Wealth International, Limited

Finance Digest for Week of October 31, 2005

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


The 1980s were the decade of the speculator – and now, 20 years later, we have such a window of opportunity again. Successful speculators should emerge from the first decade of the 21st century wealthy beyond their wildest dreams. Fortunately, it is a profession open to all. No formal education, credentials, or licenses are required. All training is on the job, and best of all, the apprenticeship is “earn while you learn”. It is an appealing job opportunity, but unfortunately one that carries a stigma.

I have been known to talk about a lot of suspiciously asocial concepts: financial crash, depression, hyperinflation, the alternative economy, hoarding. They are all buzz words that arouse vivid images and strong emotions. Perhaps the most powerful word of all, however, is “speculator”. It sounds so irresponsible, opportunistic, and dangerous. Politicians and the media throw the word speculator about so abusively. I suspect few people have ever dared to ask what one really is. In the popular mind a speculator is someone associated with shortages, price hikes, wars, natural disasters, and other calamities. A speculator is simply someone who sees, or anticipates distortions in the marketplace and positions himself to take advantage of them. He can do that because he understands their causes, and their effects.

Speculation will be the foundation of dynasties in the turbulent years ahead. The original Baron Rothschild knew how to profit from the politically created chaos of the French Revolution era. He became rich and famous by following his own advice to “buy when blood is running in the streets”. If you are the least bit attentive, the longer-term risk/reward profile for the speculator is in an entirely different league than that of the “conservative” investor.

These days, while the chattering masses are frantically looking for safe harbors against the gathering storm, the speculator is accumulating positions in the quality gold companies. While gold is more in the news than it has been in years, the average investor still views it skeptically, thinking gold investors are somehow goofy. As you will read below, that makes this a nearly ideal time to load up – though buying aggressively early last year when few wanted to know about gold was better.

Investing for income is the kiss of financial death. Why have any of the great millionaires of the past not taken advantage of the simple gimmick of compound interest to eventually take over the world? (If the Indians had invested their $26 for the sale of Manhattan for a 5% compounded return, their money would be worth $2,790,729,193. today). It is not because they have not tried, I am sure. It is because no investment will give you a true 5% for even the length of a lifetime. In fact, there is probably nothing that can be relied upon to yield even 3% over more than 40 or 50 years. It shows the futility of trying to stay ahead in any type of “secure” investment. Everything is a speculation, whether people know it or not; those who settle for a low but “secure” return are penny-wise and pound-foolish in the most profound sense.

When you settle for a “conservative” return, even the slightest miscalculation, bad luck, or government fiat can wipe you out. Taxes will always erode your capital, directly or indirectly. Inflation, for the foreseeable future, is sure to get worse and fluctuate wildly as it does. Banks and insurance companies – the very institutions that have always gotten away with offering low yields because they were so stable – will fail as they always have … especially given the current overvaluation of most U.S. real estate and the underlying loans that are looking increasingly shaky. The government itself will eventually be replaced and currency will become worthless. And there is no way to truly protect against the risks of war, theft, fraud, and natural disaster. Investing for income – especially in today’s climate, when cracks can be seen in the foundations of society itself – is the height of stupidity.

If you invest for income, you are handing over responsibility for your future to others. You do not know what they are doing with your money, you cannot know how intelligently they are going to conduct themselves in the future, and you do not even really know how sound their capital position is. That is a bad enough set of fundamentals for a madcap gamble, but in return for a simple yield, it is absurd. What, then, to do? What is the method to overcome this madness? The only answer I know of is to lay a solid financial foundation, and then gather up your cash and your courage and learn the art of speculation. Below you find some general rules of successful speculation, in summary. Decide for yourself how they match up with the opportunities present in gold and other resource stocks today.

Link here.


October is frequently a tough month but this year has been particularly brutal, due to this month’s drop in energy stocks, corporate deals that fell through, and a tough market for stock and bond markets, according to people in the industry. “Outside Japan, most of the major markets are down, the emerging markets got hurt a lot, and macro funds that decided to go long in October are going to get hurt very badly,” said Larry Smith, chief investment officer of Third Wave Global Investors, a hedge fund based in Greenwich, Connecticut, that trades based on broad economic trends around the world, a strategy known as “global macro”.

These people said that traditional “long/short” stock funds in particular have taken a beating, with declines as high as 8 to 10 percent for the month in extreme cases. Long/short equity funds, which buy stocks that fund managers believe will rise and sell short the stocks of companies they feel are overvalued, constitute a good deal of the estimated 8,000 hedge funds worldwide.

It has also been a tough month for U.K. managers. The Cantillon World Ltd.fund, a global long/short equity fund and generally a top performer, was down about 3% for the month through Friday, October 27, bringing down its year-to-date gains to about 10%. Cantillon has offices in New York and London and is run by former Lazard Asset Management star William von Mueffling. British hedge fund manager Gartmore sent a letter to investors saying October had been its worst month ever and that its $1.5 billion AlphaGen Capella fund, traditionally a strong performer, was down 3.5% for the first three weeks of the month, according to a report in the Financial Times.

Short selling – a bet that a company’s stock will decline – involves selling borrowed securities with the hope of buying them back later at a lower price and pocketing the difference. October took a chunk out of the returns of several large, traditionally high-performing funds, according to hedge fund investors. In particular, funds that held long positions in energy stocks got slammed while the broader market struggled.

Link here.

Offshore adviser registration is imminent.

At this point, it is widely known that the U.S. SEC has issued new rules requiring certain hedge fund advisers, including advisers who have their place of business located outside of the U.S. (offshore advisers) to register with the SEC as advisers pursuant to the U.S. Investment Advisers Act of 1940, as amended. While the hedge fund industry continues to speculate as to whether the new rule will be scaled back or eliminated as a result of legal challenges or the recent change in leadership at the SEC, the current reality is that offshore advisers who advise U.S. based hedge funds with more than 14 investors, or offshore hedge funds with more than 14 U.S. investors, will need to be registered with the SEC before 1 February 2006.

As this date is quickly approaching, we have prepared the following concise summary to assist offshore advisers to hedge funds with evaluating the impact of the rule on their businesses.

Link here.


Seven months ago Annaly Mortgage Management (12, NLY) fetched $19 a share, 150% of book value. Its dividend yield was 10%. Today, at $12, the price is just 90% of book. The yield is all of 4.5%. Now unfolding is a bullish brief on the biggest of the mortgage real estate investment trusts. Imagine a thrift institution without walls; you have now imagined a mortgage REIT. True confessions: I own the stock, have friends among its management and have consistently been better at saying “Buy it” than “Sell the dog short”, even when a short sale was exactly what a farseeing doctor would have ordered.

Annaly exists to produce interest income. The raw materials of income include borrowed money, judgment – and luck. With the borrowings, management invests in mortgage-backed securities. Exercising its judgment, it decides how much to borrow, at what point on the yield curve to borrow (short, medium or long) and in what to invest. Mortgage-backeds come in a variety of flavors: fixed-rate or floating, high- or lesser-quality. Annaly invests one-third in fixed-rate assets, two-thirds in floating-rate or adjustable-rate loans; it buys nothing that rates less than AAA. As for luck, a mortgage REIT needs lots of it. The shape of the yield curve, the level of interest rates and the speed at which homeowners refinance their mortgages are factors that management has no more control over than it does the weather.

The March 14 installment of this column was devoted to the yield curve – the alignment of rates from the present into the distant future. At the time of publication the difference between the federal funds rate and the 5-year Treasury note was 169 basis points. If that spread were to shrink or disappear, I said, “the Annaly dividend would certainly be cut, and the share price would probably fall.” Better to have written “would certainly fall out of bed.” Today the difference between the 5-year yield and the funds rate is only 57 basis points.

So the cost of funding a mortgage portfolio has been rising. But the yield on a mortgage portfolio has been rising only a little. In other words Annaly’s net interest margin has gone to seed. Compounding the trouble, homeowners have continued to refinance. Annaly would consider itself lucky if the yield curve steepened, mortgage rates lifted and – in consequence – refinancing activity plunged. For what it is worth, I happen to believe that these things are happening. But I cannot know, and neither can Annaly.

Happily for the prospective Annaly shareholder, Mr. Market has washed his hands of the stock, and of others like it. Annaly, the lowest-cost provider among mortgage REITs, was quoted at right around book from its 1997 inception until 2001. Annaly commanded a premium to book value from early 2001 until just a couple of weeks ago. A company so dependent on exogenous factors – luck, a layman might say – deserved no premium to book value, the bears contended. Whatever the merit of that argument, they have managed to carry it. But few things are luckier than a low valuation. At book value or below, Annaly has had most of the disappointment wrung out of it.

Link here.


San Diego portfolio manager John I. Dickerson doles out Cassandra-like warnings about water shortages every chance he gets. In ominous tones he will talk about how there is not one more drop than a million years ago, but 6 billion people now are competing for the same resource. And the biggest needs are in developing countries. Only 20% of the world has running water for residences. Two-thirds of China’s 669 cities have a dearth of water. Plus China, currently fueling 30% of the world’s economic growth, plans to add between 200 and 400 power plants, an approved 300 gigawatts, but it does not yet have the water lined up for their construction or operation. Goldman Sachs predicts a 10% to 15% expansion in developing countries’ water sectors vs. only 4% to 6% in the developed world.

