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THE INTEGRITY PREMIUM
What would the S&P 500 be trading at if we had complete confidence in corporations’ audited numbers? A lot higher than 1,300. Post-Enron, post-WorldCom, a pall of uncertainty envelops financial statements. There is what you might call the murkiness discount. You expect this kind of haircut in Shanghai or Rio, but we have it, too, right here in America. That is not bad enough by itself to trigger a bear market. But this makes the stock market worth less than it otherwise would be.
The quality of corporate audits has imploded as the government has fostered a collusive auditing oligopoly that is now fully global. There is simply no real competition among auditors anymore. With very few exceptions the auditor of almost any public corporation cannot be fired and replaced. Scott Paper just switched auditors but had a heck of a time. It is virtually impossible. As in any other field, an absence of competition begets a deterioration in quality. Today’s corporate-audit quality is a joke. This despite the big fuss Congress made over restoring integrity with the Sarbanes-Oxley law.
Remember the Big Eight and a national array of smaller auditing firms competing regionally? By 2002 a merger wave had shrunk 8 to 5. Just two regionals, with a combined 1% market share, did any significant number of audits of public companies: BDO Seidman and Grant Thornton. Then the government, in its infinite wisdom, decided that since Arthur Andersen employed one or two bad auditors, the entire firm should be destroyed. Now we are down to four big CPA firms, and one of them, KPMG, is getting a lambasting from the IRS. So we sort of have the Big 3½. What does that mean? No competition.
In any other field the government would break the foursome into the Big 14. Not here. The regulator of the auditing industry, the Public Company Accounting Oversight Board, likes the clubby and confined marketplace. Because the oligopoly is not going away, you should focus on stocks that are good enough and cheap enough that you can be comfortable with them despite zero ability to believe in audited profit-and-loss and asset-and-liability accounts. Here are a few I like.Link here.
Do not raise rates. Or else. Almost those very words were recently hurled at a central banker by a politician. Creditors of the world should be afraid for their capital. Hidenao Nakagawa, policy chief of ruling Liberal Democratic Party, happens to be Japanese, but he spoke for politicians everywhere. Yes, Japan’s statesmen will say, they revere their nation’s scientifically managed and politically disinterested central bank. Still, they would revere it not one whit less if the central bank forbore from raising interest rates.
When the Bank of Japan issued a warning recently that it is preparing to tighten policy, Nakagawa let fly. “The bank has no independence when it comes to policy targets,” he said. “If it does not understand this, we need to consider amending the Bank of Japan law.” To many Japanese politicians, including the prime minister himself, the world’s second-largest economy is too feeble to bear the burden of an overnight interest rate even a little higher than the currently prevailing 0%.
Just before Thanksgiving the Federal Reserve indicated that it might be nearing the end of its own rate-raising campaign. If true, the overnight money market interest (now 4%) would come to rest substantially below the rise in the CPI for the 12 months to October (4.7%). When interest rates were falling and inflation was subsiding for most of the past quarter-century, the reputation of the world’s central bankers was inflating. No more the bungling authors of the Great Inflation of the 1970s, the likes of European Central Bank president Jean-Claude Trichet and, of course, Alan Greenspan were triumphantly rehabilitated.
Now the world over, measured inflation rates are running neck-and-neck with nominal interest rates. It is a race that interest rates are bound to lose. At the very least, no saver listening carefully to the noises emanating from governments and central banks can harbor much optimism about earning a satisfactory inflation-adjusted rate of return. This fact helps to explain the broadening reach of the bull market for gold. In recent months bullion has raced to new highs in terms of yen, euros and dollars. Even as bondholders continue to settle for pygmy-size yields, a much smaller cohort of investors is choosing to exit any and all currencies in favor of the legacy monetary asset, gold. If the majority ruled in investments, the nod would have to go to the bondholders. But not infrequently in markets it is the enlightened minority that carries away the prize.
As for me I continue to buy Krugerrands and salt them away in a safe deposit box. My hope is that, mushroom fashion, they will thrive in the dark. I am speculating, of course. Gold has no price/earnings ratio. Nevertheless, I draw comfort from the knowledge that I am speculating against those government employees called central bankers.Link here.
THE COMMING BERNANKE BUST
Federal reserve chairman Alan Greenspan leaves the job on January 31 with godlike status. His adoring fans call him the Maestro. Even the normally staid British got swept up in the Greenspan worship and gave him an honorary knighthood. Succeeding such an acclaimed figure would be tough for any mere mortal. For the next chairman, Ben S. Bernanke, it will be especially hard, since Bernanke lacks many of Greenspan’s advantages.
Greenspan is a master politician, while Bernanke has a lot to learn about surviving and thriving in the Washington jungle. Greenspan stayed on for so long because he skillfully avoided fights with Congress and the White House. His public statements are masterpieces of obfuscation; he cannot be pinned down. His ad hoc approach to monetary policy is indefinable, allowing him to foster the notion he is clairvoyant. He sagely refuses to name an inflation target, thus giving himself wide leeway when statistics jump around.
Bernanke, though certainly smart, has served only three years as a Fed governor and six months as President Bush’s chief economist. The academic politics he faced as chairman of Princeton’s economics department pales before the challenges he will encounter as Fed boss. What evidence has emerged from his brief time on the national scene is revealing. In a jarring November 2002 speech he suggested that the Fed could drop money out of helicopters to stop deflation. That comment has now created news coverage that no central banker wants. As clear as Greenspan is obscure, Bernanke wants to set an inflation target (perhaps 2%) and wrote a book on that subject. Bernanke’s earlier public statements may box him in. His vociferous concerns over deflation and worries about a jobless recovery may force him into excessive hawkishness on inflation. In October he said that “a moderate cooling in the housing market” would not preclude economic growth in 2006. That statement will haunt him once housing crashes.
