Wealth International, Limited

Finance Digest for Week of October 17, 2005

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


A number of fellow contributors have suggested that the recent stock market pain portends a rally ahead. I remain convinced, however, that we are in a secular bear market where the recent pain will be a harbinger of much worse to come. The explanation for the difference in view lies in my “Generations” model of secular bull and bear markets. Stock market pullbacks have very different implications during strong and weak generational cycles. In the last “strong” generation from 1983-2000, the worst thing that happened was the 23% one-day decline on Black Monday, October 19, 1987. Even this was followed by two positive years before a relatively mild pullback in 1990.

The previous generation cycle of weakness occurred from 1966-1982, and it contrasts sharply with the bull market that followed it. During the 16-year span beginning in 1966, the Dow Jones Industrials returned just 10% while the CPI rose a cumulative 207% (returns on the Dow exclude dividends). The generational cycle also included a horrible and sustained bear market in 1973-1974, plus some other major pullbacks. In fact, the 1970s was an even worse bear market when inflation is taken into account. From 1970 through 1985, stocks generated total returns of 284% vs. a rise in inflation of 184%. And for the 20-year period of 1965 through 1985, total returns from equities were only about 80% more than inflation. (Two decades is a long time to generate a cumulative real return of 80%.) From the late 1960s through the early 1980s there were also many 10-year periods when stocks lagged inflation significantly. Many “long-term” investors conveniently ignore this period, or they ignore the fact that stocks lagged cash.

2005 is in the middle of a “weak” stock generation (as well as being a post-election year like 1973 and 1929). Thus, we have little to hope for from the current market weakness. (1929 was a special case because it signaled a transition from a “strong” to “weak” stock generation all by itself.)

The bull market of the 1990s was characterized by low oil prices, a budget surplus, global political dominance and respect, and Baby Boomers entering middle age, among other things. The bear market of the 2000s is accompanied by high oil prices, twin deficits, global disrespect after our 2003 invasion of Iraq, foreign central bankers wringing their hands about what to do with the dollar, and a domestic real estate bubble driven by interest-only loans (a sign of a tapped-out consumer) and Baby Boomers on the brink of retirement. During strong stock generations, market pain is generally of the athletic “no pain, no gain” variety, while during weak stock generations, stock market pain is usually of the broken limb variety. The implication for this period of pain is clear.

Link here.


The long-term average return from the stock market is 10.4%. As the earliest baby boomers are now beginning to retire, they will be relying upon their investments for income. The latest boomers have two more decades to compound their savings into a retirement payload. At 10%, boomers young and old – so to speak – have a good chance of a secure retirement. Yet, from 2005, what length of time is needed to assure the long-term average return?

NEVER – investors from today will never achieve the long-term average return. Not in 10 years, 20 years, 50 years, or the 79 years that represent the most recognized long-term average return. According to the 2005 Yearbook published by Ibbotson Associates, the long-term average return from the stock market is 10.4%. Ibbotson starts their long-term series of financial data in 1926. Eight decades is a long, seemingly credible period of time – why should today’s investors not reasonably expect a similar return over the next one, two, or eight decades?

There are only three components to stock market returns: earnings growth, valuation-level changes (i.e., the change in the P/E ratio), and dividend yields. A discussion of these three components will confirm that a reasonable future return assumption is less than two-thirds of the long-term average.

Before we look forward, let us look backwards for insights – using the certainty of history to explain the contribution of each of the components to the long-term average of 10.4%. According to Ibbotson, earnings growth contributed 5.0% to the long-term average. Since P/E ratios were 10.2 in 1926, the effect of the increase to 20.7 at the end of 2004 provided 0.9% to the long-term average. Finally, partially related to the starting and average P/E ratios, the dividend yield averaged 4.5% over Ibbotson’s period of choice. Combined together, the compounded total return (before transaction costs, fees, expenses, etc.) averaged 10.4%. So looking forward, from conditions that exist at the starting point of 2005, what are reasonable assumptions for the three factors over the next few decades?

First and foremost, we can eliminate the impact of significantly higher P/Es – the level of valuation cannot be reasonably expected to double to 41 over the next 79 years. The second component, earnings growth, is closely tied to economic growth. Today, inflation is being tightly controlled by the Federal Reserve Bank and is running below the historical average. As a result, future nominal earnings would be expected to grow at a slower rate than the historical past. Although it may not be much of a change, a 1% slower nominal growth rate shaves almost another 1% off of the potential return provided by earnings growth. Keep in mind that if inflation does increase, the resulting decline in P/E ratios will more than offset the benefit to earnings growth. So with the more optimistic low-inflation scenario, we are down to a best-case long-term return of 8.5%.

The final component, dividend yield, is directly and mathematically related to the starting level of valuation. In 1926, when the P/E ratio was close to 10, the dividend yield was approximately 5%. At the current P/E of 20, the normalized dividend yield drops to near 2.5%. The dividend policy and payout rates for companies do not change as the result of the level of its P/E ratio. A company that generates $2 per share will typically pay out $1 per share in dividends regardless of whether its stock price is $20 or $40. Yet the dividend yield when the P/E is 10 will be 5% ($1 dividend on a $20 price), while the dividend yield at a P/E of 20 will be 2.5% ($2 dividend on a $40 price). The effect of today’s valuation levels, P/E near 20, reduces the expected yield by more than 2% versus the historical dividend yield. As a result, our best-case future long-term return approaches 6%. From currently high levels, any decline in P/Es will reduce long-term returns below 6%.

Since 1900, there have been 86 20-year periods, the first was from 1900 to 1919 and eighty-five double decade periods thereafter. The results can be sorted into two groups: those above the average and those below the average. Is there a way to determine whether the next 20 years is likely to be a top half or bottom half period? This would enable us to improve our outlook by using an above-average or below-average return assumption. One characteristic that is blatantly obvious for the two halves is the starting level of valuation in the market as determined by the price/earnings ratio (P/E). It is the bellwether measure of prices in the stock market. Almost unanimously throughout the past century, when the P/E is above average, subsequent returns are below average. As well, below average P/E’s historically delivered above average returns. Based upon current market valuations, it is very likely that we are in the “below-average” batters box and should include a below-average return assumption for the next 20 years and even longer.

Link here.


With the landmark federal law making it tougher to file personal bankruptcy, those in danger of foreclosure on their houses because of delinquent mortgage payments will have one less tool to delay the process. The rewrite of the U.S. Bankruptcy Code makes filing personal bankruptcy more complicated for everyone and prevents many people with higher incomes from erasing their debts in a Chapter 7 filing. Under the current law, filing for Chapter 7 bankruptcy – a process that wipes clean most debts – stops collection activity. The new law makes it tougher for debtors to file Chapter 7 and do away with debts such as credit cards.

The new law will require that anyone with an income above the state median be put through a means test to see if at least $100 a month can be found and used for the repayment of debts. If so, individuals will be forced into a five-year debt repayment plan under Chapter 13. People who want to keep their homes will be forced to catch up on mortgage payments in that time period. Researchers estimate 5% to 10% of filers will be forced into a repayment program under Chapter 13 because of the new rules. Some likely will be people who would have chosen Chapter 13 voluntarily, because the repayment plan will allow homeowners who are behind on their mortgage payments to catch up and avoid foreclosure.

Link here. Debtor rush packs court; hundreds file before deadline – link. What you should know about the new bankruptcy law – link.


After Wall Street picked over the remains of derivatives broker Refco in the weekend of October 15-16 to see what, if anything, was worth salvaging, investors who bought the stock at its August initial public offering now face a bleak picture. On Oct. 17, Refco announced it was in “advanced negotiations” with a group of investors led by J.C. Flowers & Co. to sell its futures brokerage business, a step that could lead to its rapid dissolution. The New York Stock Exchange halted trading of Refco’s stock indefinitely on Oct. 13, with shares down 64% from the $22 IPO price.

The complete story of the $430 million debt ousted CEO Phillip Bennett allegedly hid for 7 years before the IPO, only to be revealed last week, has yet to be told. Bennett has been charged with securities fraud in an ongoing probe. But the Refco mess holds a simple and straightforward lesson for investors: Be watchful for – and beware – companies that admit their internal systems for preventing accounting problems are not up to snuff. Buried amidst the boilerplate discussion of various risks to its business disclosed in the prospectus Refco filed with the SEC on July 25, 2005 – two weeks before the IPO – was a paragraph noting that the company’s accountants had found two “significant deficiencies” in its internal controls.

Accounting firm Grant Thornton reported that Refco’s finance department did not have the resources to prepare financial statements that complied with federal law and that the company lacked a formal process for closing its books at the end of each quarter. The Chicago auditing firm, which is among the many involved parties being sued by shareholders, now says it was also among those fooled by Bennett’s moves to hide the debt. How obvious a red flag should such a warning have been to investors? Pretty obvious, if you consider the performance of all companies that made such disclosures this year when they filed to sell shares either in IPOs or secondary offerings.

Link here. Refco files for bankruptcy, sells futures unit – link.