This is a situation awash in opportunity, says Dickerson, 63, head of Summit Global Management, which runs water portfolios for wealthy clients. U.S. investors bid up water stocks 20% earlier this year; now the frenzy has cooled, and water stocks are up only 7.2% for 2005 (still better than the market’s -1.3%). But this surge has put the price/earnings multiples of U.S. utilities like Aqua America and Southwest Water on the high side – 34 and 54. More enticing prospects are found in companies serving places like China, India and Latin America, where water systems must be built from scratch.

There are two types of water investments: water utilities, which provide the stuff, and water industrials, which service the utilities with engineering, construction, pumps, pipes and filters. That adds up to 371 companies, 109 of them American, with a market cap of $623 billion. The investing appeal: revenue streams far more predictable than those from other resources such as oil. “They have better trickle-down economics, are not affected by a weak dollar or whatever else,” Dickerson says. “This is a wonderful business.” Starting in 2003 Dickerson sold off a lot of his U.S. water portfolio (today it is only 15%) and put the money to work overseas. He sees six stocks as worthy of your consideration.

Link here.


Which of the following, do you think, will wreck the ongoing economic expansion? a) high energy costs; b) rising interest rates; c) hurricane aftermath; or d) the bursting of the housing bubble. My answer is D. The other factors will add pain, but will not initiate the downturn.

$3.00/gallon gasoline and much higher home heating bills this winter seem ominous on the surface. But the reason that energy probably is not an Achilles’ heel is that the economy’s shifts over the past quarter-century have softened its impact. Even with the recent price jumps, energy accounts for only two-thirds the share of consumer spending that it did in 1980. With rare exceptions, notably the Fed’s 1994 increases, Fed rate-raising campaigns precipitate recessions. But they probably will not this time, since Fed actions lately are not bothering borrowers. Credit card rates already are at usury limits, and people keep using their plastic. Other interest burdens have stayed low. Meanwhile, the impact of the hurricanes has been minimal. The Katrina-affected area accounts for 1% of U.S. retail sales. Expect consumer sentiment to rebound and spending to continue.

The good news ends when the house price bubble breaks. Then homeowners will join low-income renters in feeling higher energy costs. Once mortgage lenders suffer and tighten lending, borrowers will feel the Fed’s full fury. Already buyers are evaporating in tony suburbs, and upscale home prices are melting in exuberant markets like New York’s.

What to invest in? Safe Treasury bonds remain my 25-year favorite. Manufactured housing is one of the few winners from the hurricanes. The government is buying lots of units for refugees. This industry’s winter of discontent, sired by mid-1990s liberal lending, seems to be over as mountains of repossessions finally are absorbed. Do not confuse these with conventional home builders, which should be sold or shorted. Here is another candidate to sell or short: regional banks. These banks had benefited from a wide spread between what they pay for deposits and collect from loans. With flat long rates the Fed will no doubt invert the yield curve to meet its objectives. Bad news for spread lenders.

Link here.


Targeted-maturity funds adjust the stock-bond mix for you as the years go by. But some take more chances with your money than others. It sounds more scientific than it is. A formula dictates that you should be equity-heavy when you are young and reap stocks’ storied appreciation through the decades while outpacing inflation. Then as old age nears, you shift into safer, income-generating bonds. The logic is that if you suffer a bear market when you are young you have plenty of time to earn the money back and almost certainly will, while a retiree might never get a chance to recover.

As logical as the formulas are, they do not alter the fact that investing still involves a lot of guesswork and that the next century in the market might be very unlike the past one. These uncertainties have not stopped the mutual fund industry from creating products built around age-based formulas. The funds automatically reallocate your money away from stocks and into bonds as you age. Overall, fund tracker Morningstar found 98 of these funds from 17 companies.

If the fund managers cannot guarantee a stock bounce-back from the next bear market, they at least reduce the risk that you will panic and sell at the bottom, only to buy back years later when you are older and stocks are dearer. All you have to do is avoid meddling with the autopilot. With any equity-rich fund, says Standard & Poor’s mutual fund strategist Rosanne Pane, “when the portfolio is down 20%, you’re going to have a bad reaction.”

Link here.


When my last laptop stopped behaving itself I called the support hot-line, and spoke to someone much more qualified than me to fix it. He told me how to run some tests and we re-set my “system configuration”, whatever that is. But despite his assurances that the system should now work it did not. After a week or two of increasing desperation in the end there was only one way I could get my computer back to predictable behaviour. I threw it out of a second floor window.

Science is about simple laws. A single scientist explained the motion of the planets and free-falling laptops. In contrast to the simplicity of scientific explanation technology is the work of countless thousands. No-one can point to a single individual and say “that person produced the modern computer.” Machines are the result of new designs and solutions stacked one on top of the other – usually until no-one wholly understands how all the pieces work together. They are masterpieces of organized complexity.

Science’s second law of thermodynamics predicted my chaotic heap of broken computer pieces, and also predicts that when a system of any kind gets complicated you have to pour in energy and effort to maintain the complexity. It correctly predicts that all organized systems eventually break down and become disorganized again. Everything from a house to a human body, from a bag of sugar to a spaceship, obeys this law. Time eventually makes organized things turn back into formless mush, and the best we can do is pump in increasing amounts of energy to hold the inevitable decay in check for a while.

The 21st century economy is a technical device. The modern western economy is a designed system too, although it used not to be. In the old days nobody seriously tried to organize the forces of economics. Instead everyone just sat out the bad times, scratching a living in fields and factories, while natural forces swung the economy to and fro. Then western economic engineers realized economic forces could be organized and harnessed. They discovered that under the right circumstances, if money flows were directed in a clever enough way, they could produce an economic system which benefited people. This has had the amazing result that those of us who have lived inside their increasingly complicated economy have become the wealthiest people ever. Nevertheless the natural laws of science and of economics will win out. There is absolutely no doubt that this cleverly organized and beneficial economic system will fail; no doubt whatsoever. The only question is “When?”.

My old computer reacted to its increasing complexity by delivering me a series of error messages. It started with “Disk read checksum error”, went through “please consult your system administrator” (by which I think it was optimistically referring to me), and finally offered what computer people call the “blue screen of death,” just before its short and violent final journey. In much the same way there are ominous error messages coming out of the western economies – in the form of the twin deficits. Every one of 100 million U.S. families spends $5,000 too much every year. They are allowed to by the U.S. government, which leaves that money in the family’s pocket while enthusiastically spending it too.

This money leaves the U.S., and is then lent back by foreigners to cover the government shortfall. The U.S. will have to pay interest on this borrowed money as well as somehow claw back over the coming years the significant sum of $75,000 from each of 100 million U.S. families. This is the unprecedented extent of the U.S. public debt. Our central bankers call these “imbalances” in the world economy. They are the error messages which nobody knows how to fix any more. Perhaps governments could raise an extra $5,000 dollars a year in tax from each family. But that would cause a spiralling implosion of demand. Suddenly millions and millions would be jobless and the diminished tax take from their employers and their salaries would leave the public purse even worse off than it is now.

So logic dictates (to the current administration at least) that we must look the other way – to tax cuts which boost the economy and produce higher gross revenues. But although it worked for Reagan no-one really believes this solution either, and it certainly is not working so far. The truth is that the previous level of taxation was somewhere near optimal. If we got an overspending habit at that rate – which we did – it would be unfixable, and debt would go up and up until something broke.

The second law of thermodynamics has patience. It allows us to expend our energies and break the economic monotony of fields and factories by organizing a perfectly good system with a perfectly useful output; yet there is never a doubt the system will eventually decay. As I was reminded by my failing computer this is no bad time to check your backup strategy.

Link here.

1987 REDUX

In focusing on history and patterns that led to substantial market declines, we would be remiss to exclude Dr. Bruce Jacobs. Dr. Jacobs is co-founder and principal of Jacobs Levy Equity Management, which is recognized as one of the world’s leading institutional equity money management firms, and he is an expert on the events that led up to and occurred during the Crash of 1987. In his wittily titled book, Capital Ideas and Market Realities, Dr. Jacobs details the account of an investment tool known as portfolio insurance and its contribution to the Crash of 1987. Much like indexing and program trading today, portfolio insurance promised a way to allow investors to participate in market rises and at the same time reduce the risk associated with market downturns.

The similarities between Long Term Capital Management (LTCM) and Leland O’Brien Rubinstein Associates (LOR) were uncanny. In both cases, the credibility of scholastic genius gave way to implicit trust that was largely unmerited. Both LTCM and LOR (and program trading today) built their models on the premise of increasing returns and limiting risk, based on the assumption of efficient markets. Like LTCM, the flaws of LOR’s posit were not apparent at first, and both experienced short-term success. Yet, as John Breazeale, in a statement resonant of Yogi Berra, comments, “If your trading strategy is fundamentally flawed, eventually you’ll lose a lot of money. In a fallacy of composition similar to LTCM, as other players entered the market and employed similar program trading models, portfolio insurance (dynamic hedging today) actually exacerbated the volatility in markets – the very thing it was designed to protect against. As the markets rose in the early-mid 1980’s, so did the amount of money in portfolio protection products. As investors began to buy, the markets moved higher. As the markets climbed, the portfolio insurance models assumed that the markets were safer and the “black boxes” took increased exposure to the markets.