Greenspan, blessed with plain old good luck, reigned while inflation was unwinding, so he spent most of his time lowering rates. Easy money makes people happy. His strategy has been not to prick bubbles but to wait until they break, then clean up the mess. The cruel irony is that Greenspan deserves a lot of the blame for the impending housing debacle, yet Bernanke will take the heat. The bursting of the housing bubble that is now beginning will bring a painful U.S. recession. Like King Louis XV, Greenspan’s attitude may well be: Après moi, le déluge.
Coming after earlier stock losses, house depreciation will leave consumers with no piggy bank with which to support their consumption habits. Their 25-year borrowing-and-spending binge will be replaced by a saving spree. The big losers will be foreign lands that depend on American consumers to buy their surplus goods and services. This scenario is beginning to unfold just as U.S. investors are stampeding to foreign stock markets, chasing the rallies that overseas bourses have lately been relishing. But investors are probably catching foreign stock cabooses, not locomotives. The dollar, which I think will keep climbing (with help from Fed rate increases), is eroding overseas stock gains. Best advice: Unload your foreign equities now on all those bullish latecomers. Start first with the export-led Asia tigers, especially China. They will suffer the most.Link here.
LIVE WITHIN YOUR MEANS
Cash dividends, so passé during the go-go dot-com boom, suddenly came back into favor with the May 2003 tax cut. Now, at 15%, the federal tax rate on dividends (from most corporations) is the same as the rate on long-term capital gains. And so there has been an explosion in dividend hikes (22% more in 2004 than in 2002) and one-time dividends (68% more). What is not to like? Companies that can scarcely afford the cash payouts they are making.
Richard Bernstein, chief U.S. portfolio strategist at Merrill Lynch, is a fan of dividend-paying companies. But Bernstein warns that some companies are dishing out more cash than is prudent. Your risk here is not just that your quarterly payout will be cut but also that you will suffer a sharp capital loss when the market reacts to that cut. Taking a cue from Bernstein’s methods, we screened large companies for those with payouts that exceed earnings or free cash or both. The flip side: companies with meager yields but plenty of room to boost their payouts.Link here.
THE GIFT OF ECONOMICS
I was first turned on to economics in 1962 by an enthusiastic teacher who made the subject exciting, Ernest Buchholz at Santa Monica College. I quickly began reading everything I could get my hands on, just so that I could argue with him. We stopped arguing a long time ago (we are friends), but I kept on reading anyway. Today, economics is as much a hobby for me as it is a job. If you enjoy mysteries and puzzles, you should love economics. And if you hate math, that is no problem. (A list of recommended books follows.)Link here.
FOREIGN BUYING OF U.S. ASSETS CONTINUES IN Q3
The latest batch of scary investment numbers regarding our friends abroad has arrived! Per the latest flow-of-funds data, released yesterday by the Federal Reserve, U.S. financial assets held by foreign investors registered a sizable increase of $212 billion during this year’s third quarter. As of 9/30, total holdings were reported at an enormous $10.681 trillion. Also as of 9/30, net foreign financial claims against the U.S. stood at $5.473 trillion, a very, very sizable jump of almost $637 billion during the September quarter, and an increase of a remarkable $1.25 trillion from a year earlier. It was roughly a mere 20 years ago that the U.S. was still a net creditor nation!Link here.
BUBBLE, BUBBLE – THEN TROUBLE
Is the chill in once-red-hot Loudoun County, Virginia a portent of what is ahead?
Psssssfffffft. That is the sound of the air finally leaking from the real estate bubble in Loudoun County, Virginia. Since 2000 it has been the nation’s fastest-growing county, where eager homebuyers always seemed to outnumber happy sellers. Until now.
Bob Semmens, a 60-year-old retired pressman, has heard that sound. After he offered up his 3,000-square-foot colonial, with three acres and a swimming pool, in early July for $759,000, he sat back to wait for the frenzied offers. A year before, houses had remained on the market for just 20 days and were snapped up in bidding wars. But “very few people were even coming out to look,” Semmens recalls. After four months, he was about to take the house off the market until next spring. But then he struck a deal – for $620,000, an 18% price cut. Semmens rues his bad timing: “Just at the time I was getting the house on the market, everything really started to slow down.”
By October, agents had 2,908 existing Loudoun houses on the market, an increase of 127% over a year earlier. The average time on the market had climbed 62%, to 42 days, since the fall of 2004. And in just two months, from August to October, the median sales price for houses dropped from $506,100 to $480,000. Anxious homeowners swap stories about a market rapidly going soft. What is happening in Loudoun is a rapid shift in psychology – a classic sign of a market turn. The buoyant optimism that fueled speculation and expectations of ever-rising prices is now succumbing to the fear of being left standing when the music stops. Real estate, the hottest play of the century in Loudoun, is rapidly cooling.
The same signs of a slowing market can be seen in hot spots across the country, from Boston and Miami to Phoenix, Las Vegas, and San Diego. Many other overheated areas could suffer even larger price drops than Loudoun County. Some, like Boston, lack the rapid growth in jobs to support rising prices. In Phoenix, high prices and cheap land have sparked a construction boom that is beginning to deflate the bubble. Other areas, such as Las Vegas and Florida cities like Miami, have seen rampant speculation. Such buying not only drives demand but “feeds the expectations of households that are not speculating,” says David Stiff, chief economist of Fiserv CSW, a housing data company. “If a significant portion of demand is speculative, that can evaporate very quickly.”
Speculation is swinging the market in Loudoun as well. Underlying demand is strong, with families flocking in for jobs and well-regarded schools. But the recent froth was churned up by investors convinced that housing supply cannot keep up with demand. Easy financing fueled the buying boom: County officials say up to 40% of new mortgages this year were interest-only loans, with low payments enabling borrowers to finance higher bids. That Loudoun could continue to balloon through the 2001 stock collapse, September 11, and 12 Fed rate hikes is a testament to its resilience. Located in the shadow of the Blue Ridge Mountains some 50 miles from Washington, Loudoun has accommodated tract houses and mansions alike without turning into a crowded suburban grid. Now, the stock of houses on the market is at a 4-year high.