Thomas Lee may delay fund after Refco.

Billionaire Thomas H. Lee’s firm may delay raising a $7.5 billion buyout fund because of losses from the collapse of U.S. futures broker Refco Inc., said a person familiar with his plans. A fund managed by Thomas H. Lee Partners LP has been Refco’s biggest investor for more than a year and sustained losses of more than $275 million in the company’s bankruptcy this week. The investment is Lee’s worst since his Boston-based firm lost about $400 million on Conseco Inc. after the U.S. insurer filed for bankruptcy in 2002.

Lee, whose company was going to begin fund-raising by the end of the year, is considering whether to put that off, said the person, who declined to be identified. Lee, 61, does not plan to be involved personally in raising money or managing the new fund, the person said. “They have probably prudently put their fund-raising on hold”q said William Atwood, executive director of the $11 billion Illinois State Board of Investment in Chicago, which has $35 million invested with Lee’s firm. The Lee fund invested $453 million in Refco in August 2004 and returned about $177 million to investors after selling part of its stake in the New York-based firm’s IPO in August.

“We’re paying a lot of money to general partners to do due diligence, and if this could have been avoided, then Tom Lee is in trouble,” Atwood said. Thomas H. Lee Partners, started in 1974 by Lee, has raised five buyout funds since 1984. Four of the funds have had average annual returns of about 50%, Lee said in April. “Managers who have never had a blow-up just haven’t been around long,” said Orin Kramer, chairman of New Jersey’s State Investment Council, the 10th-largest state pension fund with $70 billion under management. “Tom Lee’s personal reputation will be just fine.”

Two years ago, Lee stepped back from running the firm on a day-to-day basis and appointed Scott M. Sperling, Anthony J. Dinovi and Scott A. Schoen to manage it. Schoen sits on Refco’s board and was involved in the decision to sell its regulated futures-trading units to the group led by Flowers. One of Lee’s most successful investments was its $135 million purchase of Snapple, a producer of iced teas and fruit drinks, in 1992. Snapple was sold two years later for $1.7 billion.

Link here.

Refco seeks approval to auction assets after new bid.

Refco Inc., the futures trader that filed for bankruptcy protection four days ago, may get permission from a federal judge to auction its assets after a second firm submitted a bid for the company. J.C. Flowers & Co., a New York-based buyout firm, signed an agreement on Oct. 17 to buy the business for $768 million. Interactive Brokers Group LLC, the largest closely held U.S. broker-dealer, yesterday countered with an offer valued at $790 million. An adviser to the government of Dubai has said his client is considering bidding as much as $1 billion for all of Refco’s assets. 27 others have expressed interest, according to Refco’s lawyers.

Refco had liabilities of $16.8 billion as of Aug. 31, and its biggest creditors included Austria’s Bawag P.S.K. Bank and an investment fund controlled by New York-based money manager Jim Rogers, documents submitted to U.S. bankruptcy court show. Refco is the largest independent U.S. futures broker. Founded in 1969, the company employed 2,400 people in 14 countries as recently as last week, the company’s Web site said.

Link here.

Refco’s demise stirs memories of previous meltdowns.

Refco Inc.’s two-week slide into insolvency stirred memories of the last time a big Wall Street firm teetered, then collapsed – except it was quicker. 15 years ago, rumors swirled for weeks that Drexel Burnham Lambert Inc. was being targeted by regulators before the 1980s junk-bond financier filed for bankruptcy, said Martin Mayer, author of Markets: Who Plays, Who Risks, Who Gains, Who Loses (1988). “There is nothing between Drexel and Refco that is comparable in terms of speed and violence.”

Between Drexel and Refco, at least half a dozen major financial companies have melted down. Long-Term Capital Management LP, a hedge fund run by John Meriwether, lost $4 billion in 1998 after a debt default by Russia. Barings Plc, a 233-year-old British merchant bank, collapsed three years earlier after Singapore-based trader Nick Leeson racked up $1.4 billion in losses. That same year, Tokyo-based Daiwa Bank Ltd. was forced to shut U.S. branches after revealing a $1.1 billion loss from 11 years of unauthorized trading by its chief New York government bond trader, Toshihide Iguchi.

The difference for Refco is that it was not a rogue trader, or a misplaced market bet, that did in the company but rather allegedly criminal behavior by the company’s CEO. Refco’s disclosure of his debt set off a confidence crisis among clients and investors that could not be stemmed. “The whole issue is trust,” said Peter J. Solomon, chairman of the New York investment bank Peter J. Solomon Co. “The trust was broken, and people didn’t want to stay around long enough to verify.”

Apart from Daiwa, so-called rogue traders have made an appearance most often when financial companies imploded during the past decade. That was the case in 2002, when Allied Irish Banks Plc discovered that John Rusnak, a trader at its Allfirst Financial Inc., had amassed and hidden $691 million in losses in more than five years before the bank noticed any discrepancies. It was much the same situation in 1996, when Sumitomo Corp. disclosed a $2.6 billion loss on copper trades. The Japanese firm blamed unauthorized trades by its chief copper trader, Yasuo Hamanaka, who was known as “Mr. Copper” in the markets because of his aggressive trading.

Link here.

Probe of Refco widening.

The federal investigation of futures and commodities broker Refco Inc. is fast expanding beyond Chief Executive Phillip Bennett, said people familiar with the matter. Other individuals and firms – including auditors, underwriters, lawyers and former Bennett subordinates – are under scrutiny, the sources said. In addition, investigators were said to be looking for possible wrongdoing beyond fraud charges brought on October 12. Bennett has been accused of hiding from Refco shareholders hundreds of millions of dollars in bad debt through a series of short-term loans involving a company under his control.

Refco announced on October 10 it had found it was owed about $430 million by a private company under Bennett’s control, which prosecutors identified as Refco Group Holdings Inc. Prosecutors alleged the massive debt was hidden from investors during the stock offering. It is still unclear how the debt was transferred to Bennett’s holding company from Refco some years ago and why it went undisclosed for so long. Refco has said that Bennett has since repaid the debt. The accounting for the debt transfer may be a focus of investigators’ widening inquiries, sources said. Through loan transactions involving the largely unregulated Refco unit Refco Capital Markets, along with Bennett’s holding company and a customer, the debt was shifted off Refco’s books temporarily to conceal it, authorities alleged.

Link here.


How big is California? It is not just geographical trivia. That question should be at the top of mind for anyone concerned about the U.S. economy. In 2004, the GDP of the U.S. was nearly $12 trillion. But one state contributes far more than the 49 others. At 13.3% of the national GDP, California’s share is nearly double that of New York, the nation’s 2nd-largest economy. That is why Alan Greenspan cannot relent in his quest to quash the speculative fervor in “frothy” housing markets. The whole darn state of California could qualify as the frothiest bubble in the land and, by the way, harm the U.S. economy as a whole when it blows.

Goldman Sachs senior economist Jan Hatzius did some work on California to illustrate how vulnerable we are to housing. He started with the keystone of any economy – employment. After all, as much as we rely on consumers to keep the economy up and running, without employment, there is nothing to fuel the machine. “As home prices decelerate, consumption that has been financed through mortgage-equity withdrawal is likely to decline,” Mr. Hatzius wrote. “As spending slows, the labor market is likely to weaken as well.”

OK – by how much? Northern Trust Co.’s Asha Bangalore estimated recently that 43% of the jobs created since 2001 have stemmed from housing. It stands to reason that a slowdown in housing will just as easily take away what it has so generously given to the workforce. Mr. Hatzius figures that the nation as a whole could lose upward of 1.3 million jobs, or 1% of the pie, in a housing-bubble recession. And California would get hit twice as hard, losing some 2% of its jobs.

Mr. Hatzius limited his definition of “housing-related” to construction, contractors and real estate services. That explains why the numbers do not look so bad. But he conceded that this viewpoint is unrealistic: “These estimates probably still understate the total impact of a housing downturn. First, our employment numbers do not include related areas such as banking, furniture or building materials manufacturing. Second, there likely will be an indirect hit from weaker consumer spending.”

Link here. Housing prices may get doused by U.S. tax code revision – link.


The most revered figure in American finance happens to be an aging price controller. Until the end of January the price of a short-term loan – the federal funds rate – will be whatever the chairman of the Federal Reserve Board decides to make it. Never mind the conundrum of a flattish yield curve, where 10-year Treasurys now yield only 0.6 percentage points more than the funds rate. Alan Greenspan, 79, is a conundrum himself, personally: capitalist price controller, Ayn Rand-trained public servant and, most oxymoronic of all, beloved central banker. His imminent leave-taking presents an occasion both to appraise his 18-year Fed stewardship and, more important, to speculate on its consequences to all who hold, save or invest the U.S. dollar.