By the close of trading the Friday prior to Black Monday, October 19, from its August 1987 peak, the Dow had lost 17.5%. Somehow this little piece of history is overlooked. Yet, the recurrence of this “decline-before-the-decline” pattern can be seen in other crashes as well. In what could be interpreted as a false sense of security, the total equities sold that week were only about a third of that volume. This muted selling created a huge overhang of selling pressure that would wreak havoc on the markets the next week. On Monday morning, the fallacy of composition that Dr. Jacobs had debated with his colleagues was now to take place. No more marketing. No more debating, just the hard cold reality of the markets.

Dr. Jacob’s work on the intricacies of the patterns and probable causes of the 1987 crash makes a few points painfully clear: 1.) Markets are given to the irrational herding instincts of the masses, and are therefore inefficient. The extremes of the black pessimism of the early 1980’s and the manic behavior that led to Black Monday lend evidence to this truth. 2.) Fallacies of composition eventually lead to liquidity crises, where everyone wants to sell. As well, program trading and indexing foster trend following behaviors, which often lead to fallacies of composition. 3.) There are patterns that are evident before market crashes. This is true of 1929, 2000, and events leading up to Black Monday in 1987. Managers who study history and who are given to independent research can often identify these patterns and, in anticipation of decline, exit the markets ahead of other investors.

The following three issues point to the manic behavior of the masses. Exchange Traded Funds (ETF’s) and program trading certainly promote trend following behavior. And, the exponential growth of ETFs, program trading, and the U.S. Credit derivatives market is nothing short of a mania. Combine this with the bullish sentiment of the masses, and we have a formula for a 1987 style meltdown.

Jim Bianco, president of Bianco Research LLC, stated recently, “The majority of trading is no longer investors buying a stock based on a company’s fundamentals, it’s program traders buying groups of stocks and making macro plays.” Since the beginning of 2000, ETFs have grown from $36 billion to over $260 billion today. With an annual growth rate of over 29% for the past five years, 14 ETFs’ possible effects must be considered. For the week ending September 16th 2005, program trading comprised 70.9% of total shares traded, the third largest percentage of program trading ever recorded. And since their inception in 1997, credit derivatives have been one of the fastest growing areas of the derivates markets. At the end of 1997, their notional amount stood at $55 billion. At the end of 2004, that number had grown to $2.3 trillion. Amazingly, at the end of the second quarter of 2005, the notional amount had grown to $4.1 trillion. That means credit derivatives have grown at an annualized rate of 150% in the first six months of this year. And, this is just the notional amount. All of the above points to the masses acting in a largely similar fashion.

With the myriad of economic and financial problems our country now faces, most people are unconcerned if not overly optimistic. According to Investors Intelligence, bullish sentiment on the stock market has now had 158 straight weeks with more bulls than bears. In the 42 years that this has been tracked, this is the longest streak of bulls outnumbering bears. It is currently even 6 weeks longer than the 152 weeks that bulls outnumbered bears as we experienced the Crash of 2000. Keep in mind, this is a contrary indicator. That means that when there are more bulls than bears, markets historically have declined.

As you look at this information, consider these recent words of Jeremy Grantham, “The commercial or political imperative to deliver relentlessly bullish opinion is extreme, even when insiders may actually feel more bearish. To make matters worse, it seems that most of us are hard wired to be gullible; to believe that authorities know what they are doing, and that a large consensus view should probably be adopted.”

Link here.


When a hurricane is approaching land, there are plenty of warnings. When corporate executives are involved in questionable financial practices, investors often do not know what hit them until the business files for bankruptcy. How can investors avoid the inevitable Refcos, Enrons and WorldComs of the future? Sometimes there are signs, though it requires a vigilant and skeptical eye to spot them.

Yet it is not unusual for directors, company stewards who are appointed to oversee shareholders interests, to be in the dark along with shareholders. And contrary to conventional wisdom, stock prices do not always reflect internal corporate turmoil. Share prices sounded no advance warning in the case of Refco Inc., the largest independent U.S. futures broker, which disclosed that Chief Executive Officer Phillip Bennett hid $430 million in bad debts. Bennett, since ousted, was accused of securities fraud on October 12.

Major financial maladies often are difficult or impossible for investors to detect. After all, those behind the chicanery do not exactly advertise what they are doing. While individual investors do not always have access to the detailed information that may tell them of an impending blowup. Shareholders sometimes can force greater transparency and accountability. Here are some guidelines. Some light is better than none, and it certainly makes executives aware they cannot easily pull the shades on their shenanigans.

Link here.


Personal savings – funds left over after expenses, excluding stocks, home equity, and other holdings that are less accessible than cash – are at lows not seen since the Great Depression. For every $1 of after-tax income in the third quarter, Americans spent $1.01 on average, according to figures released from the Bureau of Economic Analysis. That means households are spending more than they are taking in and making up for that deficit with credit card charges and home equity lines of credit. Last year, they saved an average of 2 cents for every $1 of after-tax income. In the mid-1970s, Americans saved about 14 cents of every $1 they took home. And while the U.S. is the wealthiest nation on Earth, it saves the least among industrialized peers like France, Japan and Canada.

Some banks have come up with creative ways to promote saving, including credit and debit cards that use consumer spending to build nest eggs. But there are many obstacles. Would-be savers and consumer advocates attribute the drop-off in savings to higher costs associated with housing, health care and education. “Everyone tells young college students to save while you’re young, because time is money,” said Melissa Boone, a sophomore attending Spelman College. “Even with one or two part-time jobs, as most of my friends and I have, a lot of us are still struggling just to pay our bills, so we’re not as worried about saving money.”

Some financial experts say the low-savings trend reflects generational differences. Savings rates soared in the years after the Depression because people were not too optimistic about their futures. But the baby boomer generation grew up in relative prosperity and did not have those same fears. But others say too many people want instant gratification and do not want to make sacrifices for their future. “You have all of the ‘keeping up with the Joneses’,” said Lori Kay Johnston Wadsworth, a stay-at-home mom from Douglasville. “We’re a microwave society, we expect everything to happen yesterday.”

Link here.


A visit to the glitzy section of any city in America will give you the idea that we do not know what to do with all the money we have. You get the same impression at any high-end mall in suburbia. In fact, income thins out pretty quickly. According to the most recent IRS statistics on tax returns, for 2003, households needed at least $295,495 to be in the top 1%, $130,080 to be in the top 5%, $94,891 to be in the top 10% and $57,343 to enter the top 25%. Yes, you read that right. If your household income is over $57,343, you are well toward the front of the line when the checks are handed out. If your income is below $29,019, you sink into the bottom 50%.

Increasingly, those in the bottom 75% – households with incomes below $57,343 – are starting to look like a long, slow train wreck. Without recognition of the problem, the entire country could find itself in dire straits pretty quickly. Let me show you why.

Link here.


Since President Bush nominated Ben Bernanke to become the next Alan Greenspan, we have heard endlessly about the Fed’s powers over the financial markets and the economy, and about how hard it will be for Cousin Ben to fill Uncle Alan’s shoes. But despite the outsized attention that any utterance from the Fed chair typically gets, the economic world is not controlled by one person, or even one institution. Bernanke will be a powerful guy, of course, and well worth watching and listening to. But you have got to remember two things about the Fed.

First, it is not looking after your personal interests – it is looking after the financial system, which is not the same thing. For instance, in the early 1990s, when many major banks were effectively insolvent, the Fed bailed them out by lowering short-term rates, handing them huge profits at the expense of people who depended on CD income for food money.

Second, the Fed is far from all-powerful. In fact, it is considerably less powerful than it was when Greenspan took the helm in 1987. Since then, the U.S. has become dependent on the rest of the world – especially the central banks of Japan and China and other Asian countries – to finance our budget and trade deficits. If Asia grows less eager to hold dollars, U.S. interest rates will rise, regardless of the Fed’s wishes.

On the domestic front, our largely deregulated financial system is far harder for the Fed to influence than the old regulated system was. When interest rates paid to depositors were regulated, the Fed could raise short-term rates, lure money out of banks into Treasury bills and slow down bank lending. Now, with no interest-rate ceilings and non-bank lenders such as hedge funds abounding, the Fed’s influence has waned. The one important interest rate the Fed controls – the federal funds rate – drives short-term interest rates. Sure, that is important if you are in hock to a credit card company. But the fed funds rate does not drive long-term rates, which are set by financial markets and are far more important to businesses and home buyers.

What I like best about Greenspan is that he plays things by ear and will not say what he is really up to. That magnifies the Fed’s influence by keeping big market players off balance. The players care only about making money, but the financial system needs balance, which the Fed provides. With the Fed less powerful than it once was, guile is good. We will not know how effective a Fed chairman Cousin Ben will be until after his first crisis. But one thing we know already: a divinity, he is not.