Loudoun’s real estate community insists the market is merely reverting to a more normal state. There is another explanation, says insurance agent Joe Kelly over lunch downtown at the Leesburg Restaurant. “They ran out of stupid people.”Link here.
ARMs start hurting as rates rise.
Mortgage lenders are preparing for another wave of refinancings. But this time it will not be virtually every homeowner responding to lower interest rates, but holders of adjustable-rate mortgages responding to higher interest rates. Dallas-area mortgage broker Gary Akright has sent letters to his clients who have adjustable-rate mortgages, encouraging them to consider refinancing to lock in with a fixed-rate mortgage before what are still historically low rates go any higher.
Many homeowners who took out ARMs in the last few years are just now seeing their payments start to rise, as interest rates go up and their loans’ fixed-rate periods end. But there have been few takers so far. “They typically had a game plan in mind,” Mr. Akright says. “A lot of them are still hesitating. Until they really see it starting to move up significantly, it’s very difficult for them psychologically to move away from that.” Many adjustable-rate mortgages are fixed for a certain period, such as five or seven years, and then adjust every year thereafter. The gamble you have taken by taking out one of those mortgages is that you would be in your home just long enough to take full advantage of the fixed-rate period. “They figured they would be moving, downsizing or able to pay it off,” Mr. Akright says.Link here.
“I tell you,” began a Florida real estate developer, who was visiting us in Baltimore, “the problem in real estate is going to be worse than people imagine. I’m involved in dozens of different projects. What we’re seeing is a lot more speculation. Normally, we count on selling about 15% of our new units to investors. But now, we’re selling 60% to 70%. As builders and developers that poses no problem … at least not for right now. But everywhere I look in the real estate area in South Florida … I see fuses, and they’re lit.
“First, you have all this extra production being bought up by speculators. It’s a lit fuse, and it’s going to blow up because in a few months these units are going to be completed, and the speculators aren’t going to move in. They are hoping to flip them, but who are they going to flip them to? It’s a fuse, and I figure it’s only got a couple of more months left on it.
“Second, there are all these people who have bought more house than they could afford. A few years ago they were living in a $200,000 house, but they figure they want in on the boom … so they buy a $500,000. Why do they do that? Because that way they get more leverage, while they get to live in a better house. If the house goes up 20% in a year – which is what they’ve been doing – the guy makes $100,000 per year on his house, which is probably more than he makes from his job. Who can say no to that? But it’s a lit fuse, because it costs a whole lot more to maintain a $500,000 house than it does to maintain a house that only costs $200,000. You have to pay more insurance, higher taxes. If it’s in a development, you have to pay a fee to the community, or a condo fee. And, of course, you have to heat and cool the place, not to mention regular maintenance. It all adds up, and for many people, those bills are just coming in.
“It’s like other things, at first the whole thing is a dream. You’re living in a bigger, nicer house. You’re feeling very successful. So, you gradually expand your lifestyle to suit the bigger house. You can’t help it. Gradually, you get in trouble not only from the direct costs of having a larger house, but the indirect costs, too. I mean if you’re living in a fancy house in a fancy community, you have to have a fancy car parked in front of it. That’s just the way people are, but it’s a lit fuse, and it’s going to blow up on a lot of people.
“And third, the lenders are getting squeezed by both the regulators and by higher interest rates. They’ve got to pass the squeeze along to the borrowers. They don’t have any choice. So, gradually, a lot of people with interest-only mortgages, for example, are going to find that they’ve got to start paying principle as well as interest, and they’re going to have to make higher payments. New buyers are going to find it’s not so easy to finance 100% of a new house. People are going to get hurt because they aren’t going to be able to keep up with the expenses and the higher financing costs. They’re not going to be able to find a new buyer to bail them out. What I see is another lit fuse there. It’s burning now, but it’s got to blow up sooner or later.”Link here.
JUNK-BOND CALENDAR IS BULGING
Ahead of the traditional holiday slowdown, about $7.7 billion in new high-yield deals is being priced over a one-week span, according to The Wall Street Journal. The Journal cited a number of reasons for the bulging calendar, including relatively strong market conditions, increased investor appetite, and jockeying among investment banks to be on the top of the league tables for underwriters. And earlier this week, Standard & Poor’s reported that the global default rate for corporate speculative-grade bonds fell to an 8-year low of 1.40% at the end of November. A big chunk of the $7.7 billion will be a $2.8 billion bond issue that is part of the financing for the leveraged buyout of Hertz Corp. from Ford Motor.Link here.
NEWLY BANKRUPT RAKING IN PILES OF CREDIT OFFERS
As one of more than two million Americans who rushed to a courthouse this year to file for bankruptcy before a tough new law took effect, Laura Fogle is glad for her chance at a fresh start. A nurse and single mother of two, she blames her use of credit cards after cancer surgery for falling into deep debt. Ms. Fogle is broke, and may not seem to be the kind of person to whom banks would want to offer credit cards. But she said she had no sooner filed for bankruptcy, and sworn off plastic, than she was hit with a flurry of solicitations from major banks. “Every day, I get at least two or three new credit card offers … they want to give me a credit card, at pretty high interest rates,” said Ms. Fogle, who is 41 and lives here.
If it seems odd to Ms. Fogle that banks would want to lend money to the newly bankrupt, it is no mystery to the financial community, which charges some of the highest interest rates to these newly available customers. Under the new law, which the banking industry spent more than $100 million lobbying for, they may be even more attractive because it makes it harder for them to escape new credit card debt and extends to eight years from six the time before which they could liquidate their debts through bankruptcy again. “The theory is that people who have just declared bankruptcy are a good credit risk because their old debts are clean and now they won’t be able to get a new discharge for eight years,” said John D. Penn, president of the American Bankruptcy Institute, a nonprofit clearinghouse for information on the subject.
