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THE THEME OF EMPIRE OF DEBT IN A NUTSHELL
Many years ago, when the United States was still a modest republic, American presidents were likewise available to almost anyone who wanted to shoot them. Thomas Jefferson went for a walk down Pennsylvania Avenue, alone, and spoke to anyone who came up to him. John Adams used to swim naked in the Potomac. A woman reporter got him to talk to her by sitting on his clothes and refusing to budge.
But now anyone who wants to see the president must have a background check and pass through a metal detector. The White House staff must approve reporters before they are allowed into press conferences. And when the U.S. head of state travels, he does so in imperial style; he moves around protected by hundreds of praetorian guards, sharpshooters on rooftops, and thousands of local centurions. Today, the president cavalcades around Washington in an armored Cadillac. The limousine is fitted with bullet-proof windows, equally sturdy tires, and a self-contained ventilation system to ward off a biological or chemical attack. The Secret Service employs over 5,000 people: 2,100 special agents, 1,200 Uniformed Division employees, and 1,700 technical and administrative wonks. Everywhere the president goes, his security is handled – by thousands of guards and aides, secure compounds, and carefully orchestrated movements. …
In Empire of Debt: The Rise Of An Epic Financial Crisis, Bill Bonner and Addison Wiggin – the team that brought you the international bestseller Financial Reckoning Day – reunite to provide the first in-depth look at how the American character has shifted to accommodate its new imperial role; how we have abandoned the private virtues of personal liberty, economic freedom, and fiscal restraint; and how the government has gained control of public life and the economy. The result has been, among other horrors, unfettered deficit spending, gluttonous consumption, and fearless military adventurism. All the while, the nation slouches ever more precipitously towards bankruptcy.Link here.
SAYING GOODBYE CALIFORNIA SUN, HELLO MIDWEST
A year ago, Melanie Fischer, a lifelong Californian, was not entirely sure where Missouri was. So when her husband proposed that they consider moving there, she raced to locate the state on a map printed on her children’s placemats. Today, Mrs. Fischer and her family live in a suburb of Kansas City, in a 5-bedroom house nearly twice the size of their former home near San Bernardino, with a huge yard and a lake view from the hot tub on their deck. Still, Mrs. Fischer, 28, and her husband, Nathan, 30, had enough money left after their move to pay off the debt on their two cars and buy a 21-foot motorboat. Many of their new neighbors cannot fathom why the Fischers left sunny California for, of all places, Missouri. “You have to give up things,” Mrs. Fischer said, “to get things.”
A growing number of people are leaving California after a decade of soaring home prices, according to separate data from the Census Bureau, the IRS, and the state’s finance department. Last year, a half million people left California for other parts of the U.S., while fewer than 400,000 Americans moved there. The net outflow has risen 5-fold, to more than 100,000, since 2001, an analysis by Economy.com, a research company, shows, although immigration from other countries and births have kept the state’s population growing.
The number of people leaving Boston, New York and Washington is also rising, and skyrocketing house prices appear to be a major reason, said Mark Zandi, chief economist at Economy.com. From New York, the net migration to Philadelphia more than doubled between 2001 and 2004, with 11,500 more people leaving New York for Philadelphia last year than vice versa. But the change seems most pronounced in California, which has long been a beacon that draws people from all over the country, with its sun-drenched coasts and dynamic economy. Popular culture has reinforced that image, with fictional characters from the Joads of The Grapes of Wrath to the Beverly Hillbillies coming to the state.
Today, however, the same factors that have made California so alluring have also made it unaffordable for many young families, retirees and recent immigrants to the U.S. Some are heading to fast-growing cities like Las Vegas, as they have been for decades. But even less-glamorous destinations, like the Rust Belt and Texas, are on the receiving end of the migration.
The last few years appear to be one of the few times on record that California has lost domestic population when its job market was as healthy as the rest of the country’s, economists and demographers said. “People are saying, ‘Even though I have to take a 10 percent wage cut to go to Vegas or Phoenix, it’s actually a wage increase,’” said Ross C. DeVol, the director of regional economics at the Milken Institute, a research group in Santa Monica. “They look at what housing costs here, and they’re making decisions to go elsewhere.” Far more Californians are staying than are moving, but it is also clear that California is losing some of its attraction.Link here.
Home equity does not ensure one’s future.
America is a “spendthrift nation” where consumers save less, spend more and hope the surge in home prices will fuel their retirement, according to a research paper by Kevin Lansing, a senior economist with the Federal Reserve Bank in San Francisco. As a result, personal savings rates continue to plunge. For the past four months, the savings rate has actually been negative – a startling trend that means people are spending more than 100% of their after-tax income. This means that consumers continue to pile up a mountain of debt, possibly figuring that the unprecedented increase in property values will bail them out of the financial shortfall. “It’s human nature,” Lansing said in an interview.
For individuals, this means that they may not set aside enough money for their retirement. And for the economy, a sharp cutback in spending as consumers feel less wealthy if property values decline could cause an economic slowdown or a recession, Lansing and another economist warn. Individuals tend to save less money when they know that their assets have appreciated, especially assets based on stock holdings or real estate. Consumers apparently view the rapid increases in home values and stocks as a “substitute for the quaint practice of putting aside money each month from their paychecks,” Lansing wrote. “The increase in the housing market really accelerated in the last five years. The movement into flat or negative territory for the savings rate coincided with the very rapid rise in the housing market.”
“Aging workers should be building their nest eggs and paying down debt,” Lansing said in his research report. “Instead, many of today’s workers are saving almost nothing and taking on large amounts of adjustable-rate debt with payments programmed to rise with the level of interest rates. Many of today’s workers could face difficulties maintaining their desired lifestyle in retirement.”
“People will wake up and realize that the house will not pay for the kid’s college education and everything else,” said Christopher Thornberg, a UCLA Anderson Forecast economist. “People will have to meet these needs by saving money.” That sort of shift in consumer behavior could jolt the economy, he warned. “If the transition happens slowly, that would cause mediocre growth, but it would still be growth,” Thornberg said. “If it happens rapidly, that is the thing that could cause a recession.”Link here. “Reality time” for mortagage rates – link.
YOU BET YOUR HOUSE: HOME PRICE FUTURES ARE COMING
Worried that the value of your home may fall? You can bet on it. If you do not, maybe your mortgage company will. The Chicago Mercantile Exchange, a financial marketplace dealing in the value of everything from interest rates and foreign currencies to pork bellies, has committed to offer trading next year in a category many consumers take personally: U.S. home prices.
Housing-price futures, based on the median home price in each of 10 U.S. cities, are not being tailored for individual homeowners. But they may provide some protection for mortgage companies, home builders and anyone else with a large stake in residential real estate if housing values slide – while giving other investors a way into a lucrative market. The novel investment product is set to debut in April 2006, based on a final go-ahead given by the Merc earlier this fall after months of exploratory work.
While unusual, it will not be the most exotic contract offered by the world’s largest futures exchange. That distinction has been held for 6 years by weather futures, which are based on regional temperature indexes and enable utilities and others with a lot riding on the weather to hedge their risk. The concept of real estate futures has been discussed since the early 1990s, but it took a boom in housing prices to propel it to reality. Home values appreciated 65% nationwide from 2000 through 2004 and more than doubled in some areas. U.S. residential real estate was valued at $18.6 trillion at the end of last year – more than the amount in stocks. The price run-up has meant a huge increase in wealth. A negative sales forecast from home builder Toll Brothers this week sent stocks falling by fueling fears of an economic slowdown. Recent signs of cooling may have only fueled interest in protecting the market.
Investors will be able to trade contracts electronically based on median home prices in Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York, San Diego, San Francisco or Washington D.C. – or a composite index of the 10 cities. The indexes were developed by the real estate research firm Fiserv Case Shiller Weiss. Those who are optimistic that prices will continue their double-digit rise can buy contracts, making a profit if the increase exceeds their costs by the expiration date. Investors who want to soften the potential blow of a decline, on the other hand, can buy versions of the contracts called put options that will pay them money if the price drops, ensuring that they recoup some of their lost house profits. That strategy is akin to taking a short position in a stock, according to Felix Carabello, Merc associate director for alternative investments. But “instead of shorting IBM, you’re shorting your house.”Links here and here.
Futures trading will roll dice on San Diego’s housing boom.
Starting next year, investors will be able to bet on whether housing prices in San Diego and nine other cities will continue to rise or plunge off a cliff. The Chicago Mercantile Exchange, a leading futures market, plans to begin home-price trading in April. Investors will be able to buy contracts on the future direction of housing prices in the 10 cities, similar to what investors do now with oil or corn. The investment vehicles are designed as a hedge against the risk in cities where home prices tend to be volatile. They will be based on median price indexes designed to represent movements in home-price values for each city.
While some economists question whether a home-price derivative market will gain traction, the fact that the Chicago Mercantile Exchange would launch such products could signal a growing concern about the nation’s housing boom. San Diego ranked second nationally among cities most likely to see housing price declines in the next two years, according to a survey from PMI, a mortgage insurance provider based in the Bay Area.