Link here.


There is a world of difference between All Saints’ and Halloween. The spirits that one honors on All Saints’ were not, after all, all saints. They were real. They were spirits that might be honored … or feared. (Of course, if you do not believe in the spirit world, you have no business celebrating All Saints’ anyway.) But regardless of your views on the afterlife, All Saints’ requires at least some reflection – on the lives of our forebears, on the challenges they faced and perhaps the lessons that could be learned from them. At the very least, you might stand before the grave of someone you knew … offer flowers … and spend a moment recalling the person. This is not a ritual that lends itself to the Internet age.

Halloween, on the other hand, is an example of what Philippe Muray calls “Festivus”. Muray has noticed the way in which the genuine, dark, primeval, wild and dangerous currents and undercurrents in society have been tamed, and transformed into harmless celebrations. This applies not merely to the shift from All Saints’ to Halloween, but also the political process, where genuinely revolutionary parties have been replaced by a token opposition and emasculated rebels.

We have often noted how in America you cannot even say what you want about taxes anymore without fear of criminal prosecution. Yet, is there any real opposition – of a sort that might be described as dangerous to the government? No, we celebrate the First Amendment now; we do not practice it. Likewise, America celebrates liberty. It is like Halloween … an empty expression … a hollow festival … something to feel good about. No reflection required. No risk, either. But what would the ghosts of Jefferson and Adams think of us?

Who cares? As the GDP increases … shares rise … and the spirits of Liberty remain in the grave, pumpkins are the business to be in.

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


“I’m not a person that believes in the bubble so much,” says Donald Trump. “I have seen real estate go up and down, but it always seems to go up more than it goes down. I really think it is a good time to purchase.” Treasury Secretary John Snow agrees: “I think the bubble is a gross misnomer,” the former railroad man opines. “The idea that we’re going to see a collapse in the housing market seems to me improbable.” The National Association of Realtors, we suspect, would also deny the presence of a housing bubble, as would the Mortgage Bankers Association and the United Brotherhood of Carpenter’s and the American Society of Interior Designers and every other entity that holds a large vested interest in the housing market’s well being.

For example, a family that commits 40% of it is annual income to satisfying an interest-only mortgage, financed with no money down, is not buying a house. It is speculating. And as all seasoned financial market participants know very well, leverage creates surprises … usually bad surprises. It accentuates price action in both directions. On the way up, the leveraged speculator rarely neglects to credit his genius. But on the way down, he rails against his bad luck. Hence, if/as/when the housing market turns south, we might all be surprised by the staggering number of geniuses who encounter bad luck … and we might also be surprised by the ferocity of the price declines, as the leveraged speculators rush to “de-lever”.

Consider a few of the alarming facts that Merrill Lynch analyst David Rosenberg has identified: 1.) Housing affordability nationwide has dropped to a 13-year low, while the household debt-service ratio has soared to a record high. 2.) Over one-third of all homeowners devote more than 30% of their incomes to monthly mortgage payments. 12% of homeowners devote over half of their incomes. 3.) Sub-prime borrowers accounted for 28% of all new mortgage lending in the past six months, vs. 5% five years ago. 4.) In the first half of 2005, two-thirds of homebuyers financed more than 80% of their purchase, according to SMR Research. 5.) 17% of homeowners have a loan-to-value ratio (LTV) of 95% or more, versus only 3% one decade ago. (That means that 17% own less than 5% of their home’s value free, and clear.) 6.) About 42% of first-time buyers made NO down-payment on their home purchases in 2004.

Each one of these facts is frightening, but taken together, they are absolutely terrifying. At least they ought to terrify every investor who possesses a faint knowledge of financial market history and a 5th grade command of mathematics. Frothy asset markets ALWAYS “correct” at some point; such is the immutable law of the financial universe. And when the inevitable correction arrives, leveraged speculators ALWAYS fare very poorly. That is where the 5th grade math comes in. Never before have so many home buyers been so vulnerable to so slight a dip in homes prices. Nearly 20% of ALL American home-owners would see their home equity wiped out entirely by a mere 5% decline in home prices.

The American penchant to undersave and overspend has contributed mightily to the housing boom. But this very same habit will speed the housing market’s demise, once the trend turns. Therefore, as Jim Grant concludes, “There are worse investment rules of thumb than to stand clear of bubble-like markets.”

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


Selling a house the past few years has been easy. Put up a “For Sale” sign. Host an open house. Sift through multiple offers. Pick a buyer willing to fork over more cash than you initially asked for. Then brag about how much you got. That was then. And now? While there is still a plentiful pipeline of home buyers looking to make a deal, finding one willing to make a split-second decision to buy and pay whatever it takes to get in the door is no longer a lock, real estate agents say. In what could signal a mood shift in the feverish real estate market, tales of bidding wars and 30% annual price gains are quietly fading. Instead, there is nervous chatter about the recent increase in the number of homes for sale, sellers cutting their asking prices, and builders wooing buyers with incentives.

The reason: There are signs that the overheated market might finally be cooling. The Commerce Department, for example, said sales of new homes in September fell shy of expectations, median prices declined 5.7%, and the number of new homes for sale shot up to a record 493,000. Freddie Mac also said October mortgage applications seem to be “tapering off”. It is not just the megahot markets such as New York City, San Diego and Phoenix showing stress. Softness is also being reported in condo-happy Las Vegas, the stalled auto capital of Detroit and Midwest college towns such as Madison, Wisconsin.

Richard DeKaser, chief economist at National City, says the 5-year housing bull run peaked this summer. “What we will see is a dramatic slowing in price appreciation,” he says. Only a few, high-risk markets, he predicts, will experience price declines. Once white-hot San Diego County is a test case. Home sales there fell 4.7% in September from year-earlier levels, and price appreciation slowed to 3.8%, says DataQuick Information Systems. Despite the pullback, DataQuick analyst John Karevoll describes the market as “stable” and “more normal”.

High-end properties and the more speculative, investor-driven condominium market are under the most pressure. The Florida condo market, suffering from oversupply, overinflated prices and speculation, is prone to price declines of 20% to 30%, says Jack McCabe, a Deerfield Beach, Florida, housing consultant. In Miami-Dade and Palm Beach counties, 11,465 units are under construction, permits for an additional 14,500 have been OK’d and plans for 36,000 more have been announced. Prices are “changing as we speak,” he says.

Link here.

High-end homes getting harder to unload.

Most open houses feature a hovering real estate agent, a stack of listing sheets, and – if you are lucky – a pot of coffee and some cheese and crackers. But at The Pinehills, where the koi pond and home movie theater can come standard with a $1 million-plus home, think celebrity chefs and haute cuisine. To attract buyers, developers of this massive planned community in Plymouth, Massachusetts – the town where the pilgrims landed, about 40 miles south of Boston – called in A-list chefs to cook in their new model homes at an open house. They cannot afford not to. High-end houses are becoming harder to sell in some of the nation’s hottest real estate markets, which are being flooded with listings as baby boomers downsize. Rising interest rates and energy costs may be scaring off some buyers.

“It has turned from a seller’s market to a buyer’s market,” said Greg Spier, who builds large custom homes in suburban Boston. “The marketplace has become astute. There’s more inventory. People are becoming pickier. Maybe there’s eight to 10 homes to look at. A year ago maybe there were one to three.”

The changing landscape means real estate agents are going to great lengths to attract choosy buyers of these multimillion-dollar homes. In Miami Beach, agent Zahara Mossman says she uses podcasts to provide online audio descriptions of her listings. She said it is something that sets her apart from competitors and is critical to her success. Potential buyers can go to her Web site, and click into an audio description before deciding on whether to see it in person. “The competition is fierce,” she said. “I have an edge.” Mossman said the market is “as hot as ever,” but noted that two of her wealthy clients recently opted to rent instead of buy a home, convinced that luxury level prices are falling. “They’re going to rent for a year and watch the market,” she said. “They have money to buy, they’re just cautious.”

Warren and Sarah Bland are looking for a new home but are in no rush to buy. They sold their Brentwood, California, home two years ago – raking in a gross profit of $719,000 – and signed a 3-year lease in Studio City. “We knew a little over two years ago that we were in a bubble,” said Warren Bland. “We felt when we saw the price in Brentwood nearing $900,000, wouldn’t it be good to take our profit and rent for awhile.” Bland, 63, author of Retire in Style: 60 Outstanding Places Across the USA and Canada, said Ithaca, N.Y., which earned high marks in his book, likely is their destination. Several homes listed for $350,000 – nearly double Ithaca’s current median sale price – have remained on the market since August. That surprises him and fuels his belief that asking prices will fall. “We’re perfectly prepared to wait until spring,” he said. “Prices have stabilized in Ithaca. They may indeed drop a bit by spring.”

Link here.

REIT shares ripe for slowdown.

As the REIT industry gathers this week in Chicago for the annual National Association of Real Estate Investment Trusts convention, the mood will be more subdued than in past years. Earnings misses, interest rate fears and concerns over expensive valuations have dragged down the sector in recent weeks, leaving investors to wonder if the magnificent bull run that REITs have enjoyed over the past 5 years is coming to an end. Ever since the tech sector imploded in 2000, REITs have trounced the broader market. Individual investors flocked to the sector as commercial real estate was viewed as a safe investment that paid healthy dividends on their 401(k) and IRA dollars.