Credit card companies have long solicited bankrupt people, on a calculated risk that income from the higher interest rates and late fees paid by those who are trying to get their credit back will outweigh the losses from those who fail to make payments altogether. The companies also directed many of those customers toward so-called secured cards, which require a cash deposit. But the new law makes for an even better gamble for lenders, consumer groups say. It not only makes bankrupt debtors wait eight years to clear their debts again, but it also requires many of those who do go back into bankruptcy to pay previous credit card bills that may have been excused under the old law. Bankers defend the practice of soliciting the newly bankrupt, saying it gives them a chance to build a new credit history.Link here.
THE NEXT RETIREMENT TIME BOMB
Since 1983, the city of Duluth, Minnesota, has been promising free lifetime health care to all of its retired workers, their spouses and their children up to age 26. No one really knew how much it would cost. Three years ago, the city decided to find out. It took an actuary about three months to identify all the past and current city workers who qualified for the benefits. She tallied their data by age, sex, previous insurance claims and other factors. Then she estimated how much it would cost to provide free lifetime care to such a group. The total came to about $178 million, or more than double the city’s operating budget. And the bill was growing. Mayor Herb Bergson was direct. “We can’t pay for it,” he said in a recent interview. “The city isn’t going to function because it’s just going to be in the health care business.”
Duluth’s doleful discovery is about to be repeated across the country. Thousands of government bodies, including states, cities, towns, school districts and water authorities, are in for the same kind of shock in the next year or so. For years, governments have been promising generous medical benefits to millions of schoolteachers, firefighters and other employees when they retire, yet experts say that virtually none of these governments have kept track of the mounting price tag. The usual practice is to budget for health care a year at a time, and to leave the rest for the future.
Off the government balance sheets – out of sight and out of mind – those obligations have been ballooning as health care costs have spiraled and as the baby-boom generation has approached retirement. And now the accounting rulemaker for the public sector, the Governmental Accounting Standards Board, says it is time for every government to do what Duluth has done: to come to grips with the total value of its promises, and to report it to their taxpayers and bondholders.
The board has issued a new accounting rule that will take effect in less than two years. It has not yet drawn much attention outside specialists’ circles, but it threatens to propel radical cutbacks for government retirees and to open the way for powerful economic and social repercussions. Some experts are warning of tax increases, or of an eventual decline in the quality of public services. States, cities and agencies that do not move quickly enough may see their credit ratings fall. In the worst instances, a city might even be forced into bankruptcy if it could not deliver on its promises to retirees.Link here.
THE GLOBAL CAPEX ARBITRAGE
Capex is the rage. As I meet with investors around the world, they are virtually unanimous in their conviction that a sustained upsurge in global capital spending is at hand. It was a clear bet at our Lyford Cay roundtable this year. The capex play also is one of the three themes that drive stock selection in our own focus List. And our strategists tell me that most equity markets are now paying up for the big spenders – companies willing to expand the organic way. Rare is a consensus bet so powerful. Could it be wrong?
For starters, the analytics of the capex call are dated. Most still believe that a rise in domestic cash flows and operating rates is sufficient to spark an expansion in domestic productive capacity. This misses one of the critical implications of globalization – that closed-economy models must now be opened up to the cross-border arbitrage of both labor and capital. Given the rapid expansion of global trade in goods and in once nontradable services, it is critical to view investment in plant and equipment as a globally fungible decision. GM is closing plants in the U.S. and expanding facilities in China for a reason: The efficiency solutions of global competition push production platforms into low-cost economies. Today’s open-economy models of globalization treat the capex decision very differently than the closed-economy models of yesteryear.
As a result, in assessing the capex call, it is important to look at business capital spending in a global context. Accordingly, we have developed a proxy for global capex by focusing on investment trends in the G-5 countries (the U.S., Europe, Japan, Canada, and the U.K.) plus China. While this measure offers only partial coverage of investment in the global economy, it includes countries that currently account for 61% of world GDP as measured by the IMF’s purchasing-power parity metrics. On this basis, there can be no mistaking the sharp recent cyclical upsurge in global capex. Our global capex proxy, as expressed in the form of an investment-to-GDP ratio, surged to an estimated 15.4% of world GDP in 2005 – a sharp increase from the cycle low of 13.7% established in 2002 and a ratio that now surpasses the prior peak of 14.9% hit at the end of the bubble in 2000. For that reason alone, there is good reason to worry about a global capex cycle that may already be going to excess – a replay of the classic boom-bust patterns of past business cycles.
Moreover, there is another worrisome aspect of this sharp recent upturn in the global capex cycle. On the supply side, emphasis on capex is increasingly widespread, while on the demand side, the world remains overly dependent on the American consumer. That points to the growing risk of a potential imbalance between aggregate supply and demand. With our global capex proxy now exceeding the bubble-induced investment share of 2000, that risk cannot be taken lightly. That stock markets, which normally punish the heavy capex spenders as being reckless on cost control, are now rewarding capital spenders is another classic sign of a cycle having gone to excess. Historically, the capex play has had a fleeting existence in financial markets. Is there a compelling reason to believe it is different this time?
Alas, each cycle is different, and there may well be a very important twist to the current capex cycle that distinguishes it from those of the past. The increasingly high IT content of business capital spending – accounting for more than 50% of total spending on capital equipment in leading countries like the U.S., Japan, and Germany – shortens the shelf-life of productive capacity. That underscores the possibility of a far more dominant role for replacement spending in driving gross investment. As such, it may well be that the shift to relatively short-lived IT-enabled capacity requires a higher gross investment ratio than old-fashioned bricks and mortar capacity. Data from the U.S. tend to support that conclusion. While overall, or gross, investment in plant, equipment, and software has rebounded smartly in the past few years to a level that may now be exceeding the bubble-induced highs of 2000, virtually all of the increase has occurred in the replacement component of such spending.
As I put the pieces of this puzzle together, I am struck by a serious need to reassess the traditional character of the capex cycle. The bottom line is that globalization casts the business capital spending decision in an entirely different context. As both labor and capital shift to low-cost platforms in the developing world, the resulting “hollowing out” of the same factor inputs in the developed world all but rules out the old-fashioned burst of greenfield expansion that has been key in shaping capex cycles of the past. As such, barring the development of a new technology or the emergence of a new industry, capex cycles in high-cost developed economies will be increasingly dominated by the replacement of old capacity than by the expansion of new capacity.