But the company only puts the odds of price declines in San Diego at roughly 50-50. And it does not specify whether prices will dive or dip slightly. Hence, the potential demand for a home-price derivative market. The derivatives are not being tailored to individual homeowners. Instead, they target home builders, banks and large mortgage institutions that own bundles of home loans. Still, homeowners could tap into the high-risk investment vehicles if they chose to.
The housing derivatives market would differ from traditional commodity futures, where a product, say oil or corn, is eventually delivered. With this market, investors would be betting on the direction of the median price index without ever taking possession of a house. The contracts instead would be settled in cash based on the value of the index. The real estate research firm Fiserv Case Shiller Weiss Inc. is involved in the project, developing the median price indexes for the 10 cities. Robert Shiller and Karl Case are leading real estate economists, said James Barth, an economist and senior fellow at the Milken Institute in Santa Monica. “That tells you this isn’t to be taken as a trivial exercise. These are very solid people with stellar reputations.”
Still, many new financial instruments fail, Barth noted. If too many investors bet housing prices will fall, for example, the market becomes lopsided and tends to collapse. Although some housing markets are volatile, particularly on the East Coast and West Coast, housing overall has been a good long-term investment, Barth said. So homeowners and investors may shun a hedging strategy. Moreover, the median price index may not be accurate enough to help many homeowners reduce their risk. If prices for $1 million homes were falling, yet prices for more affordable homes were rising, the median would tend to reflect rising prices. So investing in median-based derivatives would provide no benefit to luxury homeowners.Link here.
THE RISING COST OF HEALTH CARE: OPEN SEASON ON BENEFITS
As health-care costs have risen an average of nearly 12% in each of the past six years, employers are struggling to absorb the increases and have been passing costs on to workers, who are beginning to feel the pain. And with health-care costs expected to rise another 9.9% in 2006, that trend is expected to continue. Increasingly, it appears, both businesses and their workers are reaching saturation.
Evidence suggests some employers have thrown in the towel and dropped health coverage altogether. The percentage of companies offering employer-sponsored health benefits to workers fell from 69% in 2000 to 60% in 2005, according to the annual employer-benefits survey by the Kaiser Family Foundation and the Health Research Education Trust. “It dwarfs everything else in terms of cost increases,” said Greg Boll, CEO of Cummins Power Products, which designs and assembles electric-power generators at a facility in New Hudson. “It’s a big problem for employees and businesses.” Some of the company’s 620 workers are represented by the International Association of Machinists union and both Boll and his employees know that when contract negotiations begin at the end of the year, health care is going to be a key issue.Link here.
CHINA AND THE WORLDVIEW
The world is struggling mightily with putting the theories of globalization into practice. There is broad recognition of ever-mounting imbalances of a U.S.-centric world, but there is deep conviction that the global economy has a new savior – China. After years of believing that the inevitable China crisis was just around the corner, the world has rushed to the other side of the ship. China’s booming economy is now widely expected to keep on booming for the foreseeable future – an impression certainly validated by the latest batch of Chinese economic statistics on GDP, industrial output, and money and credit. There is even hope that the Chinese consumer is now positioned to fill any void left by the American consumer. Australians are especially enamored of China – and with understandable reason: Australia has benefited dramatically from a Chinese-induced surge in its export prices.
India is also quite taken with China – but for very different reasons. Basically, India wants to figure out how it can be the next China. Mindful of the huge gap that has opened up in the past 25 years in terms of infrastructure, foreign direct investment (FDI), saving, and the sheer scale of the Chinese production platform, there is a certain urgency in coping with the “left-behind” syndrome. In my recent conversations with senior Indian government officials, there was considerable focus on the FDI issue. With a 28% national saving rate that is only a little more than half that of China, India’s need for external capital can hardly be minimized. India’s new government seems especially focused on changing the closed FDI culture that has long hobbled the nation’s development.
The China fixation also plays a key role in shaping the ongoing debate in India between manufacturing and services. Given an “inclusive” India’s new priorities in coping with massive rural unemployment, the country’s focus is on labor-intensive manufacturing activities. That is a tough calculus in today’s IT-enabled world, where manufacturing prowess has become increasingly capital intensive. That is especially the case in India, which has a strong competitive edge in IT-enabled manufacturing. To be sure, there may be important labor-intensive exceptions for India, such as textiles, auto components, small office accessories, toys, shoes, and some household equipment and appliances. But the real question is whether the potential scale of activity in such small-scale industries is sufficient to make a meaningful dent in India’s high rural unemployment.
But the conclusion that hit me hardest from this world spin was the belief that nothing could shake the China boom. Whether it is urbanization, industrialization, or infrastructure imperatives, the world seems increasingly convinced that very rapid Chinese growth in the 8-9% range is here to stay. Implicit in that conclusion is the belief that the Chinese economy has now developed a new immunity to the ups and downs of the global business cycle. That may be wishful thinking. As I pointed out to the groups I spoke with, China’s growth dynamic remains heavily skewed toward exports and export-led fixed asset investment. The Chinese consumption share of GDP seems set to fall further this year from the record low of 42% hit in 2004.
This structure of the Chinese economy speaks of a stealth vulnerability that the worldview refuses to consider. China’s main source of end-market demand is not internal consumption but the American consumer. Fully 35-40% of Chinese exports currently go to the U.S. The investment dynamic is also dependent on the need to expand export-producing capacity. Consequently, a lot obviously hangs on the staying power of U.S. consumption. Therein lies the risk – both for China and for an increasingly China-centric Asia-Pacific. Despite negative personal saving rates, record household sector debt burdens, and a lingering shortfall of labor income generation in the U.S., few in the world believe that a decade of nearly 4% real U.S. consumption growth is at risk. Should that view turn out to be wrong, then Asia-Pacific would be in for a rude awakening. That would be true of Korea, Taiwan, Malaysia, Thailand, and Singapore – all of which have become tightly intertwined in a China-centric supply chain. It would also be true of Japan, whose largest export market is now China.
In my encounters overseas, most agreed that the American consumer is running flat out and is unlikely to deliver much added impetus to global economic growth. But there seemed to be little fear of a sharper adjustment to the downside. Nor was there much appreciation of what such a possibility could mean to China – the new savior of an unbalanced global economy. There was one group I encountered on this trip that got it – the Chinese. The disconnect came on the rest of my trip – with the belief that China was now an autonomous growth story. China could develop a self-sustaining internal consumption dynamic that would shield it from an externally-driven slowing in the U.S. Alternatively, other sources of global consumption – such as Japan and Europe – could fill the void. But in my view, these are all long-tailed developments, at best – unlikely to temper the potentially imminent mismatch between the overextended U.S. consumer and an externally-dependent Chinese producer.Link here.
THE GLOBAL FINANCIAL SPHERE
To commence my analysis, I would like to remind readers that contemporary finance is chiefly a system of electronic journal entries – a massive multi-national computerized ledger of debit and credit journal entries. Little more, little less. New financial claims are created (out of thin electrons and protons) simply through the power of double-entry “bookkeeping” entries, these days proliferating in unparalleled excess between myriad institutions, companies, entities, vehicles and individuals.
There is nowadays – domestically as well as globally – no restriction on the expansion of financial claims (credit inflation), in terms of either quantity or quality, with the explosion of securities market-based claims underpinned by the perception of all-powerful global central banks. And the vast majority of these new(fangled) claims are created when the financial sector intermediates loans extended to finance asset purchases (largely real estate and securities), a process where credit inflation augments collateral value (more assets at generally higher prices) and begets only greater lending and intermediation. Analysts and policymakers will surely continue to frame their arguments around the “savings” and “capital” terminology; this despite a contemporary electronic financial apparatus of unrestricted financial claims creation, along with asset-based credit systems, that has completely invalidated the traditional connotations of these terms.
To downplay the risks of the legacy of intractable current account deficits, chairman Greenspan enjoys using the comparison to trade between individual American states – in this case going back 150 years. And, sure, I imagine trade was not exactly balanced between geographic locations back then. There were, however, important limitations imposed on the nature of trading relationships. Most trade between states would be of the goods for goods variety. Each state survived without its own central bank to readily create perceived safe money to consummate transactions. Indeed, local banks that were too aggressive in their lending (deposit creation) would in short order face liquidity and solvency issues. Trade imbalances would tend to be driven by market forces, hence would be self-adjusting and correcting.
Importantly, trading relationships from 150 years ago were governed by the Economic Sphere – the trading of goods for goods dictated by the interplay of supply and demand (note: gold and gold-backed money would be considered an integral aspect of the Economic Sphere). An expanding Financial Sphere, on the other hand, promotes credit creation and the trading of financial claims for goods. Left untended, Financial Sphere inflation will foment a progressive process of trade and investment distortions and increasingly chronic imbalances; although for some time generally heightened trade and economic expansion will shield this corrosive process from either investigation or denouncement. Resulting trade imbalances are not generally outwardly problematic in interstate trading – since transactions are consummated and claims/IOUs denominated in the same currency. Financial fragility is not in this case induced by the dynamics of exuberant trading. Each state does not have its individual Financial Sphere in which to inflate its own respective financial claims, thus mitigating credit inflation’s inevitable wealth redistribution and consequent acrimony, revulsion and financial and economic dislocation.