However, during this time, something interesting occurred. Huge bundles of money flowed into the sector, while earnings growth for equity REITs (those that do not primarily invest in mortgages) remained minimal. In 2004, equity REITs as a group posted a 32% total return. However, the group’s funds from operations – a key profit measure for REITs – rose by just 3.2% on a per-share basis, according to SNL Financial, a real estate research firm. In 2003, the industry posted a 37% total return while FFO grew 2.2%. The concern nowadays is that investors will no longer pay substantial premiums for REITs’ minimal earnings growth.

“Two years of 30% returns in a row are a huge anomaly,” says Lou Taylor, a longtime REIT analyst with Deutsche Bank. “The group on a long-term basis is low-double-digit [annual total returns] with half of that in terms of yield.” Taylor says the biggest issue facing REITs is competition from the rising yield on the 2-year Treasury note, a risk-free investment that is currently yielding 4.4%. The average current dividend yield for equity REITs is 4.7%, down from 7.6% in 2000, according to SNL.

Last year, a record $6.9 billion flowed into real estate mutual funds and ETFs. As a result of the investor dollars that were sunk into REITs over the past few years, the group is now trading at about 14 times its projected FFO for 2005, which looks pricey based on historical multiples. In 2000, the first year of the great bull run for REITs, the multiple was 8. During the past five years, REITs have seen “multiple expansion without having the accompanying earnings growth that would, by historical measure, justify that,” says Keven Lindemann, director of real estate with SNL Financial.

Link here.

Real estate funds down: 20/20 hindsight … or not?

“Mutual funds that invest in real estate have been in a swoon, losing 7% in the past three months and leading many investors to wonder if it’s finally time to sell.” ~ Wall Street Journal, Nov. 4

Hindsight is always 20/20, so I will go ahead and say it: The time to wonder about the time to sell needed to come sooner … like before those three months of losses began, back when everyone believed double-digit real estate returns would go on forever. But try telling that to the relative few who actually did get those returns over the past three years – or to the many who got in recently and hopes they still can. Nothing creates the desire to chase performance the way more than three years of 20%-plus-percent returns can, which is indeed true of real estate funds.

Still, my “hindsight” remark was not really hindsight – thanks to a source that is close to home. This past July 25, the Short Term Update published a homebuilder’s stock index chart with weekly prices going back to early 2000. It showed a +928% gain for the period, with the recent gains coming so quickly that the price line turned nearly vertical. Our commentary? The moment was ripe for what went up to start coming down. The STU even identified the stock to watch within the homebuilders index, which “could easily fall 15%-20% and more within a short period of time.” Here is a chart of the Philadelphia Housing Sector Index; the arrow points to July 25.

This is what market timing can do. Yet beyond opportunities that preview tomorrow’s headlines today, the greater relevance of this chart is in what it says about the housing sector’s long-term prospects.

Link here.


Treasury bond prices saw lower lows and lower highs throughout September and October, a pattern that defines the trend as downward. This seems completely predictable to some – Treasury prices and yields move in opposite directions, and yields (interest rates) have been on the rise. Tuesday’s rate hike by the Fed seems like a virtual exclamation point on this sequence of logic. On the other hand, look past September/October and instead to a chart of the previous 18 months, and you will see what the Treasury market thinks of the notion that “logic” and “the Fed” govern its price action. The arrow on the chart points to the last week of June 2004, when Mr. Greenspan & co. began the rate raising campaign.

Now, I could have placed 12 other arrows on the chart, for each one of the Fed hikes – and you could rightly see each one as the central bank’s attempt to push the yields UPWARD. The point is simple enough: Tusday’s Fed announcement is not the place to look if you want to know what the Treasury market will do next. Instead, we listen while the market speaks for itself – specifically, via a crucial sentiment indicator that quantifies the long and short positions of two different groups of Treasury market participants. One of these groups – the so-called “smart money” – has taken an all-time record net position in Treasuries. This indicator is not fail safe (none are), but an extreme this large speaks for itself.

Link here.


Henry Blodget, who paid a $4 million fine in 2003 to settle allegations that he published “materially misleading” research, is back peddling Internet moonshine. Never mind that the National Association of Securities Dealers, the SEC, and the New York Stock Exchange barred him for life from the securities industry. The former Merrill Lynch & Co. analyst is free to pen “securities research and opinions so long as the conclusions are not tailored to the circumstances of particular clients,” according to the Web site of Blodget’s Cherry Hill Research firm.

Sure, the rules may allow it. Reading Blodget’s views on the likes of Yahoo! and Amazon.com, though, is akin to hearing former Enron CEO Kenneth Lay lecture on accounting, or former Tyco International CEO L. Dennis Kozlowski comment on executive perks. The skin crawls. The hackles rise. It all seems a bit surreal. Blodget, remember, is the guy who had a public “buy” rating on InfoSpace Inc., at the same time as calling the maker of Internet search software a “piece of junk” in a private email unearthed by New York Attorney General Eliot Spitzer. InfoSpace traded at about $1,305 at the start of March 2000, and was valued at $113 by December of that year.

Compare Blodget’s statement that “the growth and profitability of Yahoo, EBay and Amazon are the envy of most traditional media and retailing companies,” with his claim that Internet sales are “an incredibly powerful economic trend affecting every industry, and it’s not something that investors can ignore.” The former is from an article by Blodget in the Guardian newspaper last week. The latter is Blodget quoted by Bloomberg News in April 2000. You cannot slide a cigarette paper between the thoughts of Blodget the analyst and Blodget the hack.

Blodget’s return seems to lack the humility you might expect from someone who became a symbol of the incestuous relationship between investment banking and equity research. His recent writings for Slate, for example, taunt the reader with the title “Born Suckers – the greatest Wall Street danger of all: you”.

Blodget has a right to make a living. He is clearly a talented scribe, and has a knack for self-publicity that time out of the limelight has not diminished. Could he not turn his talents to writing about sports or art, though? Or politics, given his undoubted insight into how power corrupts? He is clearly gagging to dish the dirt about what really happened during his time at Merrill Lynch, saying in March that “I would love to discuss all this directly.” His settlement with the authorities precludes him from discussing the case.

Link here.


Reserve Bank of New Zealand Governor Alan Bollard said he is willing to raise interest rates “in a way that really hurts”, to dissuade people from unrealistic expectations they can keep borrowing against their homes to spend. New Zealand’s central bank last week raised the benchmark interest rate a quarter-point to 7%, the 8th increase since January 2004. The nation’s $96 billion economy, the 12th-largest in the Asia Pacific, has the highest rates for any country with the top rating from Moody’s Investors Service.

People need to stop using their homes as a source of cash, Bollard told Radio New Zealand. Consumer borrowing rose 15.2% in September from a year earlier, buoyed by the nation’s near-record-low 3.7% jobless rate and a 14% surge in New Zealand house prices the past year. “That’s why we will keep making these warnings and if necessary take further action,” said Bollard. The central bank “can increase interest rates and we can do it in a way that really hurts.” Last week, he said he could not rule out a further rate increase until he sees a “noticeable moderation” in housing and consumer spending.

Link here.


The markets are supposed to reflect all that is known. Day by day, hour by hour, minute by minute they react to the news, to opinions, and maybe even to the passing planets. In this sense, they are “perfect”. Nobody knows more than they do. Which is merely to say that the markets are as imbecilic as the majority of stoneheads who invest in them. What is remarkable to us is that so many investors find nothing remarkable about today’s markets. The Dow is still where it has been for several years, while the majority of investors remain steadfastly bullish. According to Investors Intelligence, the majority has been bullish for 158 straight weeks, longer than any stretch since they began keeping track 42 years ago. You would think they would get tired of being bullish – especially when it does not pay.

If the market is perfect you can never go wrong by buying at the market price. That is, if you decide that a price is too high or too low, you are more likely to be wrong than right – because you will always know less than the market itself – which says the current price is the right one. Obviously, the whole idea is empty. When an investor buys or sells, he is not really arguing with the current price, he is just guessing about tomorrow’s price. All the current price really tells you is what emotion has a grip on investors right now.

The emotion we see is reckless complacency. Gas prices have doubled. Is that a problem? Nope. The trade deficit has reached 6% of GDP. Is that a problem? Nope. There is a war in Iraq that looks increasingly unwinnable … financed by borrowing from Asian rivals. Do you see a problem? Nope. American consumers’ earnings have been falling for the last two years, while their debt levels continue to rise. Does that bother anyone? Nope.

No, dear reader, there is nothing to worry about. Yes, debt levels are higher than ever, but this is a new era, in which people can support more debt – permanently. And the trade deficit? It has almost disappeared from the news. We have had a growing trade deficit ever since Alan Greenspan first stepped into the Fed. It has not hurt us yet, has it? And what about consumers? Well, they may be earning less, but their houses are still rising. So, they still have money to spend. That is what the markets are telling us. The markets have much more information than we do. And they say we can relax. The morons!