Many have preceded the chairman in the work of overriding the market’s judgment with their own, and they have usually toiled in obscurity. These were fixers of New York City rents, of interstate rail rates and even, under the Nixon Administration, of nearly every price and wage under the American sun. With the regulatory enlightenment that followed the disastrous Nixon controls, the burden of proof began to fall on those who would intervene. Except, that is, in the wholesale-dollar money market. For reasons about which thoughtful investors are remarkably uncurious, the Fed continues to fix an interest rate that lenders and borrowers might better discover for themselves.

Ours is a faith-based financial economy. Investors have always had to trust somebody or something, whether an accountant’s numbers or a counterparty’s solvency. But they have not always had to make a leap of faith about a nation’s irredeemable paper currency. Up until Aug. 15, 1971 the dollar was exchangeable into gold at the rate of $35 to the ounce, a privilege admittedly limited to governments and central banks. The lip service paid to the convention of gold convertibility at least represented an official commitment to not overuse the monetary printing press. Without such a system, a currency holder must trust in people, or – in the case at hand – one person.

Greenspan is trusted as few central bankers (and probably not one admitted price controller) have ever been before. Recently writing in the Financial Times, Harvard economist Kenneth Rogoff crowned the chairman “the Michael Jordan/Lance Armstrong/Garry Kasparov of modern-day central bankers”. Princeton economist and former Fed Vice Chairman Alan Blinder extravagantly seconded Rogoff. Chairman Greenspan is unique in one way: The people have acclaimed him an oracle. His prophesies rivet everyone, even if no one can parse what he is saying.

Do not expect the people to confer such oracular status on his successor. They will come to see that the next chairman is unable to predict the future and improve it before it can happen. Even the nimblest practitioner of the art of interest-rate management is sooner or later bound to run out of luck. And feeling betrayed, people will retroactively demote Greenspan, his celebrity notwithstanding, and shred his reputation for infallibility. He falls as short of the old papal standard as any private economist, financial journalist or central banker who ever uttered a forecast. The early-1990s real estate and banking difficulties caught him looking the wrong way. So did the excesses and imbalances of the late-1990s stock market bubble. In pushing the funds rate to 1% to forestall an imagined deflation in 2003, Greenspan hit his wall. As yields go higher and higher, bondholders will eventually hit theirs. The case against Greenspan is not that he makes mistakes but that he makes unnecessary ones.

Greenspan, however, has conflated price control with economic czardom. He has intervened early and often – “preemptively” – to achieve his macroeconomic objectives. Greenspan, an inveterate speech-giver, has pushed investors to take risks that he now counsels against. He delivered his famous “irrational exuberance” line in 1996, when he warned that the market was getting too frothy. Then he switched course and lent the prestige of his office to the dubious proposition that, in effect, the exuberance was not so irrational after all. He became as great a financial seducer and as ardent a New Era zealot as any analyst, broker or investment strategist on Wall Street. Even stranger was the advice he vouchsafed to the home-buying public in February 2004. Adjustable-rate mortgages can save you money, he said. Four months later the Fed began to push the funds rate upward.

Interest rates are the traffic signals of a market economy. Red, green or amber, they direct the flow of investment funds. One motorist might dream of never encountering a red light as he sails through intersection after intersection. But woe betide this driver if everybody else could cruise through, too. There would not be enough tow trucks. Since it swung into antideflation mode in 2002, the Fed, in effect, has turned every interest-rate light green. Bond yields plunged (then rose), credit spreads have tightened, and the yield curve has flattened. A new industry of speculative-grade mortgage lending has sprung into existence. And the inevitable credit pileups in the streets and intersections of finance will be Greenspan’s successor’s problem to clean up.

Greenspan leaves office amid a ferocious bull market in houses (with a little recent softening around the edges). This is on his conscience, as it should be. After all, he is one of its creators. To preserve the nation from an imagined deflation, the Fed instigated a real estate and mortgage inflation. And who is financing it? Why, the Asian central bankers are. They are the ultimate source of the cash in the cash-out refinancing wave, as Greenspan acknowledged in a speech in August.

Adjustments there will certainly be, no matter who succeeds Greenspan. Home with his wife watching CNBC, the retired chairman may see strange and troubling occurrences: rising interest rates, a falling dollar, a bear market in residential real estate, a rising gold price. And though tempted to interpret these disturbances as the markets’ expression of loss at his exit (he is, of course, only human), Greenspan on reflection may finally see the truth. He was, in fact, no oracle, after all.

Link here. James Jones and Global Finance – link. The Next Maestro – link.


Time Warner and Comcast had to pay a bit more than they wanted for the disgraced Adelphia Communications Corp. The final price tag for the nation’s number five cable operator was $17.6 billion – perhaps $1 billion or more than it might have cost the buyers had it not been for a certain troublemaker named William Huff. Huff buys the debt of distressed companies, and he had a crucial slice of Adelphia’s. “In this stupid world of ‘Let’s make a deal’, I say ‘No’,” explains Huff, 55, principal and president of W.R. Huff Asset Management in Morristown, N.J., which invests $17 billion on behalf of pension funds and other institutions. What allows Huff to say no is his ability to quietly acquire a sizable chunk of junk bonds and other securities of sickly companies – unlike equities, there is no requirement to report these holdings – then push for his own terms.

He added to an old position in Adelphia debt in 2002, soon after the cable company, looted by the founding Rigas family, filed for bankruptcy. He paid as little as 30 cents on the dollar for bonds that now trade at an average 92 cents. Along the way Huff turned aside various offers for Adelphia, including one for ca. $15 billion from Providence Equity Partners, working in tandem with Kohlberg Kravis Roberts. Today he controls some 30% of $6.7 billion in Adelphia debt; in addition the Time Warner-Comcast deal would give him a cash payout on the order of $1.6 billion. He and other bondholders also expect to share up to $3.5 billion or more if anything comes of a suit charging fraud against Adelphia clients, such as Deloitte Touche Tohmatsu, and lenders, like Wachovia.

Huff sees himself in chivalric terms. “I will fight like a son of a bitch for what’s right”, he says. Translation: getting the best deal for investors (and himself). On the whole, those who have backed him have evidently done well. He says that someone who invested with him in 1981 would have enjoyed a compound annual return of just under 14%, after fees, two points better than the return on the S&P 500. In our recent listing of rich Americans we included Huff with an estimated net worth of $750 million.

Link here.


Are you a bull or a bear? A Tortoise or a hare? Your answer is not as important as how you arrived at it. The investment world’s biggest divide these days is between two competing interpretations of reality: the efficient market theory and behavioral finance. The University of Chicago, where I am a trustee, is home to two of the most distinguished champions of these beliefs: Eugene Fama for the efficient market approach and Richard Thaler for the behavioral one.

My corporate finance professor, Burton Malkiel, taught me efficient market theory. Efficiency theorists argue that markets are completely rational and stocks priced to reflect all information known to investors. If there is a piece of news about a stock, investors will act promptly and adjust the share price. If the market is efficient, you cannot beat it. At least not consistently and over a long span of time. The only exception is small- and mid-cap stocks that are generally less followed.

But while the market efficiency theory is useful, it does not convey the whole story of how people invest. Human emotions, such as fear and greed, obviously drive investor decisions. Behaviorists hold up studies showing that the cheap shares, those with low price/earnings ratios, beat expensive (high price/earnings) offerings, over time. Value trumps growth, in other words. If share prices are completely rational, how can one type of stocks outperform another?

Although some might argue that these pro-value studies are flawed, behavioral academics are on the firmest ground citing the madness-of-crowds phenomenon. Most people make the same mistakes over and over. The most prevalent one is to pile in at the peak with everyone else. Since fitting in is easier than sticking out, investors flock together even when the results turn out bad. As the great economist John Maynard Keynes said, “It is better for reputation to fail conventionally than to succeed unconventionally.” No portfolio manager ever got fired for buying IBM.

Harvard professor Jeremy Stein visited my firm this summer to explore the complexities of behavioral science. We examined the “recency effect” – when people overweight current information and assume that the future will follow the present. So they buy what’s hot and avoid what’s not. Behavioral finance substantiates many of the core tenets of value investing, which I have practiced for decades: buying great businesses when they are out of favor and selling below their intrinsic worth, such as the following …

Link here.


Fund manager David Ellison missed the festivities during the great tech party of the late 1990s. A Peter Lynch protégé at Fidelity Investments specializing in finance-company stocks, he hopped over to Friedman Billings Ramsey & Co. in 1996 to run its FBR Small Cap Financial fund. And he has done very well at this, with an annualized return of 18% since inception versus 7.2% for the S&P 500.

During the depths of the recent bear market he and his bosses at the Arlington, Va. investment bank got the notion that much-battered tech stocks were cheap and due for a rebound. They also could not find a decent tech fund to invest in. So in February 2002, eight months before the market’s nadir, Ellison launched FBR Large Cap Technology fund. He has gone on to show that, even though he is not as steeped in the lore of electronic wizardry as the typical tech fund manager, he really can pick winning tech stocks.