The global capex arbitrage is a new and important feature of globalization. It warns us not to count on the old closed-economy models to keep pushing capital spending cycles to the upside. China’s dramatic ascendancy to a near-leadership position in the global capex sweepstakes underscores this development. In the cross-border arbitrage of globalization, capacity expansion is shifting from high-cost platforms in the developed world to low-cost platforms in the developing world. Investors need to discriminate between these two models and also recognize the IT bias of replacement-dominated investment cycles in developed economies. But unless the global demand base broadens quickly, a sustained resurgence of business capital spending could spell trouble for the global business cycle. Needless to say, that would come as a major disappointment to legions of investors who have rushed to the other side of the boat on the global capex call. And it would not be the first time.Link here.
RICHARD RAINWATER’S PROPHECY OF DOOM
Richard Rainwater does not want to sound like a kook. But he is about as worried as a happily married guy with more than $2 billion and a home in Pebble Beach can get. Americans are “in the kind of trouble people shouldn’t find themselves in,” he says. He is just wary about being the one to sound the alarm.
Rainwater is something of a behind-the-scenes type. He counts President Bush as a personal friend but dislikes politics, and frankly, when he gets worked up, he says some pretty far-out things that could easily be taken out of context. Such as: An economic tsunami is about to hit the global economy as the world runs out of oil. Or a coalition of communist and Islamic states may decide to stop selling their precious crude to Americans any day now. Or food shortages may soon hit the U.S. Or he read on a blog last night that there is this one gargantuan chunk of ice sitting on a precipice in Antarctica that, if it falls off, will raise sea levels worldwide by two feet – and it is getting closer to the edge. … And then he will interrupt himself: “Look, I’m not predicting anything. That’s when you get a little kooky-sounding.”
Rainwater is no crackpot. But you do not get to be a multibillionaire investor – one who has more than doubled his net worth in a decade – through incremental gains on little stock trades. You have to push way past conventional thinking, test the boundaries of chaos, see events in a bigger context. You have to look at all the scenarios, from “A to friggin’ Z,” as he says, and not be afraid to focus on Z. Only when you have vacuumed up as much information as possible and you know the world is at a major inflection point do you put a hell of a lot of money behind your conviction.
Such insights have allowed Rainwater to turn moments of cataclysm into gigantic paydays before. In the mid-1990s he saw panic selling in Houston real estate and bought some 15 million square feet. Now the properties are selling for three times his purchase price. In the late 1990s, when oil seemed plentiful and its price had fallen to the low teens, he bet hundreds of millions – by investing in oil stocks and futures – that it would rise. A billion dollars later, that move is still paying off. “Most people invest and then sit around worrying what the next blowup will be,” he says. “I do the opposite. I wait for the blowup, then invest.”
The next blowup, however, looms so large that it scares and confuses him. For the past few months he has been holed up in hard-core research mode – reading books, academic studies, and, yes, blogs. Every morning he rises before dawn and spends four or five hours reading sites like LifeAftertheOilCrash.net or DieOff.org, obsessively following links and sifting through data. How worried is he? He has some $500 million of his $2.5 billion fortune in cash, more than ever before. “I’m long oil and I’m liquid,” he says. “I’ve put myself in a position that if the end of the world came tomorrow I’d kind of be prepared.”
His instincts tell him that another enormous moneymaking opportunity is about to present itself, what he calls a “slow pitch down the middle.” But, at 61, wealthier and happier than ever before, Rainwater finds himself reacting differently this time. He is focused more on staying rich than on getting richer. But there is something else too: a sort of billionaire-style civic duty he feels to get a conversation started. As industry analysts debate whether the world’s oil production is destined to decline, the prospect makes him itchy.
“This is a nonrecurring event,” he says, “… now there’s the opportunity to do something based on a shortage of natural resources. Can you make money? Well, yeah. One way is to just stay long domestic oil. But there may be something more important than making money. This is the first scenario I’ve seen where I question the survivability of mankind. I don’t want the world to wake up one day and say, ‘How come some doofus billionaire in Texas made all this money by being aware of this, and why didn’t someone tell us?’”Link here.
Super spike, Phase Two
Crude prices may have doubled in the last year, but Goldman Sachs believes oil’s rally is just starting to pick up steam, arguing that oil prices are in a “super spike” phase that could last another four years. “We disagree with what appears to be a growing consensus that crude oil prices reached their peak levels earlier in 2005,” Goldman analyst Arjun Murti wrote. “We think oil equities can perform well through much of the current ‘super spike’ phase, and that meaningful share price upside remains.” With crude prices on track to average around $57 a barrel in 2005, Goldman Global Investment Research analysts predicted that the past year could be remembered as just the first of a 4-to-5 year phase of soaring oil prices.
Goldman predicted that oil equities will continue to perform well during the “super spike” phase and “meaningful share price upside remains.” Energy equities are currently trading only 10% above their traditional mid-cycle valuations, Goldman said. It forecasts a 20% total return upside to traditional peak and 60% upside to super-spike-adjusted peak valuations. The brokerage’s top picks include Murphy Oil Corp, Canadian Natural Resources Ltd., and Suncor Energy Inc. among companies leveraged to oil; XTO Energy, Newfield Exploration, EnCana Corp., Southwestern Energy, and Bill Barrett Corp., among companies leveraged to U.S. natural gas prices; Valero Energy Corp. for refining, and Exxon Mobil among large integrated oil firms.Link here.
COMPANIES SLOW TO EXPENSE OPTIONS
Fully 65% of public companies have not begun to comply with Statement 123R, the Financial Accounting Standards Board’s revised rule on stock-option expensing, according to a survey of 386 companies by Thomson Financial. Most public companies are required to expense options for fiscal years beginning after June 15, 2005; companies that operate on a calendar basis must begin expensing options by the March 31, 2006, quarter.