This seems like a good occasion to recall another new era, the one that came to an end almost as soon as it was first announced. …

Link here.


A “seismic shift” is underway, Jim Chanos warned a packed house at last week’s Grant’s Fall Investment Conference in Manhattan, “and it will destroy the profitability of several well-known American companies.” Chanos identified the likely victims of this seismic shift. The attendees seemed to hang on his every word. Chanos, is afterall, the most famous short-seller in the land … and for good reason. He rose to celebrity as the “Man Who Called Enron”. That is, Chanos publicly identified Enron as a questionable operating enterprise – and therefore took a very large shot position in the company’s stock – months BEFORE Enron’s fraudulent activities cratered its share price and forced the company into bankruptcy. He also identified Tyco International, Sunbeam and several corporate disasters before the fact.

But these days, Chanos is operating on a new investment theory. And, of course, he has a slate of companies that could wither and die as a result. In his presentation, entitled “Twilight of the Gatekeepers”, Chanos noted that the progression from an analog to a digital world has reduced the marginal cost to transmit and/or store information to nearly zero. This phenomenon wreaks havoc on a number of older business models, makes them obsolete and ultimately destroys them. We have seen it in music retailing, film photography, and in video distribution.

It should be no surprise then that Eastman Kodak is one of Chanos’s short-side ideas. Free cash flow at the company has fallen from over $1 billion annually to an estimated $300 million in 2005. Next year, Chanos believes Kodak’s free cash flow will turn negative. Far from a value play, Chanos thinks the film company’s business is in grave trouble. Blockbuster Entertainment, like Eastman Kodak, has seen a big drop off in free cash flow over the last two years. Digital technologies and Internet distribution have disrupted the business of video rentals. Middlemen of all stripes – the Gatekeepers – are in trouble, says Chanos. Movie theaters are another example of businesses under siege. They face a compression of release schedules (from movies to DVD, shortening the time movies remain in only in the theaters), the constant need to reinvest and long-term declines in theater attendance. The cable companies, such as Comcast and Cablevision, are also facing a threat from this digital revolution. Perhaps another way to summarize the Chanos thesis is this: Sell short pure distribution systems that compete with the Internet, or with digital technology or with any other content provider capable of accessing the consumer directly.

Jerry O’Connor, a professional real estate investor with 40 years of experience, continued the bearish theme. “Is real estate overpriced?” he asked rhetorically. “Yes,” was his unequivocal answer. O’Connor believes the U.S. housing market peaked – finally – in July 2005. If we follow the pattern set so far in the U.K., we can expect to see a flattening in home values, a build-up in inventory, a slowdown in retail sales. We shall see. In the world of commercial real estate, O’Connor offered a similarly bearish view. Real estate equities have ballooned from $380 million 1991 to $8.7 billion. As rates have fallen, real estate valuations have skyrocketed. As a result, the cash yield on real estate looks pricey compared to the yields available in the bond market. Meanwhile, many real estate investment trusts (REITs) are grossly overvalued, says O’Connor. Insiders seem to know this. REIT insider sellers outnumbered buyers by a whopping 173 to 1 in the 2nd quarter. O’Connnor’s advice: sell REITS. What to do now? Look for a margin of safety in quality companies and do not be afraid to hold cash.

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

Oil, the new reserve currency.

I borrowed the title of today’s column from Robert Friend, the successful international investor at Recon Capital. At last week’s Grant’s Investment Conference, Friend used this title to provide a context for his bullish remarks about oil and oil stocks. He is a big fan of the integrated oil stocks, especially Marathon Oil, because they are still valued as if oil were trading for $40 a barrel. But if, as Friend believes, oil deserves to trade near $60, the stocks of most integrated oil companies offer great bargains. Friend is also bullish on Brazil, both its stocks and its currency. Brazil’s currency, the real, has appreciated over the last several months, crushing the “hard” currencies of Canada and Australia, as well as trouncing the British pound and euro.

Vale do Rio Doce (NYSE: RIO) is Friend’s favorite investment in the Brazil. Vale is the largest iron producer in the world and maintains vast reserves of iron ore, bauxite, copper/gold, kaolin, manganese, nickel and potash. It is also the largest logistics and transport company in Brazil.

Like Friend, John Hathaway, manager of the Tocqueville Gold Fund, advocated investing in the resource sector, particularly in gold. He launched into his presentation by displaying the image of the Zimbabwe dollar. In 1999, about six Zimbabwe dollars were worth one U.S. greenback. Today, it would take 50,000 Zimbabwe dollars to buy one U.S. dollar. The U.S. is not Zimbabwe, of course, and Hathaway in no way meant to imply that it was. But he did mean to imply that the endgame for the U.S. dollar might closely resemble that of its Zimbabwean counterpart. The greenback is a dying currency, says Hathaway, which loses a little more of its value with each passing year. All paper currencies, Hathaway asserts, succumb to “a process of monetary elimination”.

James Grant, the conference host and keynote speaker, presented a talk entitled “Man’s Inner Bubble”. In the span of forty very entertaining and amusing minutes, Grant argued that easy credit fuels EVERY U.S. asset bubble, and that the Federal Reserve is the original source of all easy credit. Therefore, the world might be much better off without the Federal Reserve … or a Federal Reserve Chairman. Grant pointed out that before the creation of the Federal Reserve in 1913, prices “sometimes sagged”. Throughout the 19th century, therefore, prices tended to drift lower – as productivity gains and innovation drove the cost of living down. Post-1913, however, the Federal Reserve has presided over the continuous depreciation of the U.S. dollar. The appointment of Ben “Helicopter-drop” Bernanke as the new Fed Chief will likely accelerate this trend. In fact, any Fed Chief who thinks that the Federal Reserve is an inflation-fighter ought to be lashed to a mast and forced to stare at the following chart until his eyeballs burn with memory of it.

The pre-fed dollar derived its value from a strict connection to gold. Indeed, many dollars were actually minted in gold itself. Such a tether limited the production of new dollars and served to contain inflation. To help the audience appreciate the dubious benefit of the Federal Reserve’s stewardship, Grant presented a snapshot of life circa 1890, compared to today. First, there were some stark differences. Inflation was a negative 1.2% in 1890. The Federal Government was in surplus. But, there were also some remarkable, and ominous, similarities. Interest rates were low. In the 1890s, too, they had their share of securities fraud. Grant related how the bonds of Capitola township in Dakota were sold to Eastern investors and changed hands many times before it was discovered that no such township existed. Hallie Farmer’s diagnosis of 1890 (published in 1924) applies today. “The prosperity of the period was a prosperity based upon credit,” he wrote.

Today’s prosperity is no different, says Grant. Easy credit fueled the stock market bubble, the housing bubble and every other bubble – great and small – that the Greenspan Fed has nurtured. And presumably, as America’s bubble economy deflates, the dollar’s value will suffer … despite the very best efforts of the Federal Reserve and its new “inflation-fighting” chairman. But let us not forget that bad news for the buck is gold news for the gold price and the oil price and for the price of every other hard asset. Make way for the “new reserve currencies”.

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

Chihuahuas of the Serengeti.

Asset bubbles are never merely financial. They are the love-children of leveraged speculation and warped perception. Sadly, even though these offspring seem so full of life in the flower of their youth, they cannot survive adversity … especially the sort of adversity that includes rising interest rates. That is why the U.S. housing bubble will very soon perish. Rising interest rates will claim the housing bubble, promises Bill Gross, the nation’s preeminent bond fund manager, just like rising interest rates have claimed nearly every bubble that has gone before it.

No mortal may ever know death’s appointed hour, but Gross believes a few specific telltale signs will portend the last days of the housing bubble. Indeed, he believes the first of these telltale signs may already have come to pass: A 300-basis point jump in short-term interest rates. “I think it’s pretty clear,” Gross relates, “that real housing prices have peaked on average four to six quarters after the central bank first raises interest rates and following what appears to be 200 basis points of short-term rate hikes. The tightening then continues (too much exuberance!) another two quarters thereafter for what looks like a total cyclical increase of 300 basis points or so.”

Guess what? The Fed’s latest rate hike brought the “total cyclical increase” in short-term rates to 300 basis points since June of 2004 (the Fed has hiked the fed funds rate from 1% to 4%). “That’s dead on the average point where real housing prices have peaked over the past 35 years,” Gross notes. Americans are enjoying a growing economy, says Gross, “but one which is acutely dependent on housing continuing to go up, equity continuing to be extracted, and consumption continuing to be motivated by what seems to be an endless chain of paper prosperity. Wiser and more experienced counsel know that such a foundation for wealth generation is really a castle built on sand instead of granite, and the only question is when the tide will rush in to wash it away.

“Make no mistake about it,” Gross ominously concludes, “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.” Gross fears a recession … we fear a catastrophe. Because the housing boom seems more bubble-like than not, the effects could be much more devastating than most prognosticators, including Gross, would anticipate. “Operating in bubble markets, many people lose their bearings,” observes James Grant, editor of Grant’s Interest Rate Observer. “They become disoriented, financially and morally. As most investors shrugged off the preposterous high-tech valuations of early 2000 (they had become used to them), so they are prepared to explain away the risk-fraught mortgage-lending practices of 2005 (they have grown used to them to).”