His tech fund has compiled a three-year annualized performance of 31% – 15 percentage points better than the S&P 500 and 8 points ahead of the tech-laden Nasdaq index. He has done it by looking at numbers, not gadgets. He likes companies with lean structures, little debt and prices that are fairly low in comparison with earnings and book value. Covering the scandal-ridden thrift industry as a young analyst in the 1980s, he developed a preference for simple structures. Many naughty secrets were hidden inside their byzantine organizations.

It was at Fidelity that Ellison acquired the habit of focusing on financial analysis, not management and products. Converse of this rule: Do not buy just because you like a company’s executives. Ellison loves to go on about financial arcana, with little reference to what contraptions a company is selling. FBR’s portfolio of big companies (average market cap: $23 billion) trades at 24 times trailing earnings vs. the Morningstar average for the category of 32. His tech fund turns over once per year, on the low side. His dismay over debt is palpable. The 58 companies in FBR’s portfolio average a debt load equal to only 9% of tangible equity. Ellison particularly likes companies leading their industries and increasing tangible book value.

FBR Large Cap Tech has a $2,000 investment minimum and levies no sales load. Its 1.95% annual expense charge is high for a stock fund but seems excusable given the tiny asset base of $15 million. As the fund adds assets, the expense burden will lighten. Ellison and his family own 25% of the fund’s assets, so he is looking after his own interests along with those of investors.

Link here.


The flat yield curve has been worrying bond investors for months. Right now scant difference exists between short- and long-term interest rates. You are not earning much extra yield for the risk of extending your maturities. The Federal Reserve has been jacking up short rates while longer maturities’ yields have not budged much, likely because of heavy buying from abroad. So even more than before, investors, whether institutional or individual, are on a quest for yield. To help you out I have scoured the field and come up with a few choice ideas that present unusual values today. Eking out a quarter- or half-point of extra yield may not sound like much, but this additional payout makes a difference over time.

In the ten years I have been writing this column, I have never once recommended certificates of deposit; I am now. Stick to one-year certificates, yielding 4.4% or better. Longer-term CDs do not pay you that much more. If your bank will not come close to offering 4.4% for one year, see bankrate.com for the highest-yielding one-year CDs available in your state or throughout the nation.

Next in my conga line of ideas is a stunningly simple one: bonds from government agencies. Investment-grade corporates yield just 0.81 percentage point over Treasurys. That is too little, given that corporate credit quality is deteriorating and the Fed has not finished raising rates. However, government agency spreads over Treasurys are more generous. How come? Probably due to the Fannie Mae and Freddie Mac accounting scandals and continued congressional balance-sheet scrutiny of them. But hey, take advantage of this. The federal government will not allow these entities to default. Despite all that has gone wrong, they still get the highest credit ratings. Five-year corporates with the same credit quality, like Wal-Mart noncallable bonds, pay lower rates.

It is challenging, even for professionals, to know where to invest in the fixed-income market when the yield curve is flat and low. That is why you should be prudent and spread your money around. Other than the CDs, though, do not concentrate in one-year instruments. You will blink, the year will be over and then you must go through the hassle of reinvesting a lot of money.

Link here.


Robert Hormats has visited China 50 times. In a diplomatic career under presidents ranging from Richard Nixon to Ronald Reagan, and as one of Goldman Sachs’ prominent faces on the international scene for the past 23 years, Hormats is steeped in perspective. At 62, he knows one thing well: China is a great place to invest. Now nobody doubts that China is a growth machine, with an economy expanding at a 9% annual clip. If it maintains that pace, the economy will overtake the American economy (growing at 4%) by midcentury. China’s plentiful and cheap labor, plus a huge domestic consumer market, portend a bountiful future.

But China also has a well-deserved rep as a hairy place to invest in stocks. First, the Beijing government severely limits foreign purchases of shares in its companies (often controlled by the state), and financial reporting is suspect. Second, corruption, bad-loan-ridden banks, pollution, poverty and joblessness could stir social unrest and disrupt this growth. Third, in a land where intellectual property rights are a joke, investors are wary, thus casting further doubt upon the rosy predictions.

Hormats, though, believes China will surmount these weaknesses. After all, he has been anticipating a muscular Chinese economic expansion for years. Until two centuries ago, he says, China had the world’s largest economy, so it views the current surge as reclaiming its rightful due. Hormats finds striking parallels between the bustling, brawling U.S. of the early 1900s and present-day China. Way back, he notes, the U.S. was a swarming hive of stock manipulation and poor financial reporting, where corrupt officials, environmental desecration and huge private trusts ruled. He also detects an apt comparison to Japan in the heady growth years from 1960 to 1980, when cheap labor and vast energy created the first Asian economic Goliath. Equity investors benefited fabulously from America’s and Japan’s early growth spurts. To be sure, the timing has to be right.

For investors, the best part of the U.S. and Japan rapid-growth eras was that average annual stock appreciation outstripped economic expansion. Hormats concedes that buying shares on a wild-and-woolly Chinese exchange is usually a bad idea. For now he prefers stocks listed on the much more transparent Hong Kong exchange or the NYSE.

Link here.


Ever eager to observe and command, government officials like to record their countrymen’s economic dealings with people abroad. They create “balances of payments” which are to help them evaluate and manage economic relations. Last year, the American balance posted extraordinary deficits of some $668 billion, or more than 6% of GDP. This year it is estimated to exceed $700 billion. In any other country a deficit of just 3% would sound the alarm and could trigger a sudden flight of capital and a crash of the national currency. Moreover, the U.S. government itself is suffering huge budget deficits that amount to several hundred billion dollars annually and by now exceed a total of $8 trillion. Yet, few economists seemed to be disturbed; they apparently are guided by the old mott “A poor man’s debt makes a great noise; a rich man’s debt makes no sound.”

Americans obviously spend more abroad than they earn, consuming more than they are producing, and ever increasing their indebtedness to the rest of the world. Only two other countries, Australia and the U.K., presently suffer minor deficits. All other countries, large and small, rich and poor, finance the deficits with their trade surpluses. Japan is the biggest creditor with claims of some $170 billion. The petroleum exporting countries in the Near East follow with $110 billion, then China, Russia, and Switzerland. This worldwide imbalance of consumption and production obviously calls for an explanation and raises important questions of readjustment.

On first glance, the American payment deficit springs from a spending predilection of public, as well as private, profligacy. All levels of government are suffering budget deficits amounting to some 4.5% of GDP. In less than a decade the federal government managed to turn a budget surplus into a deficit by way of tax reductions and spending increases. At the same time, the American savings rate fell to barely 1%. Consumption accelerated due to extremely low interest rates and rapidly rising real estate prices. Homeowners could convert their rising housing value into ready consumption, making their homes convenient bank automats. But some are fearful that such riches have their limits, as interest rates are bound to rise and real estate prices soon may stagnate or even decline.

Many countries, rich and poor, now are supporting the richest country on earth. This odd situation raises serious questions of consequences if the creditor countries should suddenly tire of their chore and call a halt to the burden. What would happen if, for instance, the Asian central banks should suddenly refuse to add to their dollar holdings or even reduce them and instead decide to invest their surpluses in euros? Surely, such a reaction would lead to much international turbulence and severe economic crisis.

What we look for may not come to pass. The present situation of American deficits and foreign credits may continue as far as the eye can see. After all, an old monetary order, which had been created at the 1944 Bretton Woods Conference, withstood much international disorder for more than 30 years. Some economists and their friends in government like to note the similarities of that order with the new. But this economist does not see the semblance. With his eyes on huge trade deficits and foreign debts and on grave international conflict and strife he braces for more commotion and crises to come.

Link here.


Delphi’s recent bankruptcy filing has put more pressure on Congress to reform a set of pension laws that are putting the federal guaranty program in a fiscal crisis of its own. The Pension Benefit Guaranty Corp. (PBGC), a 31-year-old insurance fund set up by Congress and paid for by premiums from corporate pension plans, is already technically insolvent and is projected to run out of cash entirely in 16 years unless lawmakers act. It is already $23 billion in the hole, and its deficit is expected to grow to as much as $91 billion in 20 years, according to the Congressional Budget Office.

The PBGC is about to release its 2005 financial statements. If its own estimates for this fiscal year are any guide, it will not be good. Premiums paid to the fund should be roughly $1.8 billion, while benefits paid will be more like $3.2 billion. And this was PBGC’s best guess as of November last year, before the bankruptcy filings of Northwest Airlines, Delta Air Lines, and Delphi. Already there is talk of the need for a savings-and-loan-style bailout for the PBGC. But the House and Senate are trying to forestall a massive taxpayer bite by considering two related bills that would tighten the rules for companies that make contributions to defined benefit plans for employees.

Link here.

Pensions insurer “nearing crisis”.

The U.S. is heading towards another bailout of a government-backed insurer, similar to that of the savings and loan crisis in the 1980s but this time involving the insurance scheme for occupational pensions, a prominent economist warned. Zvi Bodie, of Boston University who is known for pioneering work on the risks of investment in equities, made his remarks in an address to the St Louis Federal Reserve Bank, noting that the U.S.’s pension crisis was predictable. He said that too many companies had tried to ride the equity bull market of the 1980s and 1990s, when instead regulators should have required them to peg their investments to long-term interest rates that mimicked the liabilities that they were building up in their schemes.