Many seem to be waiting as long as possible: 86% of surveyed health-care companies, and 76% of technology companies, have not begun expensing stock options. “Health-care and technology firms have traditionally been the biggest issuers of employee stock options and would therefore experience the biggest hits to their bottom lines once options are expensed,” noted Thomson. One interesting note: For all the hubbub, the Thomson report found that 67% of companies have not seen or do not expect to see a negative impact on their stock price as a result of expensing options.Link here.
INVESTORS DISCARDING JUNK BONDS
Hertz, the world’s largest rental-car company, is paying the price for being among the last leveraged buyouts financed in the junk bond market this year. Hertz, a unit of Ford, is offering to pay at least 1.2 percentage points more in yield, compared with similarly rated debt, to sell $2.8 billion of high-yield, high-risk bonds. A group led by Clayton Dubilier & Rice is buying Hertz for $15 billion in the largest American leveraged buyout since the $31 billion takeover of RJR Nabisco in 1989.
The bankruptcies of the auto supplier Delphi, Northwest Airlines, Delta Air Lines and the broker Refco since September have led to a bear market in junk bond sales, reminding investors that 60% of the riskiest high-yield debt typically defaults within five years. A record $50 billion of these securities has been sold since 2003. “We saw a pretty meaningful push-back by high-yield buyers,” said Paul Scanlon, managing director for U.S. high-yield instruments at Putnam Investments in Boston, which reduced the junk bonds in its $65 billion of fixed-income assets over the past year.
Sales of junk bonds, or debt rated below BBB- at Standard & Poor’s or Baa3 at Moody’s, dropped in 2005 for the first time since 2002. Issuance fell to $91 billion from a record $136 billion last year. The global high-yield default rate could rise to 3.5% next year and reach 7% by 2009, from a 9-year low of 1.9% at the end of October, according to a Lehman Brothers report.Link here.
GOLD CROSSES THE RHINE
When Allied soldiers charged the beaches of Normandy on June 6, 1944, victory seemed very uncertain and, at best, very distant. Nine months later, the Allies crossed the Rhine into Germany. Gold’s recent charge through $500 an ounce will lead to a similarly decisive and shocking victory in the monetary realm. Last summer, I suggested that the crude oil/gold was establishing an important low. So far, so good. With gold’s move to $533 an ounce, the ratio has jumped sharply since summertime. So let us revisit this ratio and consider what it might imply for oil, gold, and gold stocks.
In late August I observed: “The age of peak oil has arrived, but its investment and economic consequences are just beginning to filter down to the consumer level. Individual standards of living will be affected as permanently higher energy costs make their way into your daily life … Oil’s move up to $65 and above signals a bottom in the crude oil/gold ratio. … the ratio indicates … coming gold strength. This will happen even as oil prices climb higher.”
The oil/ratio bottomed last summer at 6.17, meaning it took 6.17 barrels of oil to buy an ounce of gold. Today – with oil at $59.94 and gold at $538 – the ratio is at 8.9 and climbing. The good news is, the ratio could double from here and still have plenty of room to grow (see chart). If the ratio continues to rise, to say, 12, while the oil price remains around $60, you would get a gold price of $720 an ounce. The all-time high for the ratio occurred back in 1988, at 33. If the ratio soared that high again, while the oil price stayed near $60, you would have gold at around $1,980 per ounce, which sounds about right to me. I do not expect that to happen tomorrow, however.
Gold will visit $2,000 an ounce sometime over the next few years, but not while oil languishes at $60 a barrel. The ratio skyrocketed in 1988 because the world was awash in cheap oil, while gold rallied. The ratio was high not because gold was “back” but because oil was historically cheap. Today, the situation is entirely different. The age of cheap oil is over. And it is ending at exactly the same time that gold is emerging from its two-decade long slumber. We are headed to a place where the oil/gold ratio does not make a new high, but where gold and oil both make new highs in absolute and inflation-adjusted terms. We are headed to a place where gold hits $2,000 an ounce and oil hits $100 a barrel, in the process sending the oil/gold ratio to around 20.
“Nonsense!” you say. “The top is in!” Maybe, but gold’s recent spurt above $500 closely resembles oil’s “breakout” above $40 in the middle of last year. At that time, most investors believed oil to be putting in a major top. OPEC, Wall Street and the major oil companies all considered $30 to be the “normal” price of oil. Few imagined a world where $60 would become the new “normal” price of oil. Likewise, most investors seem to consider gold’s latest rally a “fake-out breakout”, rather than the beginnings of an enduring gold rally.
Gold, from both a technical and psychological perspective, has been engaged in a war of attrition against public opinion and the belief in the dollar. The move about $500 is like the Normandy invasion. And above $525, the July 1944 break of German lines in Operation Cobra. This advance turned the war from a creeping reenactment of World War I into a war of movement again, the way it had begun with the German blitzkrieg of France. Only this time it was American and British tanks moving east, not German tanks moving west. It is worth nothing that the Allied drive to the Rhine stalled in the Ardennes forest in December of 1944. In fact, on December 16th, 1944, the 101st Airborne Division was surrounded at Bastogne during a surprise German winter offensive.
Eventually, of course, the Allies broke out at Bastogne and on March 7th of 1945, crossed the Ludendorf railway bridge at Remagen, across the Rhine and into Germany. Of the 22 road bridges and 25 rail bridges across the Rhine, the bridge at Remagen, taken by the 9th Armored Division, was the only bridge the Germans had not destroyed, although they tried to demolish it twice. “This bridge is worth its weight in gold,” Eisenhower, is claimed to have said. Simply stated, gold has crossed the Rhine … and now begins its inevitable conquest of paper currencies and its inexorable advance toward monetary hegemony. The move gold is making now argues for bigger and stronger gains ahead in 2006.
And both moves in oil and gold make perfect fundamental AND geopolitical sense. Oil is moving on increased global demand. Planned production increases, if executed, will not be enough to bring enough supply on line to meet the growing demand of India and China. Geopolitically, oil is at the center of many national grand strategies. It is going to stay there for awhile. And the price will go higher.
