, they will rein in their spending on frivolities such as dog walkers and personal shoppers to save enough cash to retain their position on top of the pyramid. That is not to say those in the middle will escape unscathed. The middle class has been the most prone to live beyond their means, using their houses as lender-enabled vehicles to drive their consumption.

Refco collapse may roil rates.

After fueling one of the most free-spending decades on record, the cheap, fixed-rate mortgage jumped virtually overnight from its historic 40-year lows to root permanently beyond the psychologically important 6% level Thursday, where economists believe it will keep rising dramatically. Rising fuel costs, overall inflation and even the collapse of the big bond trading outfit Refco were blamed.

Low-cost fixed mortgages, a symbol of good times in the past several years, allowed home owners to refinace mortgage debt at much cheaper rates, and use the monthly savings in their new payments – typically $300 or more – to shop and keep the economy going full steam. But the new jump in mortgage costs – when combined with weaker incomes, the national deficit, skyrocketing energy prices and overpriced houses – are driving a stake into the housing bubble, analysts say. “The gusto has been squeezed out of housing, and consumers are worrying more and spending less in order to start saving,” said Hugh Johnson, chairman of Johnson Illington Advisors.

Other Wall Streeters were more pessimistic. “We’re on our way to a train wreck,” said Peter Schiff, CEO and investment chief at Euro Capital Partners. “We’ve been living in this fantasy bubble for too long. People are going to find out their pensions and homes aren’t worth what they thought.” Many investors were fearful that interest rates could go higher due to the impact of this week’s collapse of Refco, the big bond and commodities house that fed much of the trading action of hedge funds and others.

Mortgage deduction on block?

President Bush’s Advisory Panel on Federal Tax Reform is likely to propose next week a change in the deduction for home-mortgage interest that, if adopted by Congress, would have a drastic impact on the Bay Area and other regions with high housing prices. Today, a married couple filing jointly can deduct interest on up to $1 million in mortgage debt. In a meeting this week, the panel agreed to recommend lowering that limit, perhaps to the maximum mortgage that can be guaranteed by the Federal Housing Administration.

The FHA limit varies by region, but in the Bay Area and most of coastal California is $312,895. That is the highest FHA limit anywhere in the U.S. except Hawaii. But it falls far short of the typical mortgage needed to buy a house in the Bay Area, where the median price for an existing single-family home was $726,900 in the second quarter. If a Bay Area couple bought a $700,000 home and borrowed 80 percent or $560,000, they could deduct interest on up to $312,895, but not on debt over that amount, under the tax panel’s preliminary proposal. Such a plan is not likely to pass Congress, but it could spark interest in changing the hallowed mortgage-interest deduction.

The panel has not decided whether its new mortgage-interest rule would apply to existing homeowners but is likely to recommend grandfathering them in under the old law, says Jeff Kupfer, the panel’s executive director. “I think it’s dead on arrival,” says Ken Rosen, professor of real estate and urban economics at UC Berkeley’s Haas School of Business. “It’s very biased against California and New York and favorable to Texas.” The FHA loan limit throughout Texas is $172,632. That is more than enough to buy a median-priced home in Houston ($142,500) or Dallas ($149,100).

Linda Goold, tax counsel with the National Association of Realtors, agrees that the panel’s proposal has little chance of passing. But, she says, “it has to be taken seriously because of the difficult fiscal situation we’re in. Plus, if you are going to repeal the alternative minimum tax in a revenue-neutral manner, the money has to come from somewhere.” The tax-reform panel has proposed abolishing the individual alternative minimum tax, a separate and mind-bending system that raises taxes for a growing number of Americans. A disproportionately large number of Californians owe AMT, mainly because the alternative AMT calculation disallows a deduction for state income and property taxes.

Real estate experts predict that if the mortgage-interest deduction were drastically reduced, home prices would fall, especially at the high end. This would be true even if existing homes were exempted and the new rule were phased in -- a possibility the tax panel discussed. “In 1986, Congress sucked a lot of tax benefits out of commercial real estate, phased in over five years. Within five years, commercial real estate values had deteriorated by 30 percent,” says Ms. Goold.

SQUEEZING AMERICANS DRY

With rising inflation and debt payments, the household budgets of all of us are being squeezed. The picture does not look pretty. Let’s first look at inflation. Signs of rising prices – the way in which we are most influenced by inflation – are everywhere. Regular gas now costs over $3 a gallon, insurance and property tax bills are escalating, and staggering home heating costs will definitely keep Santa from coming down the chimney this Christmas. Natural gas prices are particularly worrisome as they push up the price of electricity, anything plastic, and the general cost of manufacturing. For 2006, the big effect of hurricanes Katrina and Rita will be the needed excuse to raise the cost of insuring a home by 10 to 30% (depending on where the lucky homeowner lives). Rising diesel prices push up the cost of goods on every store shelf because they have to be trucked in. The CPI data for September, scheduled for release shortly, is likely to show an annual rate of increase, over September 2004, of at least 4%.

So, how bad is inflation? In the past year, the wages and salaries of American workers have not kept up with inflation. If the CPI (currently at 4%) was honest and included rising housing prices and did not over-indulge in hedonic price adjustment, 5.5 to 6% would be the actual reported number. Bottom line: Americans are being squeezed by prices rising faster than income. As the winter heating bills pile up and rising manufacturing and shipping costs make their way to store shelves, our loss of purchasing power will only get worse.

Second, let’s look at rising debt payments. Americans owe about $11 trillion dollars – $2 trillion for consumer debt and $9 trillion for mortgage debt. As much as one-third of the loans given today are adjustable rate (this includes credit cards, ARM mortgages and home equity loans). Americans owe over $800 million in home equity loans (“HELOC”) which are mostly tied to the prime rate, with an average interest rate of 8%. Just a few short years ago, when the Fed Funds rate was 1%, these HELOC loans seemed almost “free” at 5%. Well, money is no longer free. Americans also owe over $800 billion of credit card debt with an average interest rate of 13%. Credit card debt is tied to the prime rate and like ARMs and HELOC loans, interest rates have been moving up at a steady pace. The Federal Reserve has raised interest rates 11 times since they first started tightening and several more increases are scheduled. Every time consumers are forced to pay another 2% on average for their $11 trillion of debt, they will have no choice but to raid the cookie jar for an extra $200 billion. The only problem is that most Americans have not been saving so, unfortunately, their cookie jars are empty.

Between rising prices and debt costs, how bad is it really for the average American? Our guess is that most of us will experience an increase in monthly costs of no less than $300, and many will see their monthly costs rise over $700. Credit card delinquencies, as measured at the end of the second quarter of 2005, have been heading up towards 5%. When the minimum payment increases every month along with your heating bills this winter, I am confident consumer loan defaults will keep the bankruptcy courts busy.

Before the war and hurricanes, the budget deficit was about $400 billion, and the trade deficit was $700 billion. Now, our country gets to pay for an extra couple hundred billion for energy; several hundred billion more for consumer, mortgage and Federal debt service; a hundred or two billion for the hurricanes; and another couple hundred billion for the endless war. Pretty soon this will add up to real money!

Life on financial edge to get tougher.

Deborah Falsman ran up $25,000 in credit card debt when interest rates were low, credit was easy and bankruptcy offered a simple escape hatch. Now, the school health clerk is looking at payments that could rise by hundreds of dollars a month, thanks to new federal regulations aimed at helping Americans tame their soaring credit card debt. “You think you can pay $500 or $600 a month and get it over with,” Falsman said of her credit card debt, which financed a remodeling project for her home in Denton, Texas. “But it never seems to work out that way.”