The role globalization has played in stimulating trade, increasing the supply of inexpensive foreign goods, pressuring developing nation wages, and generally fostering “disinflation” are by now well documented. Today, globalization is acclaimed by bond managers and Federal Reserve policymakers for permanently pressuring interest-rate markets as well. It is this leap of faith for which I today take strong exception. I would like readers to try to think in terms of the distinctions between the Global Economic Sphere and the Global Financial Sphere. For a long, long time the expansion of global market for trading goods and services has played a constructive role in fostering trade, commerce, investment, output and a rising general standard of living. Yet, it is the Global Financial Sphere that has demonstrated momentous change over recent decades – especially over the past 12 years or so. This evolution has gone seemingly unnoticed and its current predicament unrecognized.
Importantly, the Global Financial Sphere is now perpetrating massive liquidity excess unlike anything experienced in the past. Global credit systems – unleashed from the King Dollar straightjacket and at the same time inundated with global “hot money” liquidity, while these days enjoying surging demand and prices for their exports – have joined the U.S. to create an unprecedented global credit bubble.
The major analytical error made of late is to confuse this newfound glut of liquidity for “savings”. This splurge of Global Financial Sphere liquidity will not forever lower global market yields – quite the opposite. It is bound for awhile to press global central bankers to raise rates much higher than anyone had anticipated. As the Fed apparently has begun to recognize, the global liquidity glut significantly mollifies the impact of central bank (baby-step) rate increases. This is a similar dynamic to the muting influence global liquidity over-abundance is having on the capacity for rising prices of oil, natural gas, unleaded gas, copper, aluminum, platinum, and other commodities to temper demand. Marketplace liquidity and speculative dynamics have changed profoundly in the 17 months since the Fed was compelled to commence its timid policy reversal.
Global Financial Sphere inflation is always evolving; its manifestations changing and tending to adapt and mutate rapidly at times. The current strain of global credit inflation is as extreme as it appears resilient. This creates an extraordinary backdrop commanded by a confluence of overabundant and unwieldy liquidity, along with an enormous and powerful global speculator community. Global central bankers have their hands full. If only the Fed would have moved more quickly and aggressively…Link here (scroll down).
DOLLAR SURGE IGNORES GLOBAL IMBALANCES
As the U.S. dollar rockets to its strongest in 18 months, many experts are tempted to conclude currency markets could not care less about the global imbalances much feared by policy-makers around the world. Economists acknowledge there is a tendency in markets to assume that if a major hiatus from these imbalances has not happened by now, it may not happen at all. But has a crisis been averted or just postponed?
The long-running debate over the risks posed to world financial stability from burgeoning world imbalances, clearly evident in the ballooning U.S. current account deficit with the rest of the world, splits into two camps. The doomsayers insist rising U.S. indebtedness is unsustainable and, any time soon, the willingness of foreigners – mainly Asian central banks – to keep plowing larger chunks of their savings into U.S. assets will wane. When it does, they say the dollar will slide, long-term borrowing rates will soar and debt-dependent U.S. households will be forced to cut back, triggering a world recession. But as the dollar surged to its highest in 18 months against a basket of major world currencies on Friday, notching up 13% gains so far in 2005, proponents of this argument could be forgiven for scratching their heads.
The optimists, on the other hand, will say “we told you so”. No such crisis is anywhere on the immediate horizon. They argue the sustainability of deficits is greater now because the increasingly interdependent global economy has seen a much higher level of cross-border capital movement over the past decade and U.S. investments remain an unusually “safe” and attractive destination. Once again, Federal Reserve Chairman Alan Greenspan led the “don’t worry” brigade last Thursday, insisting a rise in the U.S. payments deficit to more than 6% of GDP was driven mainly by long-term forces of globalization that would not disappear overnight.Link here.
Dollar party may be over soon.
The dollar is showing another round of surprising strength but some currency analysts are saying that the party is probably almost over, because the European Central Bank looks like it is getting ready to start making its first short-term interest rate hikes in 5 years – a move likely to help the troubled euro and put pressure on the soaring dollar. The widening gap between U.S. rates and those abroad has made dollar-based investments more attractive to foreigners, fueling demand for dollars. But policy-makers in Europe and Japan are showing signs they may be ready to embark on their own rate-hiking campaigns.
The dollar has made some heady gains this year. It is up about 13% against the euro and 14% against the Japanese yen, according to Reuters. It hit a 2-year high against the euro Tuesday, with the European currency sinking as low as $1.1711, pressured by interest rates as well as worries about unrest in France. Still, there is reason to pay attention to the message central bankers across the Atlantic are sending, as a stronger dollar has made traveling abroad and buying foreign products cheaper for Americans this year. But if the dollar rally is nearing an end, and if you have been waiting, it may be time to start packing for that European vacation.Link here.
Power, as Jimmy Breslin once wrote, is the illusion of power. Few are more dependent upon cultivating the illusion than the chairman of the Federal Reserve. After the last mostly prosperous 18 years, no economic figure in the world is thought to be as influential as Alan Greenspan. Every blessing that has befallen America – impressive growth rate, high productivity, low inflation – is laid at Greenspan’s door. So, too, our periodic misfortunes, like the occasional bubble or bust or the recent inflationary uptick. Senator John McCain once joked that if he were elected president and Greenspan were to die, he would prop him in his chair and hope no one noticed. But is it possible that no one would notice – that prosperity, or sound monetary management, at any rate, would go on?
The most oracular and idiosyncratic of Fed chairmen, Greenspan has personalized the office like no one before. But while he has been issuing those Delphic pronouncements, a funny thing has happened to central banking. It has become more normative – less an art and more a discipline. Central bankers have gotten better. They have also gotten luckier.
When Greenspan’s reign began in August 1987, long-term interest rates touched 9%. Today they are half that. It challenges credulity to think a single man could have fashioned such a tectonic shift. After all, long-term rates and inflation have also fallen in every other highly industrialized country (though their economies did not grow as quickly as ours). Greenspan, like other bankers, rode a forgiving current as nations regulated less and traded more. World economies benefited from the software revolution and, until recently, falling energy prices. And each central bank, including the Fed, was tugged along the path of monetary discipline by its neighbors.
In a closed economy, in which only dollars matter, the Fed alone could regulate liquidity; in a global economy, it must collaborate. This is why Greenspan has been exhorting China to revalue – and why he needs London and Frankfurt to avoid inflation almost as much as Washington. It may bruise American pride to think of Ben S. Bernanke, nominated to succeed Greenspan, as resembling another dully professional Eurobanker, but that image may be closer to his future than that of the man pulling the levers behind the curtain.Link here.
Greenspan leaves his mark on the stock market too.
In Alan Greenspan’s 18 years as chairman of the Federal Reserve, the ups and downs of the stock market have undergone some striking changes. The familiar turn of the cycle every few years from bull market to bear market and back all but disappeared in the 1990s. The new pattern was more like “up, up and away”. Alas, as it turned out, bear markets were not permanently banished, only temporarily exiled. When the long advance of stock prices finally gave way to declines at the start of the 21st century, they returned with a vengeance. But Greenspan, who is due to turn over the helm in January to Ben Bernanke, did succeed in altering, at least for a time, the ways many investors think about the interplay amongst the economy, American politics and the cycle of increases and declines in stock prices.
The old order was embodied in the famed “political stock- market cycle”, which decreed that stock prices would enjoy their best gains in years leading up to and including presidential elections in the U.S. The market suffered its worst times in the other half of the cycle, the two years following elections. The reasoning behind this was simple and clear. “Politics being what it is, incumbent administrations during election years try to make the economy look good,” say Yale Hirsch and Jeffrey Hirsch in their annual Stock Trader’s Almanac. Those same politicians “tend to put off unpopular decisions until the votes are counted,” the Hirsches said.
The political cycle had one of its most visible manifestations in post-election years. Like clockwork, stocks endured regular drubbings in 1969 (an 11% decline for the Standard & Poor’s 500 Index); 1973 (down 17%); 1977 (down 12%), and 1981 (down 9.7%). The string was broken in 1985, thanks in large measure to changes afoot at the Fed. Under then-Chairman Paul Volcker, the central bank had begun what would prove a successful long-term campaign to subdue inflation. The S&P 500 climbed 26% in ‘85. After Greenspan succeeded Volcker in 1987, the index rose 27% in post-election 1989, 7.1% in 1993, and 31% in 1997. These gains displayed a bipartisan spirit, coming under Republican Presidents Ronald Reagan and George H.W. Bush in the ‘80s, and Democrat Bill Clinton in the ‘90s.