Noting that the U.S. faced a crisis with its Pension Benefit Guaranty Corporation (PBGC), Mr Bodie said: “The current crisis did not follow from some perfect storm of unforeseeable factors. It was largely caused by the same factor that led to the S&L crisis and the demise of the Federal Savings and Loan Insurance Corporation: a mismatch between assets and liabilities.” The sharp drop in interest rates and the fall in equities markets have left the PBGC with a deficit as of September 30, 2004 of $24 billion. However, in recent months four of the largest bankruptcies in U.S. history have strained finances further. The bankruptcies of Delta, Northwest and United Airways, along with that of auto parts supplier Delphi, make it likely that the PBGC will report a substantially larger deficit when it files its year-end report in mid-November.

A recent report from the Congressional Budget Office estimated that it would cost $142 billionb to pay a commercial insurer to provide the benefits that the PBGC has promised, but does not have money to pay for, over the next 20 years.

Link here.


The job market could not be better in some areas of the country. Two areas in Florida, Cape Coral-Fort Myers and Naples are the hottest job markets in mid-sized markets, those with between 100,000 and 250,000 jobs, according to the latest job market rankings from bizjournals and American City Business Journals. “The major story in these places is very rapid population growth, with retirees, seasonal residents and tourists coming in,” says Mark Vitner, senior economist with Wachovia Corp. in Charlotte, N.C. “That has really set off a building boom,” he says. “There’s a mad rush to build infrastructure. And all the services that benefit from increasing population – financial services, retail trade, health care – are all doing well.”

If those cities are too big, check Coeur d’Alene, Idaho, where job growth is 5.9%. It is the hottest job market of between 50,000 and 100,000 jobs. For smaller towns of less than 50,000 jobs, the hottest job market is St. George, Utah, where job growth is 7.1%. Coeur d’Alene and St. George are growing as folks leave the big metro areas of California and move inland. “A lot of people and businesses want to be located in small towns. And for a long time, they really couldn’t do that. They had to be close to where the action was,” says Larry Swanson, director of the Center for the Rocky Mountain West at the University of Montana. The Internet has helped make smaller towns more accessible, while California’s problems have made them more desirable, Swanson says.

Link here.


No, I am not talking about the Northeastern US in October, although I noticed that we got better than a foot of rain in the middle of October – who could have missed that? I am referring to the macroeconomic and inflation data that has been pouring in and is beginning to strain the dams of the “all positive all the time” macroeconomic outlook. Stagflationary dynamics are starting to show up in the data. This is no minor matter for two reasons. Firstly, economic policy – never a precision instrument – is particularly inept at handling the confluence of inflationary and recessionary conditions simultaneously. Second, investors tend to feel about inflation, rising interest and softening profits the way New Yorkers feel about heavy rain. These undeserved and unreasonable perils detract from life and should never have to be tolerated. Keep your eyes out for data that suggests cooling growth and rising prices. When it rains it pours.

Link here.


Good as gold. It is an old saying meant to assure you of undeniable quality and perfection. So you might define anything from a child’s behavior to a promise you make using that term: good as gold. In fact, it is a term that was once used to define the U.S. currency, when our dollar was freely convertible into gold. Because gold can neither be created nor destroyed, it has stood the test of centuries as a standard of value. Alchemists have tried in vain to increase the supply. Economists have tried in vain to deny its worth. But historically, gold has been a secure refuge in times of trouble or political uncertainty.

In our modern and complex society, gold retains much of that historic allure. But there are simply too many currencies and transactions for the world to hide all its fears by purchasing gold. Instead, currencies themselves are traded freely – to the tune of $1.9 trillion of value every day! Fear of inflation shows up in lower values for the dollar. But ordinary people in America are basically stuck with dollars. Even if the rest of the world worries about all the dollars the U.S. is borrowing or creating, Americans live, shop, work and save in dollar terms – except for a few people who hedge that dollar bet in gold futures, gold stocks or mutual funds that buy shares of gold-mining companies. They have all been a great investment in the past two years, but they do entail some risk.

Now, Everbank, an online bank that issues FDIC-insured certificates of deposit that are denominated in foreign currencies, has come up with a unique way to “invest” in gold, while giving a guarantee that you will not lose a dollar of your principal. It is called the MarketSafe Gold Bullion certificate of deposit. It gives you 100% safety of principal, and FDIC insurance, along with a “market upside payment” that is equal to 100% of the percentage change in the average spot price of gold over the 5-year term of the CD! Here’s how the Gold Bullion-linked CD works:

Minimum CD purchase is $1,500.
Term of the CD is five years.
There is a 0% interest rate and APY.Z There are no account fees.
The total return is linked to the average price of gold.

There is no interest paid on the CD because your return is linked to the spot price of gold, which is considered the world’s closing price for gold daily in terms of U.S. dollars and is established in London at 3 p.m. London time. Your “interest” payment at the end of the CD term is actually considered a “market upside payment” and it is determined by the price of gold on 10 specific, semiannual dates during the five-year term of the CD. At the end of the 5-year term, the amount of your “market upside payment” equals the difference between the average price of gold on those 10 semiannual pricing dates, compared with the price of gold when you purchased the CD.

These CDs will be issued in series, to simplify the pricing process. The first series will come to market Oct. 25, 2005. The base spot price of gold will be established on that date, and the semiannual spot gold pricing observations will be measured against the initial gold price when the CD is issued. Then, at maturity, you will receive either a guaranteed 100% of your initial deposit (if gold has fallen in price) or 100% of the average gain in gold, whichever is greater.

Special note. These CDs are not liquid, and money can be withdrawn only if the owner dies. And in that case, there is no guarantee of principal protection. They are not suited for tax-deferred accounts, such as IRAs. For more information and a detailed explanation of the risks and guarantees, go to Everbank.com.

Link here.


Ireland must prepare for a massive fall in the value of the U.S. dollar against the euro which could see the U.S. currency fall by 30% or more. This was the stark warning issued by Economic and Social Research Institute economist Shane Garrett. He believes the evidence available suggests a large depreciation of the dollar is the most effective way of reducing the unsustainable U.S. external imbalance. “This is because it will simultaneously achieve improvement in the trade balance, and an amelioration of the net external asset position. However, it is impossible to even guess about the timing of the depreciation, given that the currency’s fall had been prophesized for several years,” he added.

He said the US is the economy with which Ireland enjoys its largest merchandise trade surplus, which was worth about €10 billion in 2003. “Accordingly, any reduction in the U.S. trade deficit may have a disproportionately negative effect on Ireland’s external balance. The contrasting profile of the US and Ireland’s trade may mitigate this however. … [I]t is difficult to see how any large dollar depreciation could be anything other than damaging to Irish exports.” He said any rebalancing of global external positions will free up some of the capital funds being absorbed by the U.S. economy.

Link here.

Dollar’s recent turnaround due to strength in crude oil?

The U.S. dollar’s value is finally rising. But one market and currency analyst warns that the only thing responsible for the turnaround is the hurricane-related rise in oil prices. All of the world’s globally traded commodities are priced in dollars, meaning there is a built-in demand for the U.S. currency. Financial expert and frequent contributor Dan Denning points out that if you want to buy oil on the global market, you will have to pay for it in U.S. dollars. “That’s one of the benefits in being the world’s reserve currency,” says Denning.

Strong crude has created a massive windfall for oil exporters – and with the exception of Venezuela, they are stashing that windfall in U.S. Treasuries. In a roundabout way, high-priced crude is keeping long-term interest rates low, because hundreds of billions in petrodollars are being recycled back into long bonds. “All of that demand, however, is predicated on the dollar being a useful, namely stable, unit of global exchange,” said Denning. “With inflation on the rampage in America and the government barely able to keep itself from a $350 billion annual deficit, the stability of the dollar as a store of value, and thus a global unit of exchange, is in doubt.”

Link here.

The end of the dollar? Not just yet.

More and more, cautious or downright pessimistic opinions about the fate of the U.S. dollar can be heard in the financial press. The common thinking among many economists is that the U.S. finances are getting so out of whack that one day it may spell big trouble for the buck. One day, foreign banks and private investors may wake up to the fact that the U.S. owes more than it can repay, panic and dump their U.S. dollar assets. And that would be the end of it.

All that may happen, one day. But that day is not yet upon us. The just-released U.S. Treasury Department data shows that in July and August, foreign investors boosted their holdings of U.S. Treasury notes, corporate bonds and stocks by the most since April last year. Why are foreign investors not scared of gobbling up U.S. investments? Let fundamental analysts ponder this question.

Link here.