Consumer advocates are largely applauding the changes, which will take effect by Jan. 1, because they will save millions of credit card holders money by trimming what they pay in interest over time. But for those living close to the financial edge, the combination of higher credit card minimums and rising consumer costs – especially for gasoline – could push them over the brink. Bankruptcy offers one means of respite for these people, but starting October 17 that option will be much tougher to pursue. New rules will make it harder for people to qualify for Chapter 7 liquidation bankruptcies, in which they surrender most assets to creditors in return for wiping out their debt.

“No one could imagine that all of these things would line up at exactly the same time,” said Bradford G. Stroh, chief executive of Freedom Financial Network, a debt-counseling firm based in Northern California. “But they are all hitting the American consumer in the fourth quarter of 2005. On the heels of that, the overleveraged consumer’s one parachute was Chapter 7 bankruptcy and that parachute is closing.”

DEFLATION’S REVENGE ON ILLUSORY WEALTH

Deflation is the unknown that scares gold bugs the most. The typical hoarder of gold is contemptuous of paper assets in general and of fiat currency in particular. He is hostile toward the very idea of central banking, convinced that the bankers, by pushing easy credit, have brought the global financial system to the brink of collapse. And he believes, most fervently of all, that only a hoard of bullion will see him through hard times unscathed.

But what if deflation produces times so tough that even bullion sinks in value because it has become unaffordable? Gold bugs should be comforted that bullion’s purchasing power held up well during the Great Depression. Moreover, at the time, gold had competition from a fundamentally sound dollar that, to put it mildly, no longer obtains. In fact, with no gold or silver behind it, the dollar has become intrinsically worthless, bereft of any backing save the blood, sweat and tears of earnest taxpayers.

So how, then, will this manifestly worthless cash become “king”, as the textbooks say cash must in a deflation? Actually, the textbooks will have to add a new chapter, since this will be the first time in history that debt deflation will have occurred in a world drowning in bogus money. Some would argue that it is a case of the irresistible force meeting the immovable object, i.e., that the existence of one precludes the other. But if you wipe out all of the credit money and run the economy on cash alone – which is what I believe will happen – cash money will become sufficiently scarce to rival gold in purchasing power.

Whatever happens, gold bugs are unlikely to bear the full brunt of a deflation. As I have implied above, they will possess an asset that probably can do no worse than hold its purchasing power. But if the global economy plummets into darkness, do not expect a few ingots and doubloons to finance a retirement in Switzerland. My reservations about gold are rooted in the fear that we will experience an actual plunge, rather than a gradual slide, into economic winter. To put it as bluntly as I can, I believe there is a more-than-negligible chance that we will awaken one morning to a financial cataclysm that has left us all flat broke, meaning, for one, bereft of liquid savings that could conceivably be exchanged for bullion.

Although nearly everyone seems to think the Fed will effect some sort of bailout before a meltdown occurs, the fact is, there is no practical way to do so. An administered hyperinflation is most certainly not the answer, since it would destroy savers and lenders as a class, rendering the bond markets largely inoperable for perhaps a generation. Far more likely is that liquidations will simply be allowed to run their course, punishing sinners more or less in proportion to their sins.

A global financial panic is certain to stampede savings into Treasury paper. But gold bugs may be deluding themselves to think that any subsequent disintermediation would favor gold assets above all others. In the first place, cash credit for the purchase of precious metals will have been reduced by liquidations to a tiny fraction of the amount currently available. Secondly, what crumbs remain of the world’s liquid savings will likely go not into bullion, but toward survival. Well down the financially flattened household’s list of budget priorities will be the need to purchase bullion to protect one’s paltry remaining net worth from the ravages of inflation.

When the workout teams tote up assets and liabilities, the post-mortem will show that America’s economic engine had been running on fumes for years and that most of our supposed wealth was merely a credit-induced mirage. In the event, gold can be counted on to hold its value relative to all else, and that is why physical bullion, if not necessarily shares, should be in every investor’s portfolio. But $1,000 an ounce? That could be hoping for too much in a worldwide depression that has virtually wiped out savings and pushed Europe’s, Asia’s, and America’s middle class to the threshold of destitution.

COMPANIES HAVE NOT BEEN IN SUCH ROUGH SHAPE SINCE THE DEPRESSION

More than $88 billion of U.S. corporate debt is teetering on the edge of investment grade and soon may join the record amount of bonds downgraded to junk this year. Hertz Corp., the world’s largest car rental firm, and radio broadcaster Clear Channel Communications are among 46 companies that probably will be categorized as noninvestment grade, according to credit-rating company Standard & Poor’s. A surge in debt-financed takeovers and concern that higher oil prices will hurt profit growth is eviscerating credit quality in the $5 trillion market for corporate bonds, according to some strategists.

Investors face greater risks, while companies once considered safe and now classified as so-called “fallen angels” may see borrowing costs rise. Not since the Depression of 1929 has corporate America received so many black eyes. GM, the world’s largest automaker, Sears Holdings Corp., the biggest U.S. department store chain, and Eastman Kodak, the largest photography company, led 27 borrowers whose $499 billion of outstanding debt obligations suffered the ignominy of being downgraded to junk. And if history is any guide, there will be no rebound soon. “You don’t see companies get downgraded and work their way up, by and large,” said Greg Peters, head of U.S. credit strategy at Morgan Stanley.

IT IS TIME TO TAKE SERIOUSLY A U.S.-LED GLOBAL RECESSION, SAYS CHINA

I think it is time that we should take a serious look at the possibility that the U.S. is going to take us down towards a worldwide recession in one or two year’s time. It is well known that the U.S. is the world’s biggest economy, taking up about 30% of global GDP, but it is now also the world’s biggest debtor country. According to the most authoritative person on this subject, the U.S. Comptroller General David Walker, who audits the federal government’s books, the tab for the long-term promises the U.S. Government has made to creditors, retirees, veterans and the poor amounts to $43,000 billion, $145,000 per U.S. citizen, or $350,000 for every full-time worker.

The Americans have been living way beyond their means for much too long. On top of this, the Bush Administration is cutting tax at least three times while fighting an expensive war in Iraq, which has already cost the country $700 billion, and currently progressing at $5.6 billion per month. Now the U.S. economy is dependent on the central banks of Japan, China and other nations to invest in U.S. Treasuries and keep American interest rates down. The low rates keep American consumers snapping up imported goods.

Any economist worth his salt knows that this situation is unsustainable. This includes the country’s economic guru driver Alan Greenspan, who recently warned his countrymen that the federal budget deficit would hamper the nation’s ability to absorb possible shocks from the soaring trade deficit and the housing boom. Now he may have to add two more worries: soaring oil prices and cyclones.

The U.S. is now clearly in huge trouble, economically, socially, politically, and internationally. The Bush Administration bungled big in cyclone Katrina’s aftermath in New Orleans, and then a minor rerun from Rita in Houston, and this will trigger the general outburst of people’s dissatisfaction with the government, leading to great internal turmoil lasting for many years. In all likelihood, long-term interest rates are going to rise, and the greatest property bubble the world has witnessed is going to burst in the next one to two years.

The countdown is in progress, and there is no way that anybody can do anything to reverse it either by short-term measures such as fiscal and monetary policy, or through long-term reform of tax policy, entitlement programmes and even the entire federal budget. This is as inevitable as gravity, and it will take place under a new and inexperienced chairman of the Federal Reserve Board. I do not want to sound alarmist, but I see very bad omens.