Gold is rising because of the fundamental mismanagement of the dollar by Alan Greenspan. And to be fair, in the club of central bankers who destroy the purchasing power of their currency, Alan Greenspan has a lot of company. Their respective tactics and strategies might differ, but the result is the same: decreased confidence in paper money and an increased appetite for gold.Link here (scroll down to piece by Dan Denning).
Gold Stocks and Burning Matches
Gold stocks move with the price of gold, but their price swings are more emphatic. In other words, gold stocks have leverage with respect to gold. That is the broad-brush picture, and it is the starting point for thinking about gold stocks. But of course, it does not answer all the questions. For example, in an unfolding gold bull market, will you make more money with junior explorers, or with producers? Is there a predictable stage of the market where you are more likely to make the biggest returns? Given a rising gold price, is anything else needed for gold stocks to take off? In particular, since gold stocks are stocks, can they rise without a favorable tone for the stock market in general?
You are going to find good reason to love gold stocks. But I hope you will not fall in love with them. Although I am a philosophical gold bug, I am not always a gold bull. I always keep in the back of my mind that gold shares are not heirlooms; they are burning matches. And while I still think this market will see gold’s biggest run in history, when it is over these stocks will lose 90% of their value … as does any class of stocks when a mania ends. But the good news is that the mania has not even begun. For a number of reasons, mostly related to the simple passage of time, digging up hard data from earlier gold bull markets – especially for the junior explorers – was surprisingly difficult. Many old-timers from the bull market of the late 1970s are now retired or pushing up daisies; some stock indexes we would like to examine do not actually exist; and the Vancouver Stock Exchange, the birthing ground of so many junior resource companies, has undergone many evolutions. I wish I had kept my chart books from 25 years ago.
You probably already know the multitude of reasons why I believe the broader stock markets are about to meet a financial Freddy Krueger. I will not repeat myself here, other than to say that we are fast approaching the point at which the U.S. government will have to choose between crushing hocked-to-their-eyeballs American consumers by continuing to increase interest rates (a rock) in order to keep the dollar attractive to the foreigners who lend U.S. markets about $2 billion per day … or letting the dollar tank (a hard place), triggering all sorts of fiscal unpleasantness. Given that less than rosy view, let us start by testing the notion that because gold stocks are stocks, they will follow the trends of the general stock market.
Unfortunately, that idea does not hold up. Gold stocks largely march to their own drummer, sometimes in the same general direction as broader stock markets, but sometimes distinctly contrary to same. Yet it is true that the strongest moves in gold stocks have occurred when the general market, as well as gold, was moving up (1971-73, 1982-1983, 1985-1987, 1993-1996). So gold stocks can move on their own, no matter what the S&P is doing. But what moves them? Generally speaking, three forces can move gold shares significantly higher: 1) The price of bullion. In my opinion, we have at least two more years of rising gold prices – including a blow-off top – yet ahead, (2) Discovery, and (3) Promotion.
For most gold investors, the quintessential bull market was the move that took bullion to $850 in 1980. To help keep that happy ride in perspective, gold had bottomed at $104 in August of 1976. From there it rose 725%, to $850 in January of 1980, with most of the gain coming in 1979. In today’s dollars, gold would need to reach about $2,000 to match that 1980 high. Despite 1979’s strong run-up in bullion prices, trading activity on the Vancouver Stock Exchange (VSE), the world’s leading exchange for junior resource stocks, was nearly constant and at modest levels for most of the year, indicating remarkably little investor interest in gold stocks. Somewhat predictably, the big trading activity did not come until January of 1980. Following gold’s subsequent steep fall to $482 in March, trading picked up again as gold rallied to a secondary peak of $711 in September.
While it is tempting to view the trading history as another case of investors piling into an investment at the worst possible time – in this case, after gold had peaked at $850 – when you look at share prices, you will see that is not quite the case. Between December 1978 and the gold’s price peak in January 1980, gold stocks turned in stellar performances. It is noteworthy that the peak for the stocks came well after bullion had peaked, giving gold stock investors a false hope that gold would retake its previous high and go to the stars. Unfortunately, the opposite happened, and the long dark night of falling bullion prices set in. Many stocks simply dried up and blew away.
Also notable is that junior explorers often do much better than producers in a bull market, even one driven by strongly rising bullion prices. To figure out why that is, think back to the dot-com boom, when the startups and miscellaneous cats and dogs far outperformed established companies. Case in point: recall that, pre-merger, Time Warner, a going concern with tangible assets and an identifiable revenue stream, was able to command a market capitalization of “only” $83 billion … while loss-making AOL, rich mainly in blue sky, was valued at $163 billion. In the case of the former, the likely returns were predictable and clearly finite. In the case of the latter, investors paid up and paid big for the dream of untold riches, much the same as they do for junior explorers when hearts are beating fast for gold.
So far, gold shares have been relatively quiet compared to gold itself. That will change, and dramatically so, once the investment masses wake up to gold and the role it has to play in the new economic realities. The investment masses will almost certainly wait until gold prices are significantly higher before piling in. But when they do, the upside for those investors smart enough to be building a portfolio of quality junior gold explorers at this stage – meaning now – will be truly stunning. In fact, I am convinced that not only will the returns be much richer than in the 1979/1980 bull market – they will be so rich that even I will be surprised at how high the better companies go. This will be one for the books. Don’t miss it.Links here (scroll down to piece by Doug Casey) and here.
Gold psychology: beyond gravity and into deep space.
Gold has traded above $500 per ounce for the past 10 consecutive sessions, a feat this market last saw when “Raiders of the Lost Ark” was in its opening run (early 1983). And while this price action is real indeed, it is the “unreal” chatter about gold that may be more significant – for example, the speculation about how high the rally will really carry prices, including published numbers like $4,000 an ounce.
Figures like this get tossed out and spread across the Internet like a good dirty joke. What was extreme in the morning is blasé by the afternoon. Soon enough someone else says that estimate is “cautious”, and everyone in the room feels obliged to nod in agreement. The psychology breaks all gravitational pull and lurches out into deep space. Call it a lack of imagination, yet those of us still anchored to mother earth can only put it in context: Was it not barely three months ago that crude oil seemed “destined” to hit $100 a barrel, assuming we did not run out first? “Dow 36,000”, anyone?