In January 2001, when the U.S. Federal Reserve began a series of short-term rate reductions, this column cited a few “rate-cut winners”, among them consumer stocks, regional banks and home builders. Excluding two banks acquired later, that group of stocks shows a 14% annualized return, versus a -1% return for the S&P 500. Today, the inflation drumbeat gets louder and louder. Last week, Dallas Federal Reserve Bank President Richard Fisher told the Dallas Chamber of Commerce, “The inflation rate is near the upper end of the Fed’s tolerance zone and shows little inclination to go in the other direction.” The Federal Reserve recently raised the benchmark overnight lending rate by a quarter of a percentage point to 3.75%, marking its 11th consecutive increase since mid-2004. And money market rates, now heading to 3.5%, are rebounding from the anemic 40-year low of 1% just one year ago.

The bad news for stock investors: Inflation can sap corporate profits if raw material costs rise faster than companies are able to pass them on to consumers. Companies can also be hurt when penny-pinched consumers cut back on non headline consumer inflation essential goods and services. Higher inflation brings higher interest rates, lowering demand for stocks as investors shift into CDs, money market funds and bonds.

So can you make money in equities in an inflationary environment? A recent report from Goldman Sachs Group suggests so. It assumes short-term interest rates (currently 3.75%, as measured by the overnight lending rate) rise to 4.25% by year-end 2005 and 5% by midyear 2006, with the yield curve flattening completely. In such an environment, Goldman advises that investors consider companies likely to benefit from higher energy and raw material costs. Outside raw materials, the Goldman report makes the case for industrial companies that will prosper in a sustained U.S. industrial recovery.

Sectors to avoid should inflation continue to rear its head? Dial down your exposure to interest rate-sensitive areas such as financials and utilities, says Goldman. The Goldman report also advises steering clear of businesses dependent on consumers. Among the reasons: expensive energy bills and higher mortgage quotes. It says that department store retailers such as Sears Holdings look particularly unattractive. … Or tear up the sell-side research and go contrarian. After all, Sears Holdings does look tempting at just 0.5 times sales.

Link here.

Inflation - who says it is dead?

The U.S. dollar’s purchasing power has eroded 87% since 1950. And in the past, one wage-earner families lived well and built savings with minimal debt, many paying off their home and college-educating children without loans. How about today? Few citizens know that a few years ago government changed how they measure and report inflation, as if that would stop it – but families know better when they pay their bills for food, medical costs, energy, property taxes, insurance and try to buy a house.

Is inflation a threat to society, beside the prices we pay and the fact fewer children have a full-time mother at home? Consider this famous quote: “There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” – Lord John Maynard Keynes (1883-1946)

This report shows the serious economic and education trends facing today’s families and youth, compared to prior generations.

Link here.


Increasingly popular high-risk mortgages could imperil both borrowers and banks if the hot housing market cools off, the head of the Federal Deposit Insurance Corp. said. With home prices breaking records, FDIC Chairman Donald Powell became the latest regulator to voice concern over people who took out interest-only or option adjustable-rate mortgages to buy homes they otherwise could not afford. Some borrowers and mortgage lenders holding such loans could be at risk if housing prices drop or interest rates rise.

“Credit losses are very low now, but mortgage lenders need to be prepared for higher losses,” Powell said in a speech to a gathering of community bankers in Orlando, Florida. “Homeowners taking on these types of mortgage product need to understand how their obligation may grow when their low introductory interest rates expire.”

Alan Greenspan recently turned up the volume on his warnings about the potential dangers of risky home mortgages – and there are signs that some lenders have been getting the message. A few have begun scaling back some types of those mortgages or making them less appealing by raising costs. Another bank regulator, U.S. Comptroller of the Currency John Dugan, has said that home lenders’ more lenient credit standards and the popularity of risky mortgages “have raised questions about how these loans will fare in the event of a rise in interest rates or a softening in house prices.” Though there are signs of cooling, home sales still are on pace for a record fifth straight yearly increase, powered by low interest rates. In the meantime, prices have skyrocketed.

Link here.


Sometimes value turns up in some fairly exotic places. Grupo Aeroportuario del Sureste (NYSE:ASR) is the Mexican airport company that was added to our portfolio last November. ASUR, as it is known, operates a monopoly in running nine airports in southeastern Mexico. For all practical purposes, if you want to visit Cancun, you must pass through ASUR’s airport. And every plane that lands there and every passenger that passes through its turnstiles produces some sort of revenue for ASUR. The company generates its revenues much like a toll road operator.

But there is more to ASUR than just its entrenched competitive position. The company produces gobs of free cash flow – cash that can be used to reinvest in the business, buy back stock, pay dividends and do all the other wonderful things that lead to higher stock prices. ASUR is up 50% since I recommended it one year ago. So far, so good.

Telecom companies are similar. They are entrenched in their markets, dominating their field, like quasi-monopolists. They also throw off copious amounts of cash flow. The theme of this particular group is simply this: Entrenched competitive positions and strong cash flow as the backbone of an investment idea. Most of these companies have dominant positions in the local calling market – a cash-spinning business, as you will see – and most pay a good yield. (See table.) What follows is a short review of two of the most intriguing foreign telcos: Telecom Corporation of New Zealand (NYSE:NZT) and South Korea’s KT Corp. (NYSE:KT).

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


At the time of the Great Plague, some people in Europe believed the disease was caused by foul air; many built high walls around their houses to keep out the bad breezes. Others went about flogging themselves with whips; they thought the malady was brought on by sin, which could only be relieved by punishment. What worked was distance. Generally, the farther you got from major population centers, the more likely you were to survive. So, if the bird flu breaks out big time, you will know where to find us: out beyond the pampas, nestled up against the Andes, a 5-hour drive from the nearest metropolitan center, on our own remote estancia.

Investing money south of the Rio Grande is an adventure. A financial adventure, of course, but the real risk is to the investor’s amour propre. Man is a social animal. He feels most comfortable when he is surrounded by other men just like himself … that is, men who are equally timid and lazy-minded. He says he always tries to get value-for-money, and he will readily cross the road to get a better deal on toilet paper or TV sets. But when he makes his important buys – property or shares, for example – he stays right where he is.

Price and risk tend to be harnessed together, like two dumb animals: When one goes forward, so does the other. Bonds, stocks and property tend to be cheap in Latin America; are they low risk, too? Maybe. On the other hand, bonds, stocks and property are expensive in North America and Europe. For the price of a single London townhouse, for example, you could buy an entire apartment building in almost any city in Latin America. Is that not where the greater risk lies?

On a recent trip to Argentina, we looked at an amazing place. It might have been Arizona or New Mexico, with cold water coming down from the Andes cutting through barren hills. On the flatland by the river were 1,000 acres of grapevines, several rustic houses built of adobe, and a marvelous old winery that had been built in 1870. In California, with less land, it might be priced at $20 million or more. In France or Italy, it would be impossible to find such a place at any price. But in Argentina, the asking price: $1.6 million. Why so cheap? Because it was not long ago that Argentina’s export industry, and its middle class, were practically wiped out. Inflation ran over 1,000% per year. The whole country went broke. So recently burned, the locals are still shy. And the foreigners have their doubts, too. They have heard that the Latin American currencies are slippery and their courts are unreliable. The Anglo-Saxon worries about getting cheated, getting sick, or worst of all, of getting laughed at.

Nations … regions … people … empires – all go through cycles. Sometimes they are ascendant. Sometimes they go down. The cycles are short, or long, clear or confused. But nothing ever stays in the same place for very long. Latin America is still cheap – following a long period of revolutions, bad government, inflation, bankruptcy and cucaracha. It looks like an opportunity, for anyone who does not mind being laughed at.

Link here (scroll down to piece by Bill Bonner).


Computer-guided trading, cited for accentuating the U.S. stock market’s “Black Monday” crash 18 years ago today, now accounts for more than half of the shares changing hands on the New York Stock Exchange. So-called program trading – defined by the NYSE as the purchase or sale of a basket of at least 15 stocks valued at a minimum of $1 million – has grown because of automation in the securities industry, the emergence of exchange-traded funds and the growth of derivatives. Rather than making the market vulnerable to another plunge, programs help expedite routine transactions, traders said. They may play a still larger role once the Big Board lifts restrictions on electronic trades next year.

“This is not your father’s program trading,” said Daniel Mathisson, head of electronic trading at Credit Suisse First Boston in New York. “We are now seeing that grouping stock trades has become the norm.” Programs account for 57% of the NYSE’s trading this year, according to exchange data. The peak of 71% was set in the week ended Sept. 16, when the calculation of the S&P 500 Index was altered and options and futures contracts on stocks and stock indexes expired. The exchange started tracking the trading in July 1988, when the proportion was about 10%. Nine months earlier, on October 19, 1987, the market had its steepest one-day drop ever as the Dow Jones Industrial Average plummeted 23%.

Then-NYSE President John Phelan pointed to programs that exaggerated price swings in explaining the plunge. Some members of Congress called for trading restrictions, or even a ban. As it turned out, a strategy known as portfolio insurance had more to do with the market’s drop than the computer-guided trading, according to Mark Rubinstein, a finance professor at the University of California at Berkeley’s Haas School of Business who has written about the crash. The strategy called for investors to sell S&P 500 futures to offset losses in stocks. On Oct. 19, the contracts’ declines made them cheaper than the underlying shares. Arbitragers, who accounted for about a third of program trades at the time, then bought futures and sold stocks, driving share prices even lower.