To us, the good news is that when the country is in deep trouble, the U.S. will not have the energy to pick on China. This will provide a much more amicable environment for China to make good use of its “period of strategic opportunity” till 2020 for the country to pass through a turbulent zone between per capita income of $1,000-3,000. But in the short term, now the U.S. not only sneezes, and all symptoms indicate that it is going to suffer from a SARS-like trouble, the whole world should take extra precaution not to get infected.

U.S. investment income close to “tipping point”.

The U.S. may be approaching a dangerous “tipping point” in its international transactions. At the end of last year, foreign investments in the U.S. were worth $2.5 trillion more than this country’s investments in the rest of the world. Yet last year, those U.S. assets abroad remarkably still earned $30 billion more than the foreign assets here.

That stunning disparity in returns is one of many reasons why the huge U.S. current account deficits of recent years have been so readily financed. The sagging net investment position was not being compounded by an ever higher interest bill – as is the case with the mounting U.S. government debt. This year the game has changed. Net U.S. investment income turned negative by $455 million dollars in the second quarter, marking a swift deterioration from a $15 billion surplus in the first three months of 2004.

If this trend continues – and there is no reason to think it will not – the U.S. will be paying a steadily rising net amount to foreigners, and those payments will both increase the U.S. current account deficit and worsen the country’s net investment position. In a recently published analysis, economists Pierre-Olivier Gourinchas of the University of California at Berkeley and Helene Rey of Princeton University warned this situation could have serious consequences for the U.S.

BLACK EYE FOR BURGEONING FUTURES INDUSTRY

The invitations are already landing for “Futures and Options 05” in Chicago next month, a banner event for a derivatives sector which has enjoyed unprecedented growth over the past 12 months. The mood was expected to be celebratory, both because of record trading volumes being enjoyed by participants and its success in attracting fresh funding as the business met the investment challenge of taking its risk-management products to a global client base with electronic, round-the-clock trading.

The accounting irregularities surrounding Refco, one of the industry’s most high-profile and innovative participants, could not have come at a worse time and threaten to dampen the mood of participants broader than Refco and its client base. Refco is the largest of the independent brokers – known as futures commission merchants (FCM) – in competition with the brokerage arms of larger banks such as Goldman Sachs, Citigroup, JP Morgan, and UBS. The company ranked 5th in terms of U.S. customer segregated funds, a standard industry measure, following its acquisition of Cargill Investor Services in August. It was also the largest source of customer-transaction volume on the Chicago Mercantile Exchange, the world’s largest futures exchange. Refco’s initial public offering in August built on the momentum generated by the CME’s own flotation at the end of 2002; since then its share price has climbed almost 10-fold. This in turn has influenced the decision of the Chicago Board of Trade to go public, an issue due as early as next week.

“When the CME went public, everyone goes ‘Wow, there’s gold in our hills,’” says one industry observer. “But when you see the first standalone broker [in trouble], that doesn’t help the industry at all.” Phillip Bennett, the ousted Refco chief executive at the centre of the current probe, was viewed by his peers as an entrepreneurial spirit “who created some real efficiencies in the operation,” according to one rival. Within the Chicago trading community there was a sense of unease and disbelief at the unravelling of events. Moreover, Refco president Joe Murphy – who is not implicated in Refco’s internal probe – also chairs the board of the Futures Industry Association, which represents FCMs. “[This is] a total black eye for the industry that has been growing in importance and respectability,” said an observer.

Refco halts client withdrawals, cash is not sufficient.

Refco Inc., reeling from the disclosure that its chief executive officer hid unpaid debts, blocked clients from withdrawing funds and said one of its units does not have enough liquidity to keep doing business. The New York-based firm imposed a 15-day moratorium on withdrawals from Refco Capital Markets Ltd. and said the unit, “which represents a material portion of the business of the Company, is no longer sufficient to continue operations.” The company said activities at its regulated futures brokerage were unaffected. Refco had $4.9 billion in customer accounts on August 31, making it the 8th-biggest futures broker by that measure after banks such as Goldman and Citigroup Inc.

The announcement came a day after U.S. authorities arrested Phillip Bennett, CEO until he was suspended by the company October 10, and charged him with securities fraud. Bennett, 57, hid $430 million in unpaid debts dating to 1998, Refco said, adding that its accounts for the past three years could not be relied on. Bennett and unidentified accomplices “hid from investors and regulators hundreds of millions of dollars that one of Bennett’s companies owed to Refco,” U.S. Attorney Michael Garci said. The criminal complaint against Bennett, who made $145 million from the IPO, lays out a scheme that the government claims began at least as early as 2004 and continued through this month. According to U.S. officials, Bennett used loans as large as $545 million to a customer to conceal debt owed to Refco by a separate company that he controlled, Refco Group Holdings Inc.

Refco bonds plunge as second unit closes.

Futures and commodities broker Refco Inc. struggled to survive on Friday as it began shutting down another unit and its bonds plunged further, fueling fears of a bankruptcy filing. The Refco Securities unit of Refco has told the Depository Trust Company that it is beginning to wind down its business, according to a posting on the DTC Web site dated October 13. DTC provides clearing, settlement and infromation services for stocks, bonds and many derivatives. That followed the halting of activities at its Refco Capital Markets unit on Thursday.

The U.S. S.E.C. said on Friday that it restricted the ability of two Refco units’, including Refco Securities, to make withdrawals of equity capital or unsecured loans or advances. Bonds issued by Refco dropped 17 cents on the dollar to 23 cents Friday morning, according to MarketAxess, indicating investors believe a bankruptcy filing is highly possible.

More Refco Victims

As the Refco affair continues to unravel, Wall Street will likely be the target of angry investors wanting their money back – so caveat emptor. Goldman Sachs Group, Credit Suisse First Boston and Banc of America Securities each could be on the hook for more than $200 million in legal liabilities in the initial public offering of Refco stock. These investment banks were the lead underwriters on Refco’s August 11 IPO. One of the hottest new issues of the summer, shares in the derivatives and commodities trading firm opened above their target range and surged 25% in the first trading session.

But now it appears that Refco’s financial statements had some serious errors. The U.S. attorney in New York has charged former CEO Phillip Bennett with securities fraud. Bennett took leave from the company this Monday, amid accusations that he hid $430 million from investors. He paid that amount to the company the day he took leave. The U.S. attorney says Bennett defrauded investors in Refco’s initial stock offering.

In recent years, banks have been held accountable for preparing securities issues for companies that were later found to have engaged in fraud. WorldCom’s banks have forked over billions of dollars, including more than $2 billion each from Citigroup and JPMorgan Chase. WorldCom, of course, crumbled into insolvency, after a massive $11 billion accounting fraud was uncovered. Its former chairman and chief executive, Bernard Ebbers, was sentenced to 25 years in a federal prison, though he is appealing the conviction.

Refco has been advised by some of Wall Street’s best and brightest, including the three firms already mentioned, as well as outside auditors Grant Thornton and buyout firm Thomas H. Lee Partners. But the stock underwriters could be especially vulnerable to shareholder lawsuits. Refco shares have plummeted 60% this week and are trading at around $10. The IPO raised $583 million, with the stock opening at $22 per share and peaking at more than $27 per share.

World’s hedge funds face crisis as Refco suspends trading.

A crisis in the world’s hedge fund industry was in prospect after one of the world’s largest derivatives brokers was forced to freeze trades potentially worth billions of pounds. The move by Refco, which acts for many leading speculative investors both on Wall Street and in the City, followed the discovery of accounts irregularities at the firm earlier this week and the issue of fraud charges against its former chief executive Phillip Bennett.