In 2001, the market reverted to post-election form, with the index falling 13% on the heels of a 10% drop in 2000 – which, by the way, represented the first election-year loss in 40 years and only the third since World War II. That brings us to 2005, which has been a going-nowhere year for the big U.S. market averages – though it has produced some significant bright spots elsewhere. The average emerging-markets stock mutual fund tracked by Bloomberg, for example, gained 20% from New Year’s through the end of last week. The average emerging-markets bond fund advanced 5.3% in the face of rising U.S. short-term interest rates.
“Greenspan is retiring and his desire to get out intact may have something to do with the unusual speculative strength this year,” says Jeremy Grantham, chairman of Grantham, Mayo, Van Otterloo & Co., a Boston-based manager of $90 billion. “This last year for him is more like the fourth and last year of a presidential cycle, when the overwhelming desire is to coast up to the election and not rock the boat.” Grantham views this bearishly, seeing “the potential for a downward spiral in risky assets” as Bernanke takes over. “For Greenspan, there is only one quarter left of coasting,” Grantham says in a recent Web site commentary.Link here.
WALL STREET: EASY STREET?
For most of us, the act of buying a brand-new Ferrari involves little more than visiting the nearest show room, handing the sales agent a check for the exact amount, sitting down in the driver’s seat, putting the key in the ignition, and sailing off into the sunset – that is, until, the sniffing salts kick in and you wake up. But for many of Wall Street’s best and brightest, this is less a dream than a reality: The annual bonuses for brokers, bankers, and traders are expected to reach record levels this year.
In the words of a November 8 Wall Street Journal, “It’s white truffle season on Wall Street as [executives] are gearing up for a bonus bonanza. Overall, compensation on is expected to go up on average of 20%.” Here is a breakdown of who is supposed to get what: 1.) Propriety traders dealing the “high-octane growth” areas of commodities and energy: Pay increases of 40-50% for total pay packages of $15 to $20 million. 2.) Prime brokers managing a bank’s relationship with hedge funds: Pay increases of 20-25% for total pay packages of $7 to $10 million. 3.) Investment bankers arranging mergers & acquisitions for corporations: 10-20% gain for total pay packages of $2.2 to 3.3 million.
Considering these numbers, a few hundred thousand “dead-presidents” seems a small price to pay for driving in style. Last we checked though, these “dead presidents” are still in their lame-duck-period, as year-end bonuses do not actually come in until – you guessed it – the end of the year. And, according to the WSJ article, the PRE-BONUS, base salary of the average investment banker ranges from $100,000 to $250,000. The 2005 Ferrari goes for $287,020. You do the math: They are betting their entire annual wage (and then some) on windfalls that have not even arrived yet. As a November 8 Bloomberg notes: “Wall Street’s answer to a spawning run doesn’t occur until just before Christmas, but already yacht salesman, private-jet brokers, fancy car dealers, the International Guild of Butlers, and others who routinely toss baited hooks into the Street’s waters are feeling a jolt on their lines.”
Blind faith in the fulfillment of these “expected” bonuses is just one aspect of the story we find noteworthy. The other is the fact that not everyone on the Street is set to finish out the year a fat cat. The WSJ piece observes: Those investing in convertible and junk, or “high yield” bonds are expecting pay CUTS of 10% as “the aftereffects of the downgrade in General Motors Corp. and Ford Motor Corp. likely eat into profits and pay packages.” Meaning: the “anticipated” bonus bonanza in those sectors such as commodities, energy, mergers & acquisitions, and hedge funds depends on the continued strength and inflow of money into those markets.
Add it all up and you have got a lot of people hoping for the same thing: that a bull market is here to stay AND those professionals working in them will be rewarded in a generous way.Elliott Wave International November 8 lead article.
SEC PROBES COMPANY PENSION PLANS
The Securities and Exchange Commission is probing whether companies have tweaked their pension plan assumptions to please shareholders rather than protect the interests of retirees, the Wall Street Journal reported, citing people familiar with the matter. Pension assumptions are used to calculate the size of a plan’s future pension obligations. The SEC’s interest in the pension plans has been known for months and details about the probe continue to surface.
Small changes, such as a quarter-point increase in the interest rate used to calculate the present value of total liabilities – can change a company’s pension obligation by billions of dollars. General Motors is one company under review. Boeing, Delphi, Ford Motor, Navistar International and Northwest Airlines have disclosed SEC inquiries about their pension plans. The SEC has not accused any company of wrongdoing. The SEC is also looking at pension accounting issues that do not involve assumptions but can boost reported earnings, the newspaper reported.
The SEC is using its subpoena power to dig into the thinking behind how companies arrive at pension accounting decisions to determine if the estimates were made in good faith or were designed to boost results. Three areas under review by SEC investigators include the discount rate, used to figure out the present value of items they need to pay in the future; the expected rate of return, used to smooth the impact of changing pension plans values on their financial results; and health-care inflation estimates. At the same time, the Financial Accounting Standards Board is scheduled to vote whether to take another look at pension accounting rules. FASB may consider stricter standards, such as making companies record the fair value of pension plan assets and liabilities each quarter.Link here.
Rule would put pension deficits on the company books.
The group that writes U.S. accounting rules voted to consider changing how pensions are treated on companies’ ledgers, including a requirement that pension-fund surpluses and deficits be recognized on balance sheets. The Financial Accounting Standards Board said in a written statement that a review is needed to make information in companies’ financial statements “more useful and transparent for investors, creditors, employees, retirees, and other users.”
That is not always the case today. Under generally accepted accounting principles, “important information about the financial status of a company’s plan is reported in the footnotes, but not in the basic financial statements,” the board said. The board said it hopes to have in place by the end of next year a rule “requiring that the funded or unfunded status of defined benefit and other post-retirement benefit plans” be included in companies’ balance sheets.
In the case of a company like General Motors, with a giant pension plan, the impact on shareholder equity could be large, depending on what the FASB does. In a filing this year with the SEC, GM showed in a footnote unrecognized pension liabilities of more than $36 billion. Under the FASB proposal such liabilities apparently would move to the balance sheet and be recorded as a reduction in shareholder equity, more than wiping out the equity reported, according to an expert at a private consulting firm, who spoke on the condition of anonymity because he is not authorized to comment.
FASB officials conceded that the issues surrounding pensions are complex and involve competing interests. “While the accounting and reporting issues do not appear to lend themselves to a simple fix, the board believes that immediate improvements are necessary and will look for areas that can be improved quickly,” board Chairman Robert H. Herz said in a written statement. Such revisions could be far-reaching. An FASB decree 15 years ago that companies put the cost of retiree health insurance on their balance sheets was a key factor in decisions by many employers to curb or eliminate such benefits. More recently, an FASB proposal to require companies to treat grants of stock options to employees as expenses touched off a huge protest. That rule took effect this summer.
There are nearly 30,000 traditional pension plans in the U.S., covering about 44 million workers and their dependents. Those “defined benefit” plans are funded by employers and promise retirement benefits based on formulas typically involving workers’ pay and years of service. They are insured by the federal government. However, the number of such plans has declined drastically – from about 120,000 in 1985 – and many of the remaining plans are badly underfunded. According to the Pension Benefit Guaranty Corp., the government’s pension insurance agency, 1,100 plans are underfunded by a total of $353.7 billion. A plan is considered underfunded when the value of its assets is less than the present value of the benefits workers have been promised. Bills are pending in both houses of Congress to tighten funding requirements and impose higher insurance premiums to shore up the PBGC.Link here.
RECORD FOR CEO TURNOVER IN 2005
More chief executive officers have left their jobs in 2005 than in any other year, according to a study conducted by outplacement firm Challenger, Gray & Christmas. So far this year, 1,110 CEOs have left their jobs, surpassing even the dotcom exodus of 2000. October saw 96 departures, 113% higher than during October 2004, including 15 health-care CEOs and a dozen CEOs from the technology sector.
But it is not CEOs alone who are feeling the heat. Turnover among top management in general has been occurring at a furious pace since the beginning of August, according to a separate study of U.S. public companies by Liberum Research. Liberum reported that in July, top management changes – arrivals, internal moves, and departures – totaled 763, but by last month they had soared to 2,056. Liberum’s October tally includes 218 changes of status for CEOs, including 67 departures. The most active area was in the boardroom, where Liberum counted 477 changes in October, including 103 departures.
And chief financial officers? Liberum reported 164 changes in October, including 57 joining from outside the company; 49 promoted from within and 13 representing other internal moves; 37 retiring or resigning; and 8 departing without a clear reason.Link here.
REFCO’S COLLAPSE MARKS ONSET OF OUTRAGE FATIGUE
As the vultures pick over the carrion of Refco Inc., nobody seems particularly indignant about the collapse of what was the 4th-largest U.S. futures broker before its bankruptcy. The 14th-biggest failure in U.S. history does not seem to be arousing the kind of anger that accompanied previous scandals. Just as donor fatigue saps people’s charitable giving after what feels like one famine, one tsunami or one hurricane too many, maybe the surplus of corporate scandals in recent years has deadened our sensitivity to financial shenanigans.