Indeed, the crazy excesses of the U.S. housing boom have become so utterly commonplace that they seem about as threatening as a snoozing kitten. Unfortunately, a pride of snoozing lions might be a more appropriate metaphor. As long as the lions [Ed: and jackals, hyenas, cheetah, African wild dogs, etc.] are sleeping, of course, even a 3-legged Chihuahua could roam the Serengeti unmolested. But the Chihuahua would never be truly safe. It would simply be oblivious to its perilous circumstance … just like many of today’s homebuyers. The lions will awaken eventually. These ferocious excesses of the housing bubble – soaring prices, shriveling home equity, vanishing affordability and idiotic lending practices – will doom the many 3-legged Chihuahuas that have accumulated neither home equity nor anything else resembling savings.

When the bubble bursts, the primal nature of the housing bubble’s excesses will become frightfully evident. Because so few Americans posses so little home equity, they possess no capacity to withstand adversity. That is why a reversal of fortunes could prove so devastating, and why the next recession could be surprisingly ferocious. The reversal may be upon us already, to the detriment of the nation’s many leveraged homeowners … and to the entire American economy. We have adored out vivacious little housing bubble. We will miss him dearly when he is gone.

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


There are only a few ways for the bull market in gold to play out, and supposedly a fixed ending in all cases. The yellow metal’s dollar price will violently launch into orbit at some point, arc into a near vertical crescendo and ultimately burn itself out supernova style. Either that or a long, drawn-out grind – a steady sloshing higher over the course of years, punctuated by occasional hiccups and countertrends to keep us on our toes. Or perhaps a combination of both, in homage to the disco era – a multiyear rise capped off with a blaze of glory.

But no matter how it happens, gold will eventually return to Earth. The fixed ending is a return to normalcy, which in gold’s case equates to dormancy. After all, what goes up must come down. Right? It is only logical. That is what everyone expects. Yet what if, this time, the future does not look like the past? What if gold were to climb to new highs, breaking the $1,000 an ounce barrier, and never return from whence it came? With apologies to Thomas Wolfe, what if the bankers can’t go home again? Now that would be something.

It is usually the case that the greater the stake in a specific outcome, the less freedom one has to connect the dots. But the ability to foresee a wide range of possibilities, including the extreme and the unexpected, is a hallmark of the exceptional trader or investor. When asked what traits made him so successful, legendary hedge fund manager Bruce Kovner observed, “I have the ability to imagine configurations of the world different from today, and really believe it can happen.” In that spirit, we lay the groundwork for our golden scenario … and one cannot hardly discuss the outlook for gold without first considering the dollar.

In spite of all the pessimism and diversification talk of recent years, IMF figures show that dollars still make up roughly two-thirds of the world’s foreign exchange holdings. Eat your heart out, Charles de Gaulle. It is good to be king. So why is the dollar so popular? What gives America free reign to settle debts in its own currency, print more of it at will and impose its fiscal whims on the rest of the world? There are five elements currently supporting the dollar as world reserve currency. The first critical element is security, provided in the form of military and economic dominance. The second element underpinning the dollar as world’s reserve currency is universal acceptance. The third element supporting the dollar is the network effect, where the value of something increases in proportion to the number of users. Fourth in the dollar hit parade is America’s willingness to act as spender of last resort. As more exporting countries rely on the prodigious appetite of the United States, more and more dollars find their way into global circulation. Last but not least, a significant element propping up king dollar’s throne is plain old inertia.

So how might the king be toppled? There is precious little to work with in terms of past example. The Economist observes the last regime change: “The pound was king during the era of the gold standard. But in the years after 1914, Britain switched from net creditor to net debtor, and by the 1920s, the dollar was the only currency convertible to gold (although the pound returned to gold in 1925). Two costly wars and two episodes of currency devaluation in Britain later, the dollar was unchallenged as the world’s chief reserve currency.” It arguably took two world wars and a global depression to dislodge the pound. That is a fairly tall order; no wonder the consensus belief is that king dollar will maintain his throne.

But for all the elements working in its favor, the reign of America’s world-beating currency has a large strike against it: The profligate policies of America itself. While it took a series of extraordinary events over the space of decades to dislodge the pound, Britain never spent others’ money with the wild abandon America has shown. To put it bluntly, the U.S. has taken a jackhammer to its financial credibility. The U.S. consumer is happily in hock up to his eyeballs, betting on further housing appreciation to bail him out, while the accelerating pace of U.S. government spending boggles the mind. The current administration appears to have less grasp of financial responsibility than a 16-year-old girl set loose with her father’s credit card.

Link here (scroll down to piece by Justice Litle).


Gold, its supporters claim, is an effective hedge against inflation. The problem for their case is the record of the last 25 years which leaves bullion still trading at a little over half its peak level. However, new research by the U.S. group H C Wainwright & Co. attempts to add luster to the case for gold. A certain dollop of caution is needed, given that the research is sponsored by the World Gold Council. But the research still raises some interesting points.

Wainwright analyzed the effectiveness of various commodities as a leading indicator with the U.S. Treasury bond market. It found that platinum, silver and gold all led the bond market by between 12 and 15 months; when those commodities rose, bond prices would subsequently fall (and yields accordingly rise). When all three commodities are combined, the correlation with subsequent bond yield moves was 0.79 (where perfect correlation would equal 1).

This would suggest that gold would be a useful hedge for Treasury bond investors. Wainwright suggests that a portfolio comprising 82% bonds and 18% gold would be insensitive to accelerations in headline price inflation. But Treasury bond yields, of course, are subject to other influences than inflation – the state of U.S. government fiances, for example, or the hedging policies of Asian central banks.

Gold, says the Wainwright study, is also a more direct leading indicator of inflation. Since 1951, the correlation between changes in the gold price and producer price inflation one year ahead is 0.37; with consumer price inflation, it is 0.50. Some of the reasoning of the Wainwright circular study seems slightly circular. Gold is a better indicator of inflationary pressures than the consumer price index, it argues; therefore investors should buy gold as a hedge against inflationary pressures.

But with gold having recently reached a 17-year peak and concern about inflationary pressures rising in the market, the study may reawaken debate about the place of gold in diversified portfolios. And it may also cause some to worry that the recent strength of the gold price, against the euro and yen as well as the dollar, is the harbinger of inflationary problems to come.

Link here.


The upcoming Senate hearings into oil company profits caught me off guard at first, given that “inquiries” like this are not normally staged unless there is an election coming soon. So with the next White House run still three years hence, all I can figure is that it is never too soon to shop for an issue. And yea, sure, it is common knowledge that recent oil company profits/earnings have reached eye-popping levels. Yet here is something even more astonishing: Some people STILL imagine that earnings drive stocks, as proclaimed by this Oct. 25 Reuters headline: “Profit Outlooks to Drive Stocks”.

It is not that I do not follow the logic. In fact I do. Really. And my guess is that back around August 31, investors lined up to buy oil company stocks almost as rapidly as motorists lined up to pay too much for a few gallons of unleaded. So when prices at the pump went down – and earnings indeed went up – well, it seemed like the best of both worlds, or some similar cliché. But wait, who got left out? Let us look at the CBOE Oil Index chart.

Once again, so much for logic. Oil stock prices fell some 20% in the month following the “oil market opportunity”. Myths die hard – or refuse to die at all. Crowd behavior is infectious, but you do not have to catch it.

Link here.


Investing in any country is a gamble. Not only have you know idea what cards might turn up, you also have a sneaking suspicion that the dealer may have one or two up his sleeve. But the burden of this little reflection is that Argentina may be worth a bet.

An economy is a natural thing. Each one has to follow its own course. All public officials can do, generally, is make sure private property is protected by the courts, and otherwise get out of the way – eliminating all the many restrictions, taxes, permits, prohibitions, pay-offs, and emoluments that inhibit commerce. This, of course, is the last thing public officials want to do. Before WWII, Argentina was one of the world’s richest countries. “As rich as an Argentine,” was a common expression in England. Between the wars, the English gentry, down on their luck but up on their manners, hoped to marry off its daughters to prosperous Argentine planters. Some did.

But then, Argentina slipped into a puddle of socialist do-goodism from which it never was able to climb out. Economic growth was spotty. Inflation was chronic. Rules were imposed to prevent this … stop that … and inhibit something else. Labor restrictions made it hard to employ people even during boom periods. But in 1989, the country seemed to hit bottom. Inflation hit 3000% that year. Soon after, the Argentines were told to get to work and stop complaining. By 1997, the country was growing at a 9% rate, but there were problems. The country was consuming and investing more than it produced. And the curious system of international finance tempted Argentina to borrow even more. Fund managers bought emerging economy debt based on an index of borrowers. This had the perverse consequence of increasing the availability of credit to the nation that borrowed the most. That is, as Argentina borrowed more and more, it became a bigger part of the index of emerging market debt. Why people pay fund managers to follow the indices, we do not know, but that is what they did. The more Argentina owed, the more the fund managers wanted to buy its bonds.