It is not their face value alone that made these predictions memorable. It is also what happened soon after they were made. They marked a high in ways that are easy to recall, more so anyway than all the accompanying technical indicators that also identified the extreme for what it was.Link here.
Yesterday, J. Christoph Amberger strolled into our offices in Baltimore, handing out fresh copies of his newly published book, Hot Trading Secrets. “There will be a quiz,” he said in his usual clipped, Germanic tone. And tossed a copy in our direction. Like any self-respecting author would do, we opened the book straight to the index and looked for the name Addison Wiggin. Sure enough, on page 268, Christoph writes, “Markets are reflections of human emotion and as such are immune to moralistic directives of history.” Christoph is a student of markets and as such is entitled to his observations, but we had not expected to be used as an example of “moralistic directives”.
“Classic perceptions of value, and hence of bubble theories,” Mr. Amberger continues, “over the past two decades have developed a tendency to explain not how the market works, but how it ought to work. This development is not new. Recent studies, such as Famous First Bubbles by Peter M. Gerber, are uncovering that much of what we believe to know about the Dutch “Tulipmania”, for example, has been based on rather shaky assumptions that were fostered by moralist treatises whose general tenor we find in later key works such as Charles MacKay’s Extraordinary Popular Delusions and the Madness of Crowds, and even in the 2003 NYTimes bestseller Financial Reckoning Day of my dear friend Bill Bonner and fellow St. John’s alumnus Addison Wiggin.”
“Trading has its own set of risks,” Christoph maintains, “You can gain a lot, and you can lose a lot. It’s the nature of the game. Make sure you never risk more than you can afford to lose. Once you’ve covered your liabilities, shelter and basic income, set aside a fixed amount of money for trading. But most of all, don’t look at the market as a divine tool whose task it is to validate your world-views.” Money is good. And it is the end that justifies the means, you might say. Fair enough.
We like a market gain as much as the next fella. But we do not claim to be able to have a crystal ball. In fact, we have very little to go on when making investment recommendations other than an intimacy with the asset class being recommended … and history. We require our analysts to get down and dirty with the details of their areas of “expertise”. Justice Litle and Kevin Kerr, who contribute to Outstanding Investments and Resource Trader Alert respectively, are two of the best analysts in the business. Still, we are in a bull market, so the tides of the market are on our side. The trick, if there is one, is to figure out how to read the waves, and determine which way the tide is going. Make a good guess. And recognize – in the end – that we probably still do not know. Any attempt to do otherwise would be pure hubris. And deadly for all of us.
The best tool we have for understanding markets and where to place your bets is history. History has a way of “giving people what they deserve, not what they expect,” to quote my partner in crime in this Daily Reckoning project. But that does not preclude Christoph’s “Dynamic Market Theory” or nullify it in anyway. The “moralistic directive” that Christoph sees in our work reflects trends in history, not something of our own design.
You may be following along as John Mauldin artificially dissects a new book by the research firm GaveKal and our own effort Empire of Debt. Mauldin has pitted GaveKal’s approach to the markets, and their determination that “this time it really is different” against your editors contention that people may make progress with respect to technology and improvements in every day life, but with respect to markets, economics and politics the same mistakes are made over and over again. We received this e-mail from a reader while scribbling away this morning: “If history shows little or no probability of success why repeat it? Doing so impedes progress, wastes time and resources, and usually leads to crisis. Just imagine where we would be if Edison kept repeating his experiments with the same variables that failed the first time.”
Here we might paraphrase an observation the Austrian economist Friedrick Hayek made about bureaucrats and centralized economies. The economy, and by extension, the market is infinitely complex. Especially now with the globalization of financial markets, trillions of transactions happen every second. No one person can possibly have enough information at any one time to make an informed decision. And even if you did have a method for collecting all that information, by the time you acted on it … it would be obsolete, irrelevant. So what do you do? You stick to the old chestnuts like “buy low, sell high”. How do you know what is low? Well, you have little help in making that determination, except for what has happened in the past.
History also reveals that humans can be counted on to do the damnedest of things. In our “moralistic” tome Financial Reckoning Day we recount the tale of how cousin of the Duc D’Orleans committed murder on the rue Quimpacoix in the 1720 frenzy for shares in John Law’s Misssissippi Company. Yes, guilty as Christoph charged. We learned a great deal about what happened in those days from Charles MacKay’s Popular Delusions. But while doing the research for that project we also remember a penny stock scheme that made the papers involving tech stocks, the mob and a couple of unfortunate murders on the Jersey shore. La plus ca change, plus c’est la meme chose. We are always being confronted by history, hubris and the belief that this time it really is different.Link here (scroll down to piece by Addison Wiggin).
THE TRUE GREENSPAN LEGACY
Reading so many ecstatic laudations on Fed Chairman Alan Greenspan, “the greatest of all central bankers,” two other names and occurrences came to mind. The one was John Law and his tremendous wealth creation through rigorously inflating the share prices of the Mississippi Company. And the other was former Fed chief Paul Volcker and his recent article in the Washington Post titled “An Economy On Thin Ice”, wherein he expressed his desperation about the economic and financial development in the U.S. Though he never mentioned his successor’s name, it was all about him and his policies: “Under the placid surface, there are disturbing trends: huge imbalances, disequilibria, risks - call them what you will. Altogether, the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there seems to be so little willingness or capacity to do much about it …”
What, after all, are the great merits of Mr. Greenspan, according to the conventional laudations? They are, actually, seen in two different fields: first, in the striking successes of his actual policies; and second, in notable contributions to both the theory and practice of monetary policy. His policy successes seem, indeed, all too conspicuous: lower inflation rates than expected despite strong GDP growth; high gains in job growth; and low rates of unemployment. And yet only two mild recessions, of which the second one, in 2001, was so mild