The implications of the 15-day trading moratorium on the company’s Refco Capital Markets subsidiary may be felt across the world financial system, depending upon the size of the funds caught up inside Refco and the types of institutions which are unable to remove their money from the operation. While the company gave no details of the size of the funds it had tied up in its capital markets arm, it described the operation as representing a “material portion” of its business. The capital markets arm is an offshore broker for stocks, bonds and currencies and is the subsidiary that 57-year-old Mr Bennett allegedly used to help hide the debts. He is accused of moving debts in and out of the subsidiary to hide the fact that it was counting debts as revenues which it was in reality unlikely to receive.

BIG BOOST IN CHECKS TO RETIREES

Thanks to resurgent inflation, Social Security recipients in 2006 are likely to get their biggest cost-of-living increase since 1991. Cost-of-living adjustments, or COLAs, are based on the average inflation rate for the third quarter (July, August and September) of each year compared with the previous year. On Friday, the government will release inflation data for September and Social Security will be able to calculate next year’s benefit increase. Based on actual data for July and August and an estimate for September, that number could come in around 3.8%.

That would be highest annual increase since January 1991, when benefits jumped 5.4%. Since then, the annual raise has been above 3% only twice – 3.7% in 1992 and 3.5% in 2001. This year’s increase, effective Jan. 1, was 2.7%.

Offsetting the increase will be rising premiums for Medicare Part B, which are deducted from most people’s Social Security checks. The government announced last month that the Medicare Part B premium for most people will go up by $10.30 per month (or 13%) to $88.50 per month. Part B helps pay for doctor’s bills, outpatient and other services not covered by Medicare Part A, which covers hospital stays.

STINKY WATER, SWEET OIL, PART II

America’s oil shale reserves are enormous, totaling at least 1.5 billion barrels of oil. That is five times the reserves of Saudi Arabia! And yet, no one is producing commercial quantities of oil from these vast deposits. All that oil is still sitting right where God left it, buried under the vast landscapes of Colorado and Wyoming. Obviously, there are some very real obstacles to oil production from shale. After all, if it was such a good thing, we would be doing it already, right? “Oil shale is the fuel of the future, and always will be,” goes a popular saying in Western Colorado.

But what if we could safely and economically get our hands on all that oil? Imagine how the world might change. The U.S. would instantly have the world’s largest oil reserves. Imagine … having so much oil we would never have to worry about Saudi Arabia again, or Hugo Chavez, or the mullahs in Tehran. And instead of ships lined up in L.A.’s port to unload cheap Chinese goods, we might see oil tankers lined up waiting to export America’s tremendous oil bounty to the rest of the world. The entire geopolitical and economic map of the world would change … and the companies in the vanguard of oil shale development might make hundreds of billions of dollars as they convert America’s untapped shale reserves into a brand new energy revolution.

Presidents Gerald Ford and Jimmy Carter may have been entertaining similar ambitions in the late 1970s when they encouraged and funded the development of the West’s shale deposits. A shale-boom ensued, although not much oil flowed. The government spent billions and so did Exxon Mobil. New boomtowns sprung up in Rifle, Parachute, Rangely, and Meeker in Colorado. And then came Black Monday. May 2, 1982. The day Exxon shut down its $5 billion Colony Oil Shale project. The refineries closed. The jobs left (the American oil industry has lost nearly as many jobs in the last ten years as the automobile and steel industries.) And the energy locked in Colorado’s vast shale deposits sat untouched and unrefined.

Extracting oil from the shale is no simple task. The earliest attempts to extract the oil utilized an environmentally unfriendly process known as “retorting”. Retorting required mining the shale, hauling it to a processing facility that crushed the rock into small chunks, then extracted a petroleum substance called kerogen, then upgraded the kerogen through a process of hydrogenation (which requires lots of water) and refined it into gasoline or jet fuel. But a new technology has emerged that may begin to tap the oil shale’s potential. Royal Dutch Shell, in fact, has recently completed a demonstration project (The Mahogany Ridge project) in which it produced 1,400 barrels of oil from shale in the ground, without mining the shale at all. Instead, Shell utilized a process called “in situ” mining, which heats the shale while it is still in the ground, to the point where the oil leaches from the rock.

Does it really make sense to heat the ground up a thousand feet down for three or four years and wait? Of course it does. According to Shell’s Terry O’Connor, Shell could harvest up to a million barrels per acre, or a billion barrels per square mile, on an area covering over a thousand square miles. It is still early days in the oil shale fields of Colorado and Wyoming, but it looks to me like someone is gonna make a lot of money out there. I am working hard to discover how we outside investors can play along.

Stinky Water, Sweet Oil … The Last Word

Last week, I paid a visit to Royal Dutch Shell’s oil shale project in Colorado. The visit left me with more questions than answers, but I came away from the place with the sense that this opportunity is very real … or, at least, it soon will be. After driving across a vast expanse of “Nowhere”, Colorado, my brother and I met up with a few geologists from Shell. Of course it is just those large, unpopulated tracts of high desert that make the area so appealing from a geopolitical point of view. Tapping into the oil shale 2,000 feet underground is not going to bother too many people. And there are no spotted owls around either. If the technology to turn shale into oil works, the entire area will become a new American boom patch.

Shell thinks the whole thing is economic at a crude price of $30. So barring a major reversal of geopolitical trends, they are forging ahead. Since the Bureau of Land Management owns about 80% of the oil shale acreage in Colorado, there is no investment play on private companies that might own land with rich shale deposits. Although, if Shell and the DOE are right that you can recover a million barrels of oil per acre, it would not take much land to make a man rich out here.

There is dispute within the industry over how long, if ever, demonstration extraction technologies can become commercially viable. I have spoken with some of the smaller companies that have applied for leases from the BLM. Some of them will have to raise money to conduct the project. And some of them have been less than forthcoming about how exactly their extraction technology is different or better than previous methods. How will it all unfold? Well, for starters, it could all utterly fail. To me, Shell’s in-situ process looks the most promising. It also makes the most sense economically. There may be a better, less energy-intensive way to heat up the ground than what Shell has come up with. But Shell, Chevron, and Exxon Mobil clearly have the resources to scoop up any private or small firm that makes a breakthrough. And there are a host of smaller firms involved with the refining and drilling process that figure to play a key role in the development of the industry, should that development pick up pace.

WHAT TO DO ABOUT CHINA AND THE YUAN?

Richard T. Wilkey, who runs a small Wisconsin company that makes cutting blades for lawn mowers and harvesting equipment, worries that he will soon be vulnerable to competition from China. But he is afraid that by the time he gets help from Washington, it may be too late. As a result, Mr. Wilkey, a longtime member of the National Association of Manufacturers and a loyal Republican, finds himself at odds with a number of much bigger industrial companies and with President Bush over how to deal with China. He wants the administration to pressure the Chinese to increase significantly the value of their currency now, not months from now. “If we get their currency valued as it should be – 40 percent higher than it is today – that will give all of us a measure of protection,” said Mr. Wilkey, who is president and principal owner of Fisher-Barton, the company based in Waterton, Wisconsin, that manufactures the cutting blades and other parts for farm equipment.

Revaluation means the Chinese would have to charge more in dollars to earn the same revenue in their currency, pushing manufacturers there to make their exports more expensive in the American marketplace. That would ease the pressure on Mr. Wilkey and on other small manufacturers. Many big manufacturers export to the U.S. from factories in China and benefit from a weak yuan. The growing rift among manufacturers over trade policy comes with Treasury Secretary John W. Snow in China this week hoping to persuade its leaders to move more quickly on the currency front. While the rift is a challenge to the administration’s more cautious approach, it also is a warning signal to the Chinese of a potential protectionist backlash in the U.S. if they do not revalue the yuan more rapidly.