“Program trading was the messenger and you want to blame the message,” Rubinstein said. Since the crash, the use of programs has changed. Index arbitrage now accounts for only about 10% of trading, according to the NYSE. The emergence of exchange-traded funds, or ETFs, has contributed to growing use of programs. Created in 1993, the funds enable investors to buy or sell a single security that represents an index. Their value reached $251.5 billion in August, according to the Investment Company Institute.

Link here.


Clerks at U.S. bankruptcy courts processed a record 205,129 personal bankruptcy filings last week, and a private consulting firm estimates that a backlog of unprocessed filings could push the total to 300,000. Hundreds of thousands of people have clogged the courts in recent weeks trying to beat a deadline of this past Monday, the day a new, more stringent law took effect. Lundquist Consulting, a Burlingame, California, company that compiles bankruptcy statistics, said bankruptcy filings doubled from the previous week’s record of 102,863 filings. Lundquist expects around 300,000 filings this week because of the weekend filings and the backlog at the courts, said company analyst Jane Truch. “We knew there’d be a rush – every time a fee or law changes, we get that. But this was 15 times the normal level of activity,” Gardner said.

Link here.

Bankruptcies to shake up banking.

Bank of America, the No. 2 U.S. bank, expects to see higher loan charge-offs in the 4th quarter as consumers rushed to file for bankruptcy ahead of the new bankruptcy legislation, joining a chorus of banking behemoths. The news came as the Charlotte, N.C.-based company reported its 3rd-quarter profit increased 10% as surging revenue from credit card fees, investment gains and trading offset an increase in bad loans. Speaking at the company’s 3rd quarter earning conference call, BoA’s new CFO Alvaro de Molina, said the company expects “meaningfully higher charge-offs” but declined to estimate just how much of a loss the company expects. Chargeoffs are money lost, or written off, from uncollectable loans.

He added that while there are “higher and higher potential losses in the fourth quarter, how much are those that would have been reflected in 2006 and were just brought forward” remains to be seen. He said the company’s increase in bad loans was not reflective of any fundamental change in the economy or credit trends but a function of higher bankruptcies spurred by the new bankruptcy laws. BoA set aside $1.16 billion for bad loans in the third quarter, up more than 78% from $650 million a year earlier, and one-third higher than the second quarter. Net charge-offs rose about 60% from a year earlier and about 31% from the second quarter.

Competitor JPMorgan Chase (Research) reported that it expects a $500 million charge-off from the spike in bankruptcies while Citigroup said that it sees a $310 million bankruptcy-related loss in the 4th quarter. Both companies said the majority of those bankruptcies were likely accelerated to meet the deadline before the new bankruptcy litigation and they expect to reap some benefit in 2006 from putting those bankruptcies behind them.

Link here.


Ta dah! To nobody’s surprise who has ever lived – or even visited – there, Manhattan is the most expensive place in the U.S. – according to a new survey by Runzheimer International, a Wisconsin-based management consultant. The study considered what a typical family of four earning $60,000 annually spends and compared the costs of maintaining that lifestyle in more than 300 U.S. locations. In Manhattan, that family would need to spend $146,060, 137.9% than in the average American town. It topped runner-up San Francisco by more than $24,000 to earn the dubious distinction of being the nation’s priciest town.

In the top five locations, which also included Los Angeles, San Jose, and Washington D.C., housing costs make up the lion’s share of total living costs. The survey factored in local and state income taxes, costs associated with owning two cars (except in Manhattan), public transportation costs, goods and services, sales taxes, and costs to own a 2,500 square foot house (mortgage payment, insurance, real estate taxes, utilities and maintenance). In Manhattan the survey figured those housing costs amounted to a whopping $100,532 annually and accounted for nearly 69% of all living costs. In San Francisco, similar housing would cost $79,156.

Link here. The BEST places to live in the U.S. – link.


For the first time we see inflation actually showing the results of rising energy costs, and the number is ugly. But it is not as ugly as it could be. Like the making of sausage and laws, looking at how the Consumer Price Index is calculated it is not pretty. “A 12% jump in energy prices in September caused the CPI to rise by 1.2 % last month, the largest monthly increase since a 1.4% rise in March of 1980. The sharp rise in September followed increases of 0.5% in each of the prior two months, bringing the annual inflation rate for the quarter to 9.4%.” (Dean Baker at CEPR)

However, if you look at the core inflation, without food or energy, it was just 0.1%, which is the same as it has been for the last five months. That means that the annual rate in the core inflation rate for the last quarter has been just 1.4%. But as we will show in a few paragraphs, that number does not tell the whole story. If you take out the housing component of the core index, you find that inflation has been rising 2.2% over the last quarter. But the government changed the way it calculates the housing portion of the CPI back in 1982. If you use the old method, you would find that inflation is 5.3% today and even core inflation is 4.3%. This is a far cry from 2.2%. Can you imagine the 10-year bond prices if inflation was thought to be 5.6%? Somewhere north of 7%, I would think, and certainly high enough to put more than a crimp in housing prices.

If all of this sounds a bit confusing, that is because it is. Let us see if we can shed some light on the process.

Link here (scroll down to piece by John Mauldin).


Let me state categorically that [this] sequence is barely questionable, almost inevitable, 99% unavoidable, and in modern parlance – a ‘slam-dunk’.” – Bill Gross, The Bond King, October 3, 2005

A half-trillion dollars. That is what Bill Gross is responsible for. Why is he entrusted with managing a half-trillion dollars? It is simple. Bill Gross has delivered double-digit annual returns in bonds for over three decades. He is the best bond manager in the world. That is why they call him The Bond King. What is his secret? I think his “secret” – if you can call it that – is that he actually thinks for himself. (This is rarer on Wall Street than you can possibly imagine.) Because of that, I always make a point to read his monthly Investment Outlook when it comes out. With his investment calls, Bill Gross may not always be right on the timing. But as his 3-decade track record shows, his calls are nearly always pretty darn good.

So when Bill Gross comes out with a call that is “almost inevitable” and “99% unavoidable”, as he did in his latest Investment Outlook, we have to take notice. If Bill is that confident, then we have got to think about adjusting our portfolios for this “almost inevetible” situation. And we have got to figure out how to best profit from it. Bill Gross is confident that a major change in the U.S. economy is just around the corner. What is “almost inevitable?” According to Bill Gross, it is: 1) a housing bust followed by, 2) a weakening U.S. economy. In his own words, he says:

“Make no mistake about it, the froth in the U.S. housing market is about to lose its effervescence; the bubble is about to become less bubbly. If real housing prices decline in the U.S. in 2006 or 2007, a recession is nearly inevitable.” Bill outlines the sequence he sees. And then he backs it up with facts. One source of facts for Bill is a new study by the Fed, which looked at real estate markets in 18 major countries over the last 35 years. Most people believe that “you can’t go wrong in real estate”, and that “real estate doesn’t go down over long periods.” But based on the findings in this important study, that is simply not true. While real estate rises over the long run, there are distinct periods where it falls.

The Fed found that housing booms peak, on average, 4-to-6 quarters after that country’s Federal Reserve first starts to raise interest rates. Here in the States, the Fed has raised rates for 5 quarters now. Based on history, we should be extremely close to the top. What happens after the peak in real estate prices? The Fed then hits us with a whopper: “Subsequently [after the peak], real house prices fall for about five years, on average, and their previous run-up is largely reversed.” Wow.

So where to from here? How do we make money on this almost inevitability? You could bet against the housing stocks … but they are very volatile. And besides, based on their earnings, the stocks seem very cheap to many investors. So that makes them a little dangerous as short sale candidates. You could bet against retailers, as once people feel their “house ATM” has run dry, they will not be buying as much stuff. But here again, that bet is at least partially in the market: Wal-Mart – THE retailer – is trading at 6-year lows. But my vote is for the one trade that nobody else is thinking about - selling short junk bonds. If the economy tips toward recession, then more people and more companies start to default on their loans. Which loans are most vulnerable to default? Junk loans, of course … loans to the highest risk borrowers.

Right now, interest rates on junk bonds are near their lowest levels in their recorded history, at around 8%. I find this amazing. People are willing to accept a measly 8% interest on loans from extremely risky borrowers. What this tells us is that investors are not afraid of default today. There is good reason for that. With the exception of the blip of a recession in 2001, we have had relatively good economic times for nearly 15 years now. But rainy days do come. We are making a bet that the rain will come some day.

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


The Power Of Myth is all well and good in the realms of literature, theatre, cinema, and even comic books. Alas, a myth can grow so deeply cherished that most people mistake it as fact: When Superman becomes real in the collective mind, all the evidence in the world will not overcome the delusion. Take the “benefits of diversification"” myth, for example, which has given birth to the $4 trillion stock mutual industry – a big reality by anyone’s yardstick. Here are a few points to consider. Along the way, ask yourself if this adds up to “diversification” (quotes and chart from the Oct. 3 Wall Street Journal).