It takes a lot to compete with the likes of Parmalat, the Italian dairy company that falsely claimed to have $4.9 billion tucked away in a rainy-day bank account; or Enron, which had a market value of more than $68 billion before its December 2001 bankruptcy; or Freddie Mac, which had to restate three years of income for a margin of error of $5 billion. Even so, the story of Refco is a doozy. It is not so much the allegation that CEO Bennett was slithering $430 million of debt between a series of different accounts to keep it off Refco’s books. That kind of sleight-of-hand is so common these days they are probably planning to add it to the MBA syllabus at Harvard Business School.
It is not even that most of the losses that dragged the firm down were accumulated as long ago as 1997, during the currency crisis that gripped Southeast Asia. No one expects audit reports to unearth accounting malfeasance anymore, even when the books have been cooked for years. Or that Refco’s bankers – Credit Suisse First Boston, Goldman Sachs Group Inc. and Bank of America Corp. – raised $670 million in August by selling shares in the broker without uncovering the financial cavity. Whatever due diligence means these days, it is not your father’s due diligence.
The really interesting wrinkle in the whole Refco debacle is the allegation that Bennett, a 57-year-old graduate of Cambridge University in the U.K., tried to keep the balls in the air for as long as possible. He had the chutzpah to borrow €350 million ($413 million) from an Austrian bank to fill the hole, pledging his soon-to-be-almost-worthless 34% stake in the brokerage firm as collateral. There is something almost heroic in Bennett’s efforts to keep the smoke from clearing and the mirrors from cracking, with the Austrian bank’s money arriving just hours before the jig was up.
Some of Refco’s clients pulled money out of the broker, diminishing its client accounts to $3.4 billion as of Oct. 24, down from $6.5 billion on Sept. 30. That still leaves $3.1 billion that customers were content to leave sitting at the firm even after it filed for bankruptcy. It takes more than a $430 million fraud probe to ignite concern these days. One reason why Refco’s expiration has not attracted more disapprobation might be the lack of direct repercussions in the global financial markets. So far at least, we have seen no failed transactions, no settlement blow-ups, no trades that had to be unwound. Nevertheless, the absence of angst over the rapid disappearance of a major financial firm is puzzling. It suggests our moral compasses are now too warped to register disturbances in the ethical forces that should, however weakly, provide boundaries to corporate behavior.Link here.
GOODBYE OBSOLETE G-7, MEET THE RELEVANT G-20
Australia, with 20 million people and a $618 billion economy, is rarely thought of as a global power. Yet the leaders of a country whose economy ranks 13th in size may just shake up the world order as we know it by reducing the influence of the Group of Seven nations. It would be replaced with a more inclusive regime for managing global economic affairs. Should it happen, so much the better. “As the world economy has changed, so too, these institutions must change,” Australian Treasurer Peter Costello said last month in China.
The G-7 is, let’s face it, becoming irrelevant. Those seeking evidence of this impotence need look no further than this year’s surge in energy prices. The mightiest economies could do little more than issue useless press releases and communiques. Why? Demand from economies beyond the G-7’s purview now plays a major role in determining global prices.
In February, signaling that some humility is in order, the G-7 invited a number of emerging economies to attend one of their periodic meetings. They included Brazil, Russia, India and China. Australia would like to see more of the same, and it is uniquely positioned to push the issue. One reason: it is a member of the Group of 20 nations, and next year it will chair the group’s annual meeting. Another: because Australia is itself a developed economy, it may have more clout with rich nations to argue for a more equitable global arrangement. In other words, the G-20.
It is not just a matter of fairness. The G-7 includes Canada, France, Germany, Italy, Japan, the U.K. and the U.S. The G-20 consists of those countries plus Argentina, Australia, Brazil, China, India, Indonesia, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey and the European Union. The G-20 covers about two-thirds of the world’s population and more than 80% of global output. Not only does it include the world’s most populous and fastest-growing nations, but also some of its most important oil producers and voracious consumers of commodities.
Granted, getting seven economies to agree on anything is a chore in the best of times, never mind 20. If economic leaders are to have any leverage in this globalized world of ours, they are going to have to open their clubby little world. Since those holding power are always reluctant to give it up, it is more likely the G-7 would prefer to add a couple of members than let the G-20 take over. That would be a mistake. It would mean cherry picking economies it likes, rather than honestly respecting the emerging new global order. The G-7 would be wise to admit the system of financial leadership that made sense 15 years ago or even three years ago does not today and pass the baton to the G-20.Link here.
YIELD CURVES … THAT’S HOT!
I did not want to write about bonds again today, but Merrill Lynch made him do it. … Actually, Merrill Lynch, Eaton Vance, Dresdner Kleinwort Wasserstein and CIBC World Markets all teamed up together to make me do it. This esteemed cluster of investment banks simultaneously downgraded bonds. There is no “buy” signal known to man that is more compelling than a mass, simultaneous “sell” recommendation from Wall Street. Knowing this fact, what choice did I have but to write about bonds again?
I began warming up to the short-end of the yield curve about three weeks ago. But thus far, the short-end of the yield curve has not been warming up to me. My affection for 5-year Treasury notes has gone unrequited. Nevertheless, I continue to hold a candle for the 5-Year Treasury note. And now that so many former bond bulls have become bears, bond buyers might soon be feeling the love … of a bond rally.
When so many Wall Street bond bulls become bond bears, every seasoned, contrarian investor must consider taking the other side of the trade … just like the commercial futures traders have been doing. The “Commercials”, often considered the “smart money”, have accumulated their largest net-long position in 5-year Treasury-note futures since early August. Coincidentally, or not, the 5-year rallied sharply throughout the month of August. During this mid-summer rally, the 5-year yield dropped from 4.28% to 3.82%. We would expect the NEXT 5-year rally, if it occurs, to produce much larger, and much more enduring, gains than the August rally. Indeed, we think there is a good chance that 5-year yields are close to an important peak.
So far, the bullish scenario has not (yet) come to pass. Instead, the unsanctioned (by me) bearish scenario continues to play out. The price of the 5-year has dipped one full point since our October 21st column, pushing its yield up to 4.47% from 4.26%. Hardly a disaster, but disconcerting just the same. Perhaps the market has merely provided a better entry point, perhaps not. Whatever the case, we remained captivated by this trade. The 5-year may be a bad bet, but we just cannot take our eyes off of her. There she stands with her voluptuous 4.5% yield amidst an economy that looks uglier by the day. Home sales are slowing and auto sales are plummeting, just to mention two indicators of economic health … and yet the Fed continues to raise rates. At some point, the economy should visibly slowdown, if not pass out completely.
Consumer spending of every sort is plummeting, largely because the cost of debt is rising.Link here.
BUYOUT FIRMS SEEK COMPANIES TO TAKE PRIVATE
In an era of low interest rates and reduced expectations from the stock market after the bursting of the tech bubble, large institutional investors are seeking to supercharge their returns by pouring money into private equity firms, leaving them awash in cash. Those firms, in turn, are looking to buy companies where they see a chance of increasing profits. And buying out a public company and taking it private brings with it an automatic multimillion-dollar profit boost, as the company no longer has to comply with the costly securities legislation that emerged from the turn-of-the-century Wall Street scandals. “Companies are increasingly going private because the environment for public companies has gotten tougher,” said Chinh Chu, senior managing director at New York-based private equity firm Blackstone Group, which is buying Irving, Texas-based La Quinta Corp.
The Sarbanes-Oxley Act of 2002 was passed in response to the high-profile scandals at Enron Corp., WorldCom Inc. and other companies that used accounting tricks to levitate profits. The costs of meeting the requirements of the act have increased dramatically every year since its passage, according to a recent report by Foley & Lardner LLP in Chicago. The average yearly costs of being public for a company with less than $1 billion in annual revenue has increased from just over $1 million in 2002 to $3.4 million now, according to the report. More extensive audits are the main driver of this expense.
Rarely, if ever, would a company say it agreed to be bought out and give up control of its destiny simply to avoid the cost and nuisance of regulatory requirements. If that were the case, the markets would not be seeing a resurgence of IPOs by companies clamoring to enter the capital markets. The primary reason a company agrees to a buyout is usually industry-specific. Trends in the hotel industry were the prime movers behind the Wyndham and La Quinta deals. And the buyout of Neiman Marcus Group was one of a series in the department store sector. But in such deals, Sarbanes-Oxley usually does get a mention.
And avoiding costly regulatory requirements is not the only benefit of going private. Mark Hauptman, chief financial officer of health and insurance provider UICI said being private will allow his company to take a more long-term approach. “We don’t have to meet the quarterly expectations of Wall Street,” Mr. Hauptman said. “We can make decisions for the long term.” UICI announced in September that it was being sold to a group of private equity firms in a $1.2 billion deal. “You might want to lower the price of one of your products, which would hurt earnings in the short run, but it might be the best long-term strategy,” he said. “It might take a few years to increase the volume to offset the lower prices, but a public company is under pressure to meet the quarterly number.”
In La Quinta’s case, as a public company it might want to, say, refurbish 10 to 15 hotels simultaneously and take them out of commission for several months. But that would result in the company missing its earnings targets, said Tom Ward, director of investor relations. Instead it would have to remodel one or two properties a year. “Now we can knock down 20 hotels at once if we want,” Mr. Ward said.