The administration still favors gradual revaluation, achieved through negotiations, says Tony Fratto, acting assistant secretary of the Treasury. So do multinationals like Whirlpool, which makes microwave ovens in China and exports them to the U.S. The unified support from the business community that President Bush enjoys on almost every other issue breaks down over China policy.

THE BOOMING (AND BUBBLING) 51ST STATE

“I used to drive out on the island … you could see the ocean and the beautiful views … and you could stop off one of the little restaurants along the way … enjoy a cold beer, a nice steak. Now, you see nothing but housing developments and the traffic is horrible.” My grandfather was telling me about the changes in Puerto Rico over the last several years.

Puerto Rico is a Commonwealth – existing in the gray area of non-statehood, a sort of vassal in America’s empire, a prize in a long-forgotten war with Spain. Puerto Ricans have voted many times before on the issue of statehood. The voting has been very close. So far, the status quo has won out. But the last election fiasco was eerily similar to the U.S. presidential election in 2000, with the Supreme Court of Puerto Rico casting the deciding votes, along party lines, that sent their man into office. Statehood lost its closest contest yet. I am confident that at some point in the not-too-distant future, Puerto Rico will join the Union as the 51st state.

Until then, it will continue to mirror the U.S. in other ways. Puerto Ricans seem to love SUVs and fancy cars as much as continental Americans. Consumerism is also in vogue, with retail chains such as Walgreen’s, JC Penney and Macy’s enjoying success here. Plus, nearly 70% of the island’s workers are employed in service industries. And Puerto Ricans, too, have their own housing boom. For years, Puerto Rico’s housing market reliably appreciated 5-10% per year. This year, the market is getting hotter. In 2005, the average sales price is about $311,000 – up nearly 16% from 2004. Nearly 75% of Puerto Ricans own their own home.

It is no wonder prices are rising. Population density is among the highest in the world, with nearly four million people living on an island of about 3,500 square miles. By some estimates there is a housing shortage, with 100,000 more units needed. Still, as in the mainland U.S., the housing bubble is also being fueled by cheap credit. Curiously, while late payments occur four times more often than on the mainland, Puerto Ricans are less likely to wind up in foreclosure. As in the mainland, there is also cause for worry. Basically, the islanders have succumbed to the temptation of using their home as an ATM machine – just like Americans.

Doral Financial is the dominant mortgage company on the island, with 40 branches and $11 billion in assets. Doral enjoyed a stellar run over the last 10 years – its stock price rose more than 8,000% from 1995 to its 2005 peak. Then in March of this year the stock was ripped in half, on news that the company was being overly aggressive with its derivative portfolio and would write off hundreds of millions of dollars. But the beating was just getting started. Downgrades from various analysts continued to push the stock lower. Then the credit agencies got in on the act, with Fitch downgrading the company as well. Eventually, the stock hit bottom under $10 per share, but has since rallied.

Today, however, I am inclined to stay on the sidelines with housing – if not actively bet against it. When the housing bubble finally finds its pin, it will be like an ATM machine that no longer dispenses cash. That will not be good for banks, homebuilders, credit card companies and a slew of other businesses that have, to date, prospered in the credit-induced revelry of the housing boom. Freeman Tilden, in his book A World in Debt (published in 1935, but still a terrific read), described fortune as a “willful jade” that set about victimizing human beings, “especially debtors.” Credit cycles turn, dear reader, and this one will turn also – both in the mainland U.S. and in the future 51st – and anywhere else easy money has left her unmistakable footprints.

DECLINES THAT ARE NOT “SUPPOSED” TO HAPPEN?

What can be more frustrating than watching your stock portfolio decline? To watch it fall when declines are not “supposed” to happen. Just ask Apple Computer shareholders. Yesterday (Oct. 11) the company reported that its quarterly earnings quadrupled – which, in turn, has led to a 5% drop in its share price. (Media reports say revenue was “weaker than expected”.)

You could likewise ask AMD shareholders. The chipmaker reported a 44% rise in sales from a year earlier, and a 73% leap in quarterly profit – yet its share price has fallen some 14% over the past two trading sessions. (In this case AMD’s earnings were far stronger than expected, so the media was fresh out of lame excuses.)

In fact, the “earnings up, stocks down” trend has probably cost MOST stock investors sleep during the past month. Among the S&P 500 companies that have reported so far, Q3 earnings are running an average 26% higher than year-earlier results. What is more, these earnings have come in 9.8% higher than the mean expectations of analysts. And the S&P 500 Index itself? Down 5% since September 12.

The notion that “earnings drive stocks” is complete fiction. If the market’s dominant trend is downward, that trend will make a mockery of earnings – exactly as it has in September and October. So: if the market’s direction is the question, what can the chatter about “earnings” do except produce more frustrated investors?

THE NEWEST BULL MARKET … IN REAL ESTATE!

You heard it here first: the new bull market in residential real estate is under way. According to SNL Financial, apartment REITs are up 21% over the past 12 months. That is a little higher than the average REIT, and way above the S&P 500’s 6.9% return in the same period. Apartment vacancies in the country’s top 70 markets are down, according to www.reis.com. During the third quarter, vacancies fell to 5.9%, down from 6.6% during the same period last year. And, as you would expect, fewer vacant apartments mean higher prices. As vacancies fell, rents rose 1.2%, net of all concessions (things like free first month’s rent, for example). Lloyd Lynford, CEO of reis.com, says that landlords are offering fewer concessions. Fewer concessions mean that the apartment market is favoring landlords instead of renters. “I am pretty comfortable saying that the apartment recovery has taken hold,” Michael Cohen, an economist at Property & Portfolio Research in Boston, told the Wall Street Journal.

When insider selling among REITs hit a 3-year high earlier this year, our recommended apartment REIT’s CEO was the only insider actually doing some buying. He said he thought the share price was low and he did not think the market was recognizing the true value of the company’s apartments. It is a sleepy little stock in a boring business, but it is already produced a total return to shareholders of over 13% since January, much of that in cash dividends. And it is still within pennies of our maximum buy price. I can hardly think of a better business to be in right now. If high-energy prices persist and interest rates go up, marginal homebuyers will become apartment renters. Everybody has to live somewhere, and when you cannot afford to buy, you rent.

CUTBACK IN R&D SPENDING RAISES RED FLAG

Are companies squandering the future keeping their shareholders happy? While third-quarter corporate profits, being reported now, are expected to soar an additional 15% compared with the year-ago quarter, companies are shoveling much of their fat cash flows back to investors through dividends and share buybacks. In the process, research and development, better known as R&D, is being ignored.

Companies spent slightly less on R&D as a percentage of revenue in the second quarter than they did a year ago, according to a USA TODAY analysis of Capital IQ data, looking at members of the S&P 500 index. Spending on R&D by companies in the benchmark S&P 500 index has grown 3.3% over the past four quarters, well below the 11.6% growth in revenue during the same period, S&P says. Meanwhile, the dollar value of stock buybacks and dividends, two ways to return cash to shareholders, jumped 92% and 13%, respectively, in the second quarter, says Howard Silverblatt, market analyst at S&P.

The lackluster R&D spending concerns some. Companies “are going to have to increase sales, and to increase sales, they are going to have to increase other things like R&D,” Silverblatt says. One reason companies are R&D averse: They fear investor retribution. In a reversal from the late 1990s, when dividends were dissed and companies could not spend enough on R&D, investors now want executives to return cash to them, says Jim Paulsen, strategist at Wells Capital Management. Investors and executives fear R&D spending is “being thrown down a rat hole,” Paulsen says.