“From 1950 to 1965, equity mutual funds turned over their portfolios at an average rate of 17% per year; in 1990-2005, the turnover rate averaged 91% per year.”

“As shown in the chart, direct ownership of stocks by American households has declined from 91% in 1950 to just 32% today. The 9% ownership stake held by financial institutions in 1950 crossed the 50% mark in 1983, and now totals 68% of all stocks.”

“The excessive advisory fees, expenses, hefty sales loads, and huge commissions on portfolio transactions paid to brokers in return for their sales support consumed something like 45% of the real returns earned on fund portfolios during the past two decades. Institutional investing is now largely the business of giants. America’s 100 largest money managers alone now hold 58% of all stocks.”

Now, some would say that none of the facts above speak to the benefit of “diversification”, namely that it helps reduce risk. Our reply is, Let the evidence speak for itself: From 1983 to 2003 the S&P 500 averaged a 13% annual gain while the average stock mutual fund investor earned 3.5% annually over the same period. In the real world, the only thing diversification has managed to “reduce” are investor returns. The truth is this: An ever-larger number of people give their money to an ever-smaller number of managers, who in turn oversee the taking of an ever-bigger slice of the pie.

Elliott Wave International October 20 lead article.


“I love the 5-year Treasury right now,” your editor declared to his colleagues yesterday during their monthly editorial meeting in Baltimore. “In fact, I like the entire yield curve, from three months out to 30 years.” I have not become a bond bull, dear investor, just a bond opportunist. “The U.S. economy is much slower than the official figures indicate,” Dr. Richebacher warned me during my visit to Cannes last week, “I expect the GDP to be negative in the first quarter of next year, if not earlier.” Bond fund manager Bill Gross has been uttering similar remarks of late. “Our Fed will likely be in the … position of lowering rates come mid-year 2006,” Gross predicted recently.

Either these two savvy, independent thinkers are onto something, or they are both suffering a form of sunstroke from toiling too long in the beachfront communities they inhabit – Richebacher in Cannes, and Gross in Newport Beach. But if these two men are correct, Treasury yields might start falling very soon … at least for a while. Interest rates along the entire yield curve might fall. But since your editor is a chicken, he would rather buy the 5-year than the 30-year. Today’s buyer of a 5-year Treasury yielding 4.30% would do very nicely if yields dipped back below 3.70%, the level at which the 5-year traded last June.

The obvious risk, of course, is that the yields will not fall, but will continue their recent ascent in step with rising inflation. In which case, the buyer of Treasury securities would fare poorly. Inflation may, indeed, accelerate. But it might also wither on the vine as U.S. economic growth stalls and heads into a tailspin. Already, the personal savings rate has tumbled below zero, despite the fact that consumer spending is also plummeting. In other words, even though consumers are retrenching, they are still unable to save money. The chart below explains much of the reason why. Rising energy bills have consumed a growing percentage of the American consumer’s meager savings, as well as a growing percentage of his massive borrowings.

“As a consequence,” BCA Research observes, “this year the increase in consumer spending on energy will exceed the support from housing for the first time since 2000. The corresponding squeeze on consumer purchasing power points to a slowdown in household spending growth in the months ahead.” We agree. Rising energy prices have completely eliminated the wealth effect – or “wealth delusion” as Dr. Richebacher would say – that cash-out mortgage refinancings have been providing for the last several quarters.

But despite this obvious squeeze on consumer liquidity, the Federal Reserve has continued to jack up short-term interest rates, the effect of which has been to place a financial noose around the necks of many American consumers. No wonder that so many of us are gasping for air. “With the Fed tightening and energy prices high,” one trader observed, “growth must eventually weaken. In that environment, yields have to eventually come down.” The logic seems impeccable. And yet, yields have been going up, while every member of the FOMC takes a turn “jawboning” rates higher still.

Raising short-term rates may seem necessary in light of recent nose-bleed inflation readings. But raising rates seems utterly unnecessary, if not downright suicidal, in an economy that is leveraged to the gills, lacks savings and relies upon inflating assets for its daily bread. We are worried that the Fed will do what it has so often done: raise rates too high and for too long, thereby triggering a recession. We are worried, and yet, we would not mind trying to make a buck amidst our angst. That is why we like 5-year Treasurys.

Link here (scroll down to piece by Eric J. Fry).


We have learned a lot about inflation in the past 35 years. From the double-digit price increases of the 1970s to a close brush with deflation in 2003, the inflation saga has gone through a remarkable transformation. The interplay between globalization and new IT-enabled technologies changes the very context of the inflation debate. Financial markets and central banks need to update their perceptions of the New Inflation.

The rules changed in the 1990s. Trade liberalization led to globalization, and closed-economy models gave way increasingly to the new realities of open economies. At the same time, IT-enabled technological change led to the birth of the Internet – the virtual glue that cemented cross-border connectivity in goods and services, alike. Central banks were unprepared for these developments. Fixated on closed-economy perceptions of price stability, they were surprised by the disinflationary consequences of the interplay between globalization and the Internet. At the same time, central banks came under the influence of the IT-enabled productivity boom – convinced that a new strain of productivity-led inflation immunity was emerging that could justify unusual monetary accommodation. This powerful combination – disinflation in conventional CPI-based prices plus monetary accommodation – provided an entirely different context for the inflation debate. It gave rise to the Asset Economy.

The 2000s began with a breakdown of monetary discipline in a post-asset-bubble world. Three months into the millennium, the equity bubble burst. Central banks dusted off the script of the 1930s and eased aggressively, injecting more and more liquidity into disinflationary economies. Real interest rates dipped back into negative territory, and the developed world lurched from one asset bubble to the next – from equities, to bonds, to property. The metaphor of the water balloon suddenly did not seem so far-fetched: In a world awash in excess liquidity, the inflation had to go somewhere. As globalization and technological change continued to squeeze pricing in goods and services, the surplus liquidity went to the other end of the balloon – the Asset Economy. Now, of course, central banks are attempting to reclaim the high ground.

As I see it, three powerful forces emerge from this saga – globalization, technology, and monetary policy. The first two are holding down inflation and, barring an outbreak of protectionism, are likely to do so for the foreseeable future. The third force -- monetary policy – has the potential to be an important swing factor. However, it is not clear what type of inflation – CPI or asset-based – will arise from excess monetary accommodation. Here, as well, context, is key. It may well be that liquidity injections are not powerful enough to outweigh the secular disinflationary forces of globalization and IT-enabled technological change. In a low nominal interest rate climate, that could well mean that the transmission of monetary stimulus gets directed more at asset markets than at goods and services.

The New Inflation should not be confused with the end of inflation. There are very plausible conditions that could lead to a meaningful and sustained reacceleration of price increases. In the end, however, I do not believe that commodity-specific supply shocks are enough in and of themselves to trigger a broad-based outbreak of inflation – even in economies such as the US, where slack in labor and product markets is dwindling. The New Inflation is dominated by a powerful inertia that is exceedingly difficult to dislodge. We may have inflation scares in the year ahead, but I suspect they will turn out to be false alarms. Stock and bond markets could be whipsawed if they discount mounting inflation. Central banks are at risk of going too far if they tighten in fear of the ghosts of inflation past.

Link here.


The long-awaited China slowdown has failed to materialize. There have been some brief periods of hesitation over the past year but nothing on the order of magnitude of the cyclical downshift I had been expecting. This raises a key question for the global economy: Can anything temper the Teflon-like resilience of a rapidly growing Chinese economy? The Chinese data have zigged to the upside at just about the time I thought they would zag to the downside. Almost all the major macro indicators in China were stronger than expected this past summer.

Notwithstanding China’s seemingly never-ending investment boom, the issue of sustainability is now an increasingly serious question. The latest GDP statistics raise a major warning flag in that regard: Fixed asset investment surged to an astonishing 54% of GDP in 3Q05 – up fully six percentage points from the 48% share a year earlier. Such investment ratios are unheard of in the modern-day realm of economic development. Even in their heydays, investment ratios in Japan and Korea never climbed much above the low-40% channel.

The China boom is a sight to behold. As impressive as the data are, they do not do justice to the true power of the Chinese growth miracle. But the laws of the business cycle have not been repealed. Nor has China been granted special dispensation from those laws. I was wrong to expect that the confluence of investment and export pressures would trigger a China slowdown in late 2005. That mistake tells me that there may be a good deal more near-term momentum to the economy than I had previously thought. But I would be wary of extrapolating this resilience indefinitely. Because of China’s excess dependence on the over-extended American consumer, the Chinese export outlook faces far more immediate risks than those which eventually might come to pass on the investment side of the equation. Even so, the mounting overhang on China’s supply side – investment share of 54% of GDP -- is increasingly worrisome. It is mea culpa for now, but I still feel there could be a serious test to an unbalanced Chinese economy in 2006.

Link here.
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