Equity firms often cash in their investment in companies by selling shares in an initial public offering when the companies have achieved new levels of profit. Since it was known as Southland Corp., 7-Eleven has been in and out of the private and public realms. It typically takes about a year for a company to clear all of the regulatory hurdles and transition from a public to a private company. Federal securities laws require companies with at least 300 shareholders to file regulatory reports, so many companies simply buy out enough shareholders to drop below that threshold.Link here.
WHY MONEY SUPPLY MATTERS
For governments in general and the U.S. government in particular, Ludwig von Mises had a policy recommendation: do not increase the stock of money any further. He made this point in “Monetary Reconstruction” (written in 1952 and published in 1953): “The first step must be a radical and unconditional abandonment of any further inflation. The total amount of dollar bills, whatever their name or legal characteristic may be, must not be increased by further issuance.” Why did Mises take such a position, one which would presumably provoke outright opposition from many of today’s mainstream economists?
The answer lies in two interrelated issues. First, to Mises inflation was the source of many evils because inflation would mislead businessmen in their investments (by creating an illusory boom), cause waste of scarce resources and would inevitably lead to economic crises. Ensuing recessions, even depressions, would provoke public opinion to call for (even more) government market intervention, thereby undermining the very ideal of a free society. Second, Mises considered inflation – and therefore economic crises – to be a monetary phenomenon, brought about by governments’ increase in the quantity of money: “There is no means of avoiding the final collapse of a boom brought about by [bank] credit [and therefore money] expansion.” As a result, it appears all too consequential that Mises – a steadfast defender of the free society – recommended an end to the expansion of the stock of money.
It might be a relief to followers of Mises’s economic program that keeping inflation low and at a stable level has become a widely accepted societal objective. However, a major issue of concern remains. Central banks under the government-sponsored paper money system keep expanding the money supply. To make things worse, central banks, in line with many economists, currently appear to pay relatively little, if any, attention to money supply growth. Against this backdrop, the question is: how long must money grow (“strongly”) before it should be of concern to central banks? Or to put it differently, what is the shortest period of time over which money growth seems to be reliably associated with price inflation?
Of course one should not expect that changes in money supply have an immediate effect on inflation. Taking into account adjustment processes, it takes some time for the change in money supply to make itself felt in the economy. So in the following the relationship between money growth and consumer price inflation (central banks’ actual “target” variable) shall be examined across three time periods: two, four, and six years. To examine the question of whether the relationship between money growth and inflation is notably close over any of these time horizons, and, if it is, how clearly that relationship holds up over shorter time horizons.
The results of an admittedly rather simple analyses suggest that a relatively close relationship between money growth and consumer price inflation seems to exist at least over long time horizons in all currency areas. This finding could serve as a reminder that ignoring money growth for too long a period may be unwise when central banks aim at keeping consumer price inflation in check. However, would these findings really justify central banks’ practice of considering money supply changes important only in the long run but not in the short term?
Interestingly, money expansion seems to lead changes in nominal wealth since around the end of the 1990s – a change in nominal wealth seems to have followed changes in money supply. The insights above could suggest that the consequences of money growth – and in particular “excessive” money growth – are not confined to final product prices (measured by CPIs or output deflators), but also increasingly affect asset prices, which in turn are usually not included in consumer price indices. If that is so, two interrelated conclusions could be drawn. First, it might no longer be appropriate for central banks to focus their efforts on “targeting” consumer prices when the overall objective is to preserve the value of the currency. If monetary policy really wants to stick to common practice (that is, following an “index standard” as proposed by Irving Fisher), what would be needed is a much broader measure of the economy’s price level, including the prices of current production as well as asset prices.
What if monetary policy would expand money supply to keep a broadly defined price index stable. Would that eliminate Mises’s concern? The answer be no, most importantly because according to Mises the expansion of the money stock would inevitably distort the structure of relative prices – even if a (broadly defined) price index would not change – and consequently lead to misallocations and, sooner or later, precipitate economic crisis. And it is the very consequence of such a crisis that Mises identified as a major problem:
“But still more disastrous are [the crisis’s] moral ravages. It makes people despondent and dispirited. […] The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the inevitable collapse. In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.”
That said, to Mises even a monetary policy that would pursue a pre-determined rate of money supply expansion (as proposed for example by Milton Friedman’s k-percent rule) for stabilizing a broadly defined price index would remain a potential source of crisis which, in turn, bears the risk of undermining the value of the currency. This explains why Mises, in an effort to reduce that very risk to the ideal of a free society, argued for stopping the expansion of the money supply, thereby arguing for a concept quite different from today’s state-of-the-art monetary policy.Link here.
China money supply growth accelerates due to yuan revaluation.
China’s money supply growth accelerated in October due to the effects of hot money inflows and central bank policy changes in response to the revaluation of the currency, the yuan, HSBC economist Qu Hongbin said. China’s M2 broad money supply was up 18% year-on-year at end October, the fastest growth rate since April 2004. It was marginally above the 17.9% rate recorded at end-September and has been on the rise since February this year. M1 was up 12.1% from a year earlier at the end of October, against the 11.6% year-on-year growth recorded the previous month. “Clearly you can see this kind of monetary growth continuing,” Qu said. “It’s largely due to the July change in the exchange rate which has basically resulted in some kind of change in credit policy,” the economist added.
China revalued its currency, the yuan, by 2.1% against the dollar in July, scrapping its 11-year-old peg to the U.S. unit in favor of a link to a basket of currencies. Qu said that the central bank seems to be pulling back from its open market operations to keep the onshore short-term rate low in the hope of stemming the flow of hot money betting on further currency appreciation.Link here.
Measuring gold’s link to inflation.
The chart plotting the rate of change in the Producer Price Index (PPI) against gold paints a remarkably clear picture. But to understand why that picture is not just a coincidence, consider why gold is always in demand. Gold is real money, and it has been real money from the beginning of recorded history. Specifically, while government-printed paper currencies come and go, gold has been respected as a medium of exchange and a store of value throughout countless generations. But the dollar and other paper currencies have advantages of their own, especially their greater short-term stability of purchasing power. So gold and the dollar compete for the attention of investors and consumers. And when inflation rates rise, the dollar’s appeal versus gold weakens.
Movements in the PPI are a good – perhaps the best – barometer of inflation, because the PPI is free of much of the statistical “noise” that goes into the more familiar CPI. In the chart, any rate of change in the PPI above 0% means inflationary pressure in the economy. Below 0% means deflationary pressure. As you can see, with some explainable exceptions, the PPI and gold move together. You can also see that the trend is currently in place for both higher inflation and higher gold prices.
Of course, forecasting PPI inflation is no easy matter. But the chart does tell us emphatically that when we see growing forces for inflation – rapid expansion in the money supply engineered by the Federal Reserve, artificially low interest rates, growing government deficits, unsustainable trade imbalances and currency competition – we should expect rising gold prices.Link here.
THE MORE THINGS CHANGE, THE MORE THEY REMAIN INSANE
“Alan Greenspan has welcomed the ability of new technologies in financial markets to reduce transaction costs, to allow the creation of new instruments that enable risk and return to be divided and priced to better meet the needs of borrowers and lenders, to permit previously illiquid obligations to be securitized and traded, and to make obsolete previous divisions among types of financial intermediaries and across the geographical regions in which they operate.” The words are those of Donald Kohn, a man who is a Fed governor, a Greenspan aficionado, an attendee at the Jackson Hole confab in August, and probably (only history will tell) a jackass. He and other speakers elaborated a view, which is both new and old, and completely mad: that technology, innovation, globalization and sophistication have made the financial world a safer place.
We noted the evidence of these modernizations in this space over the last few years and gave them some precision only a few days ago. Since Alan Greenspan took over at the Fed, levels of debt throughout the entire financial system have increased greatly. Over the past decade, adds Dr. Kurt Richebächer, “consumer debts are up 121%, to $10.7 trillion,” while real consumer income was either stagnant or falling. More alarming, but also more puzzling, is the increase in derivatives. The ISDA reports that international interest rate and currency derivatives outstanding shot from $865 billion in 1987 to $201.413 trillion in 2005. It is these last figures to which Mr. Kohn refers. These sophisticated financial instruments make it possible for 8,000 hedge fund managers, and thousands more money managers spread all over the world, to go long, short, and upside down all day long.
Financial institutions make their money by originating and selling what are inherently risky positions. In a bank-dominated financial system, the banks themselves, and ultimately a banker, stood to gain or lose as the loans came due. If the banker made bad bets, he could be disgraced, broke, and out of business. But in this new, more sophisticated world, financial institutions create derivative products and sell them to hedge funds. Once sold, the salesmen earn a commission and the risks are transferred to the buyers. The funds have every incentive to take risks. If they win, the managers take a bit part of the gains. If they lose, they suffer no personal penalty. Ultimately, no one knows how risky the system is, or who, exactly, stands to lose if it implodes.