A new study by consultant Booz Allen Hamilton encapsulates these fears. It found that big R&D spenders do not get returns on their outsized investments and that R&D spending has no effect on growth, profitability or shareholder return. R&D is “a roll of the dice of what you will get back,” says Barry Jaruzelski, vice president of Booz Allen and co-author of the study that looked at 1,000 companies going back six years. But Paulsen says the study’s methodology is flawed because it began measuring the effectiveness of R&D spending right when it was peaking and the economy tanked. Tracking the yield of R&D spending back 30 or 40 years would likely have contrary results, he says.

PROSECUTORS CHALLENGE LEGAL DEFENSE FEES FOR ALLEGED CORPORATE MALFEASANTS

An unprecedented legal maneuver by federal prosecutors may threaten the legal fees that corporate executives rely on from their employers. The maneuver surfaced during the retrial of two former executives of Westar Energy Inc., chairman and chief executive officer David Wittig and chief strategic officer Douglas Lake, who were accused of stealing $37 million from the Topeka-based utility. Prosecutors perceived Westar as the “victim of a crime”, Jim Cross, a spokesman for the U.S. Attorney for the District of Kansas, explained. “We do not believe that a victim should be required to pay the legal fees of a defendant.”

Westar’s bylaws, like those of many public companies, require it to advance to executives any reasonable legal fees and expenses arising from their employment. Prosecutors argued that this right was forfeitable because it was linked to their alleged misconduct. In attacking Westar’s indemnification and legal-fee agreements, prosecutors reportedly obtained a broad restraining order on Wittig’s and Lake’s assets, including the defendants’ rights to the advancement of legal fees.

“We were horrified,” said Susan Hacket, general counsel for the Association of Corporate Counsel, that the government had discovered that “a good way to roll the defendant is to prevent them from even raising a defense.” The trial judge ultimately placed the legal fees in escrow and let the jury decide the issue. Last month Wittig and Lake were convicted on multiple counts, including fraud and conspiracy, but the jury reportedly found that their right to advancement of legal fees was not tied to their conduct, and thus not subject to forfeiture.

Most executives named in lawsuits against their employer would be “hard-pressed” if they had to pay for litigation costs out-of-pocket every time the company was sued, argued Hacket. That is particularly true if the defendant’s personal assets are frozen. The Supreme Court let stand a lower-court ruling against two former executives of Gemstar-TV Guide International. That ruling effectively bolstered the ability of the SEC to freeze payments to corporate executives under Sarbanes-Oxley.

Stock-research lawsuits not paying off.

Investor lawsuits based on allegations of faulty stock research may not be as lucrative as plaintiffs’ lawyers had believed. Levin, Papantonio, Thomas, Mitchell, Echsner & Proctor, one of the nation’s largest class-action law firms, settled approximately 300 claims against Merrill Lynch for about three cents on the dollar, for a total payout of $2 million. “After all the apocalyptic prediction, we have overwhelmingly prevailed … because the plaintiffs’ lawyers could not show their clients saw misleading reports or relied on them,” said a Merrill Lynch spokesman.

Another law firm, Hooper & Weiss LLC, has reportedly filed about 1,000 cases against Smith Barney, also charging that the brokerage house issued faulty research. Only 232 cases have been decided so far, and the Hooper & Weiss record stands at just 76 wins and 156 losses, with a total payout of $1.7 million in damages. Investor lawsuits have been piling up over the last two years, following the so-called global settlement of 2003, in which 10 Wall Street brokerage firms agreed to pay regulators a collective $1.4 billion for issuing dubious equity research in exchange for investment banking business.

THE GREAT RESOURCE BULL MARKETS, THEN AND NOW

A quick refresher: the last great resource bull market, roughly from late 1971 to early 1980, saw, among other things, gold rise 2,390%, silver 3,487% and crude oil 1153%. Naturally, a number of geopolitical and economic factors contributed to these gains. In an attempt to add some structure to this exercise, I will set out to compare the resource sector of the 1970s to that of today.

In 1970, “mining” was not the dirty word it has become in today’s politically correct world. Back then, getting a degree in geology or mining engineering was a perfectly acceptable career move, and such training could be had at any number of prestigious universities. Today far more geos are retiring than graduating. You can see this at any mining convention: it is a sea of gray hair, or no hair at all. This may be bad for mining companies, but it can be positive for investors: the dearth of experienced exploration geologists and mining pros limits discoveries of new deposits and keeps supplies tight. It also makes it easier for us to identify promising companies. They are the ones attracting the best talent.

In August 1971, after years of Johnson’s “guns and butter” policy and its consequent inflation, Nixon unleashed the price of gold. Nixon’s move had nothing to do with promoting free markets, about which he could not have cared less – as demonstrated by his simultaneous implementation of idiotic wage and price controls. De-pegging the gold price was really about defrauding the Europeans, who kept trading increasingly worthless American currency for gold at $35. In a classic case of unintended consequences, the dollar lost ground against gold further and faster than Nixon ever dreamed possible. Given that the same kinds of moronic domestic and foreign policies at large in the 1970s are at work today, we have good reason to think prices will take off like they did three decades ago, starting from a similar low base.

Many people think commodity prices are higher now, but in inflation-adjusted dollars many key commodities are actually cheaper than they were before the last great commodities bull market peaked. For example, the current “record high” crude oil price of $68 is only $31.63 in 1981 dollars, when oil peaked at C$38.34. Gold, at $440, is only $185.55 in 1980 dollars, when gold peaked at $850. In fact, at $440 in 2005 dollars, gold is actually lower than it has been in 30 years, save for the 2000-2003 period when it bottomed. At $1.73, copper today is at about half of the 1980 peak of $1.44. This does not mean prices cannot temporarily go lower – for the short-term, given my overall pessimism about the U.S. economy, I am particularly concerned about base metals – but it does paint a bullish picture for commodities for years to come.

At the right commodity prices, there is literally an infinite amount of mineral wealth out there. But mines are not like a McDonald’s that you can knock together in a few weeks on any given street corner. A typical exploration cycle – the time it takes to find and evaluate a mineral deposit – is about two years. If a property appears economic, then the company has to engage in a lengthy and bureaucratic permitting process (ensuring there are no semi-rare salamanders in the area, for example). They also have to do the extensive and expensive drilling and mine plan analysis required to complete a bankable feasibility study, as well as raise the small mountain of cash necessary to keep the process moving along. The bottom line is that it takes a long time to bring a mine into production, which means that for many metals, supply is relatively, if not absolutely, inelastic.

Of course, for prices to rise in real terms, demand has to outstrip supply. On the supply side, the situation looks extremely bullish for silver, copper, nickel and gold – significant new mine production of these metals is unlikely to be realized in the near term. But will demand continue to rise? As long-time readers know, I believe commodities are ultimately trending toward zero (once nanotechnology and other major new technologies live up to their potential), but we are a long way from there.

At this stage of the super-cycle, more people have access to markets than ever before, increasing their standards of living and therefore increasing their demand for resources. Starvation was a common phenomenon in the ‘70s; now former basket cases such as China and India are emerging as world economic powerhouses. Such developments never go smoothly, of course, and I am concerned by the possibility of a cooling in the global economy affecting many things – base metals in particular. Long-term, however, the question is not “if” demand for commodities will grow, but, “How fast?”

BIRD FLU AND … ELLIOTT WAVE?

The spread of bird flu has dominated European headlines this week. When R.N. Elliott first discovered Elliott Wave Principle back in the 1930s, he applied it to forecasting the stock market. But later, Elliott’s successor Robert Prechter observed that stock market trends reflect far more than stock prices. First and foremost, stocks mirror the ups and downs of society’s overall mood state – or social mood, as we call it.