It was no easier for Argentina to resist the lure of easy credit in the ‘90s than it has been for America in the 2000s. By the end of the period, Argentina’s foreign indebtedness approached $150 billion. That would be peanuts for the U.S., but it was a lot of money for a country like Argentina. A few smart fund managers saw the disaster coming (Asian central banks, take notice). They sold off Argentina’s bonds. Pretty soon, the country was in crisis again, unable to make its debt payments. In December 2001, riots and looting broke out. President De la Rua decided that it would be better to stiff the foreign creditors than to further annoy the locals with austerity measures. Before the month was up, Argentina made history with the biggest debt default ever.

There are a lot of ways to ruin an economy. Argentina has experimented with most of them. It has devalued its currency, and revalued it. It has pegged it, and then knocked down the peg. It has regulated, controlled, inspected, taxed and confiscated. Following the 2001 crisis, earnings fell by 30% – with half the nation slipping below the official poverty line. What is remarkable is that the Argentine economy has survived at all. In September, the Argentine economy reported its 37th consecutive month of GDP growth. It is growing about 7.3% this year, 5.6% projected for next year.

“The government has been incredibly lucky,” says Luis Secco, a Buenos Aires consultant. And here we find the big difference between the U.S. and Argentina. If a country such as Argentina does well, it has luck to thank. North of the Rio Grande, people thank neither the stars nor the fates. Instead, they salute their Fed chief and pat themselves on the back. Argentine economists have even tried to quantify their good fortune with a “luck index” – said to measure the impact of global economic conditions. The index hit a high of 9.8 (on a 10-point scale), last year. This year, it is expected to be around 8.

Meanwhile, the government budget is in surplus (before interest payments). Foreign currency reserves are increasing. Foreign debt, as a proposition of GDP, has fallen below 40%. Inflation is below 10%. The trade balance is positive. And the economy is growing twice as fast as America’s. But what America has in most abundance – confidence and credit – Argentina lacks. Just try to buy a house in Buenos Aires or a ranch out in the country. No one will offer you credit. While Alan Greenspan comments on the solidity of the U.S. economy, Argentine officials speak about their economy’s fragility. While American economists look ahead and see only progress, Argentine economists look ahead and see hesitation and backsliding. They warn of inflation. They warn of social upheaval. While Americans see a glass half full, Argentines see one that is bone dry.

We do not know how to cure Argentina’s economic problems. But we have evidence that confidence is not permanent, but cyclical. Having been so low for so long, we expect to see it turn up on the pampas. In America, on the other hand, confidence and asset prices are likely to go in the other direction.

Link here.


Large-company pension plans will weaken this year due to mediocre returns that have not kept pace with growing pension obligations, according to a report by Credit Suisse First Boston. The investment firm estimated that the defined-benefit plans of the S&P 500 may be underfunded by $218 billion at the end of this year, compared with $165 billion at the close of 2004. “A flat stock market, combined with a growing pension obligation, does not bode well for the health of defined benefit pension plans,” wrote CSFB. Only a 4th-quarter stock-market rally like last year’s turnaround, or a spike in interest rates at the long end of the yield curve, would prevent an increase in the underfunding level, added the report.

If the pension plans weakened, wrote CSFB, the companies that sponsor them might see their balance sheets deteriorate; pension costs might go up, putting pressure on earnings; and most important, companies might have to contribute more to their pension plans, draining cash. Less capital would then be available to reinvest in and grow the businesses, pay dividends, buy back stock, or pay down debt. The anticipated deterioration of the large pension funds further drives home the crisis swirling around defined-benefit plans, a great idea decades ago but one that has come back to haunt many old-line companies that are saddled with swelling, relatively unpredictable costs while struggling to thrive in an increasingly competitive global business world.

A number of high-profile bankruptcies at Delta, Northwest, and Delphi are reminders that future retirees may not be able to rely on this payday and that the Pension Benefit Guaranty Corp. may not have ample money to meet these future obligations. This, in turn, has sparked a debate over whether taxpayers without pensions should bail out and fund the pensions of individuals who work for companies that promised pensions but may no longer be able to deliver.

Link here.


This must be the dumbest American industry ever. For the past 58 years, or ever since their profit-and-loss records have been kept, U.S. airlines have rung up a cumulative net loss of $14 billion. A loser for all time. There will be another loss of as much as $10 billion in 2005, the carriers’ trade group estimates. Three of the five biggest U.S. airlines are hiding from creditors in Chapter 11 bankruptcy proceedings. And these are good times for the U.S. economy.

Airline executives have excuses for their staggering $32 billion in losses during the past four years, which wiped out what through 2000 had been a cumulative historical profit of $18 billion. They cite the terrorist attacks of Sept. 11, and the subsequent recession that discouraged air travel. Now, with passengers back, the income statement is blotched by soaring prices for jet fuel. Still, aberrant as those events may be, they do not absolve the industry. Airlines keep making the same mistake: overloading the skies with planes and then cutting fares to unprofitable levels to fill them. “Every 10 years, beginning in the 1970s, the industry has had a crisis,” says Julius Maldutis, an independent analyst who has seen them all.

The industry now may have 20% to 30% more passenger-carrying capacity than it needs, says George Hamlin, a former airline executive and a director at MergeGlobal in Arlington, Virginia. The excess capacity is the equivalent of one or two major airlines. Maldutis points out that the industry’s dust-up of the early 1990s ended with the deaths of Braniff, Eastern and Pan Am airlines, which allowed the others to raise prices. In the six years starting with 1995, the industry earned $23 billion.

In the current climate, however, airlines do not die. US Airways in September escaped from its second trip into Chapter 11 as it merged with America West Holdings. UAL, the parent of United Airlines and in bankruptcy court since 2002, is certain to be set free. Delta Air Lines and Northwest Airlines, both of which went into Chapter 11 in September, will not be liquidated; they will come back with lower costs and lower debt, as mandated by the courts. Prolonging the life of inefficient airlines reflects, in part, the failure of the financial markets to work, Hamlin says. If failed airlines could not get fresh money, they could not keep flying.

Given the industry’s sorry history, it seems unlikely the airlines will ever cut their capacity enough. They will still feel forced to match the low fares of the latest upstart – a foolish reaction since the only low-fare airline to succeed over time has been Southwest Airlines. And, of course, there will always be the temptation of the latest gleaming jets to roll off the Boeing and Airbus production lines.

Link here.


If you are or ever have been a member of the Audubon society, you have probably mastered the art of “watching with your ears,” i.e., listening for the singular pitch and timbre of the song before identifying a bird by sight. Ask us and the world of fine-feathered friends sounds a lot like the world of finance – as explained by the mainstream press, that is. Take, for example, recent news stories on the Euro market. According to the fundamental “experts”, in order to nail the near-term trend in the currency, traders must hear for the specific intonations in the voice of European Central Bank President Jean-Claude Trichet during his opening comments on interest rate policy. And on November 2, as the euro soared to a 10-month high against the Japanese Yen, the usual suspects put their heads together and agreed – one bird was coming through the inflection in Trichet and other ECB officials’ tone: the hawk.

As expected, the ECB left rates unchanged at its November 3 meeting. As for “any comments indicating rate increases” in the future – President Trichet’s testimony sings a very certain tune: “The ECB stands ready to move any time when it is required by our mandate… Inflation risks are on the upside. We [maintain] strong vigilance and are very clear that we clearly could move at any time. No central bank would consider it advisable to wait for inflation before acting.” This statement is not just hawkish; it is Alfred “The Birds” HitchHAWKISH.

Problem is, those who expected the euro to fly high following Trichet’s comments ended up eating another kind of bird: namely, crow. To wit, on November 4, the euro plunged against the U.S. dollar to hit its lowest level since August 2003. Fact is – the bird (no matter hawk or dove) – is NOT the final word on where the euro is headed. The wave pattern unfolding in prices IS, which is exactly what our November 3 Specialty Service currency forecast had in mind when it presented this daily analysis on the Euro/U.S. Dollar: “Thursday’s drop argues forcefully that prices are in the stages of a decline. Zooming in, we see prices in [a powerful downtrend] which should be accompanied by increased selling pressure as the market moves to challenge the 1.1870 low. We’ll maintain a confident bearish bias on the euro while resistance is solid.

Elliott Wave International November 4 lead article.


Has the house down the street from yours just sold for a bundle more than you ever imagined houses in your neighborhood would sell for? You might find yourself scratching your head at the amazing fact that some folks will pay much more than what a house – or a stock – may be worth.

Bob Prechter wrote about the optimistic investor psychology that posits that prices will always go higher in his book, At the Crest of the Tidal Wave. He points out that when he entered the stock market business in 1975, the typical investor was very sophisticated. Why? “Because anyone who was still in the game after the 1968-1974 bear market either knew something about markets beforehand or had learned a lot as a result.” Bob says that many investors today are caught up in a financial mania and, as with any mania, it is not necessarily the sophisticated people who are doing all the buying. Rather, it is everyday people who do not really have the experience to do well in the markets, but who do have the optimism that all will turn out well. Here is an excerpt from his book that describes the problem with that kind of psychology.

Link here.
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