We do not know any more than anyone else. We only note that the more stable and safe a financial system becomes, the more investors are lured to take risks, and the more financial intermediaries are encouraged to develop new products to help investors part company with their money. Eventually, the lack of perceived risk creates a situation in which real risk is greater than ever. When people think there is no risk, for example, they see no need to save money. But when people have no savings (savings rates in America were recently negative) they are most at risk, and often driven to react in panicky, desperate ways. That is, where we find ourselves today.
It reminds us of the geo-political situation prior to the Great War. That too, was a period of fast innovation, stability, technological progress and globalization. Thinkers at the time came to the same conclusions about these things as Donald Kohn, 100 years later. The world had become too sophisticated for war, they said. Interlocking treaties would serve to prevent any nation from firing its cannons first. New technology made war too devastating to contemplate (or, taking the opposite side of the argument … many argued that technology made it possible to fight a war with few casualties!). And modern, globalized markets meant that war no longer made sense. That was the point made by Norman Angell, in a celebrated book of the time. A nation’s wealth was built on factories and trade, he pointed out. War was now out of the question, because it would destroy wealth. But in 1914, began the most deadly and expensive war in human history.Link here.
IS JAPAN BACK?
When Rakuten, Japan’s largest online shopping mall, quietly acquired a piece of the Tokyo Broadcasting System and announced its intention to merge TBS in Rakuten, it created quite a stir in the Land of the Rising Sun. This sort of thing was not supposed to happen in Japan. Instead, a kind of forced stability was the hallmark of Japan’s economy. It was supposed to be devoid of the more freestyle elements of American capitalism, such as takeovers and mergers. But that era is over.
The Japanese stock market was once the greatest show on earth. America, indeed the world, could not get enough of Japan. Books extolled how Japan was primed to take over the world. America, these pundits predicted, would soon be a poor vassal in a new Japanese Empire. Come to think of it, you hear arguments along the same lines made today about China. After the peak in 1989, the curtain fell, and it has been largely riding the skids since. The Nikkei Stock Average fell to a low of 7,831 in April 2003, a drop of 80% from its high. That seems to mark the bottom. Since then, it has slowly crawled out of that hole. Today, it sits at around 13,199 – near 4-year highs and a 68% gain from the bottom, but well below the old peak of 38,915.
I first wrote a bullish piece on Japan in April 2004. Since then, the Nikkei has rallied and Japan has been in the news more. A recent cover of The Economist reads, “The Sun Also Rises”. Trading volume in Japan has surged, reflecting an influx of money looking for a stake in Japan’s recovery – everybody from European pension funds to flush Middle Eastern oil barons. Normally, I would not get excited about something so hashed out in the mainstream media. But it is hard to ignore the world’s second largest economy. And we may come to different conclusions for investment purposes.
So the question is this: Is Japan’s revival real, or are the seemingly bullish sentiments on Japan premature? To offer a preview, I lean more toward the former. Let me show you the collected evidence, which I believe offers a compelling portrait of an economy on the mend.Link here (scroll down to piece by Chris Mayer).
WHEN BUBBLES BURST
For the last couple of years, the prospect of a housing bust seemed purely theoretical. But now it seems all too real. Suddenly, the worst-case scenarios seem uncomfortably plausible. And even the best-case scenarios do not look that great. Thus, when Toll Brothers offered its disappointing sales forecast earlier this week, the mortgage lenders of the nation must have felt a few pangs of anxiety. Afterall, what is bad for the homebuilding goose is never good for the mortgage-lending gander. The nearby chart illustrates the close connection between the two industries. For several years, companies like Countrywide Financial and Toll Brothers have been nurturing each other’s prosperity. No surprise then that their respective share prices have been rising in tandem. Perhaps, then they will also fall in tandem.
“Since Hurricane Katrina in early September, we have observed buyers taking longer to make their purchasing decision,” Robert I. Toll, chairman and CEO of the nation’s largest luxury homebuilder, glumly explained. “It appears we may be entering a period of more moderate home price increases, more typical of the past decade than the past two years.” Left unsaid was the unnerving possibility that Toll’s downbeat forecast remains still too optimistic … and that we may be entering an atypical period of moderate price DECREASES, in which case, mortgage lenders like Countrywide Financial may be entering a period of moderate (to substantial) earnings decreases.
“A bubble is to a boom as a martini is to a beer,” writes James Grant, editor of Grant’s Interest Rate Observer, “So much more potent is the former, why does anyone settle for the latter? You know the reason: the morning after. Which will serve to reintroduce Countrywide Financial Corp., the nation’s top mortgage originator and No. 1 mortgage servicer.” Countrywide is the biggest, and fastest-growing, mortgage-lender in the nation, which is exactly the wrong kind of lender to be if, as Grant believes, the housing boom is about to become less boom-like. “House prices, say we, are in a bubble, not just a boom,” Grant declares. “Their rise in real terms in the decade since 1995 represents a significant and telltale break from the experience of at least the four prior decades. … Equally, mortgage debt is in a bubble, as it must be. Without the debt, who could afford the houses? As these bubbles have inflated, Countrywide has dazzled. It must dazzle less after the comeuppance.”
Grant has not always cast a skeptical eye toward Countrywide. To the contrary, in February 2000, he penned a glowing – and timely – analysis of the mortgage lender’s stock. The share price has soared 5-fold since then. Therefore, now that Grant has turned bearish toward the stock, we are inclined to lend him our ear. “A post-bubble mortgage crisis has no place in Countrywide’s five-year plan,” Grant jokes. To the contrary, the company’s CEO, Angelo Mozilo, dismisses such doomsday notions.
Whenever asset prices tumble in any financial market, profit-making opportunities become far less numerous than loss-avoidance opportunities. Unfortunately, many market participants continue to position for profit-making rather than loss-avoiding. They keep trying to make a buck in a falling market instead of looking for a place to hide. If, therefore, the housing boom is winding down, the nation’s largest mortgage lender will be unlikely to find a place to hide, especially because its CEO dismisses the need to look for one.
“From 2002 through 2004 the size of its sales force more than doubled, to 13,000 from 6000, and it has quintupled since December 2000.” Because the housing boom contributed greatly to Countrywide’s rapid growth, we may only imagine the contribution a housing bust would make. To assist the imagination, it bears mentioning that Countrywide’s profitability per loan has been shrinking, EVEN DURING THE BOOM! Its mortgage-lending profit margins have been plummeting all year. If profit margins at the giant mortgage lender were falling during the boom-time first half of 2005, what will become of these profit margins during the post-Katrina-post-Toll-Brothers-warning second half of 2005? And what will become of them in 2006? Your editor, a homeowner, does not relish the thought that the housing boom may be ending … but Countrywide Financial must be relishing that thought even less.Link here (scroll down to piece by Eric J. Fry).
OIL SUPPLY, OIL DEMAND, AND POLITICAL THEATRE
Today’s non-news event was the Senate hearing on “energy costs”. As the heroic politicians grilled the evil oil company executives, crude oil prices went up, down, and sideways. Yet let us be creative and imagine that uncontrolled candor broke out in the hearings. The first question would have gone something like this:
Senator Windbag: “We got the idea to drag you guys up here back when gas prices were way higher – more than high enough to make you the target of a perfectly good two-minute hate on behalf of the American people, naturally. Now look what has happened. How did you guys get crude prices to fall 20% in nine lousy weeks?”
Oil Company Ogre: “You think WE made prices fall? Ha-ha, that’s rich. Call in a rocket scientist if you want a real answer, cause I do not have a sweet clue. We all figured $70 a barrel was only the start of higher prices, especially when all those rigs and refineries went off line. I am just glad I cashed my stock options back in September.”
So much to rant about, so little space. Let us briefly consider what does not matter, and then what does. It was telling indeed that in its coverage of the hearings, The New York Times ran a graphic titled “The Supply Side of Oil”. And while this graphic showed four charts, not one of them showed any oil supply (or demand) data. Instead it showed long-term declines in 1.) oil sector employment, 2.) petroleum engineering students, 3.) investments by oil companies, and 4.) the oil reserve replacement rate. Gosh, why do you suppose that all those categories were in decline?
As for what does matter, the three charts below tell you 90% of what you need to know – assuming, that is, that you wish to separate fact from fiction. The news stories said the oil company execs were taken to task for not building new refineries in 20 years. I do not know if they replied by showing the chart above, but I know I would have. The “crude runs” data means the amount of crude oil processed through the system. Here is the chart to show anyone who thinks it is a “demand” problem. This chart’s purpose is to shut the mouths of people who say “supply shortage”.
The rise and fall of energy prices during the past 6 months had nothing to do with supply or demand or greedy oil companies or even grandstanding politicians. The up and down price trends were a function of market psychology, period. The burden of proof rests on anyone who says otherwise. Analysis based in fact is the foundation for accurate market forecasts. This point is a simple one, yet it is also a commodity that really IS in short supply.Link here.
Exxon’s shopping list?