In a nutshell, a rising (“bull”) stock market indicates improving social mood, while a falling (“bear”) market signals that society’s mood is worsening. Bob Prechter observed that how a society “feels” has a major impact not only on the stock market, but also on the whole of our collective lives. For example, there is a clear correlation between bull and bear markets and trends in music, fashion, politics, sports, religion, and many other social and cultural manifestations. We have also established that throughout history, there has been a definite connection between bear markets and epidemics.

When we look at epidemics such as the ones that occurred during and after the fall of Rome; the Black Death (Bubonic and Pneumonic Plagues) of 1350-1400; famine and cholera pandemics in Britain in 1825-1849; the influenza epidemic of 1917, etc. – there always appears to be a bear market in force, and the extent of the epidemics tends to correlate with the size of the setback in [social] mood, says Prechter. We are still examining several theories that may be able to explain it, but the fact remains: Epidemics and pandemics seem to hit populations during major negative social mood trends.

What Europen bear market? Yes, European stocks did fall hard in 2000-2002, but look at how strongly they have recovered since then. And like other cultural signs – ominous as they may be – the spread of bird flu by itself is not sufficient to make definitive conclusions. But it makes you wonder, doesn it not?

DEJA VU 1994

In many respects, it is starting to feel like 1994 again. The September CPI report – with headline inflation surging to a 4.3% y-o-y rate (projected for September) – hints at a worrisome deterioration on the price front that appears to have caught America’s Federal Reserve by surprise. In response, the Fed is now threatening to take its policy rate beyond neutrality into the restrictive zone, a major source of anxiety in financial markets. In my view, these fears are overblown. As was the case in 1994, the inflation scare of 2005 is likely to be a false alarm.

It helps to revisit the state of play in 1994. The Fed began that year with a “zero” real federal funds rate – 3% in nominal terms, in the context of 3% inflation. The central bank had held the policy rate steady at that rock-bottom level for 17 months – an unusually accommodative stance for a U.S. economy in cyclical recovery in the aftermath of the mild recession of 1990-91. The Fed was erring on the side of ease, largely in order to provide support to a beleaguered U.S. banking system that had just been through a major credit crunch only a few years earlier. And then along came a full-blown inflation scare – sparked by a 30% surge in commodity prices in late 1993. A major acceleration in core CPI inflation was perceived as being just around the corner. Beginning on February 4, 1994, the Fed tightened by 300 basis points over the next 12 months – putting an unprepared bond market through its most wrenching year in modern history. In retrospect, the inflation scare turned out to be the Fed’s foil back in 1994. Inflation fears became an all-too convenient excuse to renormalize its monetary policy.

Fast forward to the present and there is an eerie sense of déjà vu. Following a whiff of 30% commodity inflation in early 2004, a full-blown energy shock unfolded in 2005. So far, the core CPI has not budged, but fears are widespread that it is only a matter of time before there is a meaningful and worrisome acceleration of core inflation. That is entirely possible, of course, but I doubt it. With energy and labor cost pressures building, any “cost mark-up” model of inflation would be flashing a distinct warning sign. But the leap between domestic cost pressures and pricing leverage is much more of a stretch today than it was in 1994 and, for that matter, than it was over a much longer period of history. Research suggests that mounting import price and labor cost pressures have much less of a bearing on underlying inflation today than was the case earlier. The reason, in my view, boils down to one word – globalization. A breakdown of the linkage between costs and prices represents a profound shift from the inflation paradigms of yesteryear.

I suspect that the Fed is actually quite sympathetic to this line of reasoning. But I would not put it past the U.S. central bank once again to use inflation as a foil in order to provide cover for a normalization of the policy rate. As was the case in 1994, today’s Fed finally appears to have arrived at the conclusion that it can no longer afford to keep pumping excess liquidity into the system. But the subtext of this realization has less to do with inflation in goods and services and far more to do with inflation in asset markets and the imbalances that arise from asset-based suppression of national saving. Alan Greenspan has experienced something bordering on a religious conversion on this general topic recently, when he conceded that persistently low nominal interest rates can lead to a steady stream of asset bubbles. In my view, the Fed seems determined to set the policy rate high enough in real, or inflation-adjusted terms, in order to insure that it has regained traction with the real economy and asset markets. If it needs the excuse of an inflation scare to pull off the policy normalization, so be it.

History rhymes rather than repeats. There are similarities and differences between 1994 and 2005. But I am struck most of all by the common thread of a dramatic normalization of monetary policy – taking short-term real interest rates from über accommodation to an outright restrictive stance. I am also struck by the likelihood of what could eventually turn out to be yet another false alarm on the inflation front. Finally, I cannot help but wonder if the bond market rout of 1994 is a hint of what lies ahead in the not-so-distant future. After all, that is what normally happens in a current account adjustment. Carry trades could also be unwound – especially those in high-yield corporates and emerging market debt, where spreads are historically low.

THE OTHER OIL CRISIS

There is an oil crisis coming. Except that it is not the crisis you would expect. The price of oil is likely headed lower, not higher. The next oil crisis, therefore, is the looming sell-off in oil stocks that will send many of them to significantly lower prices. Today, most people feel higher oil prices are a cinch. “Everyone” knows we are in an energy bull market. “Everyone” knows about the supply bottlenecks and the voracious demand from China and the hurricanes and all that. When you start reading lead stories about a coming energy crisis in Barron’s, The Wall Street Journal, The Washington Post and other mainstream papers – it should give you some pause.

Walter Deemer is a market strategist with more than 40 years of experience, and pause he has. His advisory, “Market Strategies and Insights for Sophisticated Investors”, recently turned bearish on energy stocks. “It actually is difficult for me to imagine more perfect conditions for a long-term top,” he says in a welling@weeden interview. “We’ve had a huge, multi-year run in the stocks, even though – until quite recently – the consensus expectation was always for a pullback in the commodity price. Now, practically all we are hearing is … ‘This time is different.’” Those four little words, arranged just so, may be the most dangerous phrase in all of investing.

Deemer reports that the Bullish Consensus (an indicator that tracks the buy/sell recommendations of commodity advisories) has been running 87-88% bullish on the price of crude oil in the last several weeks and spiked to 96% bullish recently. “I have never seen a reading of 96% bullish on anything,” Deemer says. “That is an incredible extreme. At 96% bullish, we just have to look back some day and say, ‘It was obvious,’ it seems to me.” If you have any kind of contrarian streak at all, buying red-hot oil and related energy stocks should feel uncomfortable. But it is more than just contrarian comforts at play. There are sound market reasons as to why oil prices north of $60 are not likely sustainable.

Shad Rowe, in a short piece appearing in the Sept. 9 edition of Grant’s Interest Rate Observer entitled “Bearish on Crude”, laid out the basic argument for lower oil prices. In brief, higher prices are making alternatives look cheaper and changing the way consumers and businesses use energy. Rowe, relying on Adam Smith’s metaphor, observes, “The invisible hand is moving fast.” Rowe writes: “At $50 to $60 a barrel for oil, coal, nuclear power and liquefied natural gas are relatively cheap substitutes for stationary plants such as utilities. … We are already seeing extensive fuel switching at stationary facilities around the world.”

Nearly every day, I clip out some article about energy users switching to lower cost sources. In Malaysia, do not be surprised to see palm oil used as a base for diesel fuel by 2007. Even right here at home, a group called Panda Energy is hard at work building an ethanol plant in Kansas that will use a billion pounds of cattle manure each year as a renewable fuel to power the plant’s operations.

This is not pie-in-the-sky stuff, or even cowpie-in-the-sky stuff. You do not need a great imagination to see how demand for oil backs off at the margin — both from efficiency gains and the use of alternatives. Much of this demand for oil will not snap back. Once it goes, it will be gone for a long time. As Rowe notes, after the oil shock of the 1970s, it took two decades for demand to reach the level achieved in 1978 – even though the economy grew enormously over those two decades. Basically, the market adjusted – Adam Smith’s invisible hand – and the economy as a whole became far more energy efficient. And we have not even talked about supply.

As Rowe sums it up, “At $55, there is room for a lot of technology, fuel switching, conservation and exploration.” The long history on oil, and energy generally, is one where the gloomy natural scientists and engineers are always surprised and always wrong. This is not to say the price of oil cannot go higher, or that the oil business cannot remain a good business to be in for several more years. The point is that oil is still a commodity and it is still subject to cyclical swings. It seems to me, we are nearer a top than a bottom in the price of oil.

GLOBALIZATION?

At the risk of raising some eyebrows – globalization of what? The other question is – how long will this form of it last? Both are answerable. In my own recollection, the term might have gained visibility as a social buzz phrase at one of the 1990s’ Davos gatherings of intellectual speculators. It also seemed to arrive with the acronym NGOs. Some eventually figured out that most non-governmental organizations exist to lobby governments to do what governments want to do, which is to expand expenditures and power. Of course, and to be serious, the best way to understand a social buzz-phrase is to look at those who are against it and those who are for it.

The left is distressed by the new globalization so it must be good. Confirmation of this can be provided by looking at the old globalization movement that was so popular with politicians, neurotic intellectuals, academics, and so many leading newspapers during most of the 20th Century. By far, the most persuasive movement was the global expansion of international socialism – more precisely known as Communist International or Comintern. The spread of doctrinaire authoritarianism through most of the 20th Century has been the most invidious and powerful such movement since the Catholic Church was corrupted into a bureaucratic monster in the 1500s.

The purpose of this brief address is to outline that the transition from global authoritarianism to increasing regionalism, personal freedom, markets, and international trade is not new. It has happened before and, because the left is so accustomed to having its way – often brutally – the transition has not been easy and will not be easy. Like rusting cars, arbitrary intervention never sleeps.

It is essential to outline just how big the ongoing political change is. The change from so many murderous police states prior to the 1980s to greater degrees of freedom and democracy has only happened three times in the last 2000 years. The mechanism of change seems to be that after about 80 years of experiment in authoritarian government, those at the top lose the will to impose authority as the oppressed public suddenly loses the complacency of submission. That process began its initial phase in the late 1980s and the symbol was the Berlin Wall coming down. Many cherish Ronald Reagan’s “Mr. Gorbachev, tear down this wall” speech of July, 1987. Lech Walsesa, Margaret Thatcher, and Pope John Paul II were highly influential as well, but it was the people who physically tore down the wall and big-name dictators could not stop it. As an aside to this action, in 1975 Barbara Grey made similar conclusions about similar regime changes in ancient Egypt.

That is the big picture, which sketches the biggest political reformation since a similar process conducted by Protestants, Dissidents, and Non-Conformists, to name only a few of the political-religious movements of the late 1500s and early 1600s. The so-called Protestant Reformation was not limited to religion, but involved an intellectual and practical correction of the bullying political culture. The enduring attempt by alchemists to generate something for nothing was displaced by sound money and a broadening of public participation in debt and equity markets. As you can understand, mainly it was governments that were gullible enough to fund alchemists.

The change to sound money represents the advent of modern finance and the discipline of chemistry displacing the superstitions of alchemy represents the advent of science and applied science. The resulting product innovation provides the greatest health, prosperity, and longevity that society has ever enjoyed. Given the intensity of the left’s lobby to oppose or amend the new phase of globalization, it is a sound movement and, of course, of interest to both sides is – how long will the trend last?

All three great experiments in authoritarian government were global and ran for some 80 years. During this, the movement used any cult or superstition that enhanced the power and wealth of the state. Or, as it was called in Roman times – the “Genius of the Emperor”. Over most of the last 100 years, the genius of policymaking has been revered and celebrated in most of the world. No matter how bullying, brutal, or murderous the state became, celebrants outnumbered skeptics. Jean-Paul Sartre summed it up with an apology “Judge communism by its intentions and not by its actions.” Back in Roman times, not all worshipped policymakers. Gaius Tacitus was a historian. Despite this, he was skeptical of grand ideas. “Corruptisima republica plurimae legis” which, roughly translated, reads as “the more laws, the more corrupt the republic”.

Once Rome’s experiment in authoritarianism collapsed, and it should be added that they invented the “New Deal” long before Roosevelt did, the culture of northern Europe was population expansion and a long but slow period of innovation. The “Dark Ages” was an inappropriate description by humanist scholars. The “Quiet Centuries” would be more accurate. The measure of success was that the population in the north thrived as the Mediterranean basin suffered depopulation.

For much of the period that followed, similar attempts to centralize authority didn't really hook up until the 1500s. Then, for a number of reasons too extensive to cover in this paper, Spain led the globalization of brutal and murderous authority. With huge shipments of gold and silver from the new world, Spain enjoyed the biggest treasure windfall in history. As with ambitious governments before and since, the greatest accumulation of wealth in history has been inadequate and the state resorted to massive borrowings and currency depreciation. Three defaults during the 1500s did not temper Spain’s relentless ambition, but nevertheless the international canker of authoritarianism and rampant inflation ended in the early 1600s.

England’s history provides the clearest and least brutal transition to greater sovereignty of the individual. The monarchy was often tempted to enlist France’s assistance to impose authority. Due to a massive effort by Protestant business leaders in London, the “Glorious Revolution” of 1688 was successful. This completed the limitation of the Crown’s tendency towards absolutism. The next attempt at centralization was associated with a minor but nevertheless 20-year inflation that culminated with Napoleon. Fortunately, the nation of shopkeepers and consumers, under the umbrella of 19th Century liberalism, prevailed until, well, the 20th Century.

Tyrannical centuries have only happened with extraordinary accumulations of wealth and when traditions of limited government become corrupted by ambitious politicians and bureaucracies. In England, impressive increases in general prosperity and the standard of living began in the mid-1600s. Urges for authoritarianism were thwarted by constitutional liberties, a free press, and sound currency. Given a full understanding of previous political excesses in the 3rd and 16th Centuries, it would have been impossible in 1895 to forecast that the 20th Century would replicate authoritarian horrors that were the feature of earlier examples. More specifically, it would have been impossible to forecast that the U.S. would begin yet another experiment in central banking with the seductions of a flexible currency. Also, it would have been impossible to predict the arrival of charismatic economics with Keynes’s personal notions made formal in his book of 1936.

However, given the details of the duration then and the symptoms of the collapse of the two previous tyrannical centuries, it is possible to derive some conclusions about this phase of globalization. Will the trend away from collectivism towards the sovereignty of the individual continue to work out? After all, under Clinton in the U.S., Chretien in Canada, and with Schroeder and Chirac in Europe, the last decade of credit inflation and booms has seen a revival of ambitious neo-authoritarians. Historically, the surrender of centralized power to the individual has occurred on the contractions following huge asset inflations. Obviously, the world is eligible for a contraction that could be more deep and widespread than the one that followed the inflation in tech stocks in 2000. In which case, politics should resume the great reformation symbolized by the fall of the Berlin Wall. While there is no guarantee that this reformation will continue, there is no guarantee that it won’t. Now is about the time when the antidote to the disease of central planning is due to resume its liberating course.