In boom times, oil companies are supposed to be out in the field, drilling for oil & gas. But when oil companies actually make some money in the biz, the folks on Capitol Hill believe that they should be drilling the oil companies. It is all politics, if not showmanship. And you know the script. Haul the big-shot execs up to the long green table in some dark-wooded chamber, and rip them apart for the benefit of the unblinking cameras. It is the American way. So what is a prosperous oil man to do? Stash the cash, of course. But first, we have to study a bit of history.
In 1980, at the peak of the oil boom of that era, the oil sector made up about 28% of the S&P 500. Starting in 1981, the price of oil began to fall from about $48 per barrel (in then-dollars, equivalent to over $90 now). Much of that fall in price had to do with the arrival of massive, new oil production from Alaska and the North Sea, among other places. Just a few years later, oil was selling for as little as $6.00 per barrel, during a few lowly weeks in 1988. Along with the fall in the oil price, the oil-stock sector dropped to about 7% of the S&P. Today, in this booming, bubbly, frothy economy of ours, the oil sector is still a mere 10% of the S&P. So will history repeat itself? Heck, I dunno. But it might rhyme, and therein lies the opportunity for the forward-looking investor.
I said, “stash the cash.” Where? Well, the usual items come to mind. The big oil companies might raise dividends to shareholders - it is about time. Closer to home, oil companies will let their internal costs rise, with salary increases, fancier offices and maybe a few more corporate jets. Good for housing in the tonier parts of Houston, maybe. And it might be OK for Gulfstream, but let us look beyond these minor ripple effects. Oil companies will also surely hire more personnel, if they can find enough technically qualified people graduating from the depleted ranks of the nation’s geology and petroleum engineering programs. Lastly, if history rhymes, we are going to see a blowout of spending within the oil service sector, as well as oil company takeovers, better known as “drilling for oil on Wall Street”. By the time the politicians get around to enacting any so-called “windfall profits tax”, there will not be many windfall profits to tax.
What are a few of the prime takeover targets? Among the larger independents, keep an eye on Anadarko (APC), Apache (APA), Devon Energy (DVN), Forest Oil Petroleum (FST) and Kerr-McGee (KMG). Whether these guys get taken out or not, they are all superior-quality companies with great management and terrific levels of technical competence. They will make money on their own, takeover or no, and do very well in the coming years. Further down on the food chain of independent oils, and still on the A-list of quality companies, look at Denbury Resources (DNR), Pioneer Natural Resources (PXD) and one of my favorites, Talisman Energy (TLM). Each one is a gem in its own right.
You still want more? Where else to look? There is nothing wrong with the Oil Service HOLDRs Trust (OIH). It is a composite of many of the best companies in that segment of the industry. As the sector rises, OIH will benefit. If you are a service-stock picker, one of the best vendors of the machinery that controls oil flow, and prevents blowouts, is good old FMC Corporation. And in terms of smaller oil- service companies, two of my “gold standards” are Lone Star Technologies (LSS), supplier of high-strength tubular goods to the oil wells of the world, and Core Labs (CLB), the world’s finest provider of analysis and systems for enhancing ultimate oil recovery from the world’s depleting oilfields.
So there you go.Link here (scroll down to piece by Byron King).
MR. GREENSPAN, TIME FOR A COFFEE BREAK
How is history made? In the case of Alan Greenspan, recent media testimonials in anticipation of his retirement leave no doubt that he is among the good and the great. Oh, there is the occasional dissenter (the Moscow Times grumbled that his money expansion led Americans to spend and forget to save), but the aggregate has been most complimentary.
In late 2004, Lawrence Lindsay tossed his bouquet into the crowd. The former Federal Reserve Board governor (from 1991 to 1997) wrote a guest editorial in the Wall Street Journal. His “Life After Greenspan” discussed the man’s qualities. Lindsay initiated his exploration with the January 3, 2001, fed funds rate cut: “Mr. Greenspan combined his access to, and understanding of, anecdotal information with his accumulated knowledge of market signals to make what, in Washington at least, was a very contrarian decision. The country was fortunate that Mr. Greenspan’s experience as a trader and business consultant trained him to combine instinct, experience, reason and facts to operate in the real-time manner required for making successful judgments.” Lindsay explained why this fearless decision was so contrary to public opinion: “The widespread euphoria resulting from the stock market bubble, coupled with the myopia of the political season, made it extremely hard to doubt that all was well with the economy.”
The atmosphere of January 3, 2001, was not of euphoria but panic. The Nasdaq Composite had fallen by over 50% from its 2000 high; stars of yesteryear had been sucked into black holes: Microsoft had fallen from $119 to $43, Cisco from $82 to $43. “His accumulated experience of markets” had proved no more a guide in this situation than to the day-traders selling the fractional remnants of their Lucent investment (which had sunk from $77½ to $13½). On January 2, 2001, the Nasdaq Composite, more or less an index of technology stocks, fell 178 points – a loss of 7.2% in one day. Of the January 3 decision, Fred Hickey wrote in The High-Tech Strategist: “The only surprise was the magnitude of the rise – 14.2% on the Nasdaq Composite index – the biggest one-day gain in percentage and points [+325] in history.”
Memories blur and no doubt Lindsay’s essay fastened Greenspan’s stainless reputation in readers’ minds. Whether Lindsay’s memory had blurred is a different question. He was too modest. Lindsay was well aware of the stock market mania well before 2001.
Greenspan had lodged his name in Bartlett’s on December 5, 1996: “…[H]ow do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have been in Japan over the past decade?” “Irrational exuberance” is the phrase that has haunted Greenspan for the past nine years. He took a pasting from all corners: How dare he suggest that stocks might not be the favored asset for all Americans? His suggestion was timely; though he learned his lesson. He never dared suggest such a possibility again. For perspective, he issued his warning when the Nasdaq average closed at 1,300. He would keep his mouth shut even as the Index soared to 5,048 in March of 2000.
The Federal Reserve Open Market Committee (the FOMC – composed of the seven governors of the Federal Reserve Board and five of the 12 Federal Reserve bank presidents), met on December 17, 1996. Protocol at such meetings calls for members to express their current assessment of the economy. Lindsay opened his comments by thanking Mr. Greenspan for his best efforts in the celebrated speech. He then predicted, “1997 is going to be a good year for irrational exuberance.” Lindsay cited “irrational exuberance” in the bond market, in the bank credit market, and a false sense of laxity concerning inflation. His repartee calls into question whether Greenspan’s instinct, experience and reason were as advanced as Lindsay’s.
Lindsay’s 2004 Wall Street Journal profile goes on to describe Greenspan’s finer characteristics: “This skill at making intellectual insights relative to real-time decision-making is important not just in the making of policy, but in explaining it. … Mr.Greenspan’s prior experience in both markets and policy making gave him this credibility.” Mr. Greenspan’s credibility is not in doubt. Nobody else in Washington could hold a candle to his incandescent halo. But the reasons must be found outside the criteria Mr. Lindsay applies.
A review of his February 13, 2001, appearance before Congress is a feeble testament to the maestro’s “experience as a trader” and “his accumulated knowledge of market signals.” Greenspan was quite optimistic about business prospects. The linchpin of his thrust was “the projections of equity analysts, who, one must presume, obtain their insights from corporate managers.” He cited the “three- to five-year average earnings projections of more than a thousand analysts” as reason to forecast “sustained elevated growth….” By 2001, the average investor knew better than to presume analysts’ forecasts were of much use three months ahead, and, as to where they got their information, probably from the investment banking faction of their own brokerage firm.
Greenspan warbled on about “productivity-enhancing capital equipment” that, he admitted, businesses now held “in surplus”. This did not deter his optimistic Congressional address. Even so, he nailed the extent of the overinvestment in another part of the same speech: “Overall, capacity in high-tech manufacturing industries rose nearly 50% last year.” An industry that had been booming for a decade and then accelerates its capabilities by 50% in one year is an easily identified candidate for a short sale. His flaccid analysis was set straight by the chairman of Intel Corporation, Andy Grove: “I think people loaded up with not just physical inventory but got ahead of themselves in capacity building and network capacity building. We built in an overcapacity of all physical things.”
The economy and markets continued to deteriorate at as ferocious pace, despite several more fed funds rate cuts. What happened next was the route of all money when profitable capital formation is scarce: it speculated. Speculations chase the rising asset class. The rising asset was house prices and that is where the overissuance of credit found a home. Paul McCulley, bond manager at PIMCO, the largest U.S. bond mutual fund family, wrote to his clients in July, 2001: “There is room for the Fed to create a bubble in housing prices, if necessary, to sustain American hedonism. And I think the Fed will do so, even though political correctness would demand that Mr. Greenspan would deny any such thing.”
The next Federal Reserve chairman has been named but you never know. Forthwith is a recommended standby, should Mr. Bernanke lose his way. Before the search, a former Bush administration figure acknowledged the White House “is very concerned that whoever they get not only has understanding of monetary policy, but experience working with financial markets and the ability to use business and market contacts to get ahead of the statistical economic data.” You have got the bridge watch, McCulley. Mr. Greenspan – time for a coffee break.Link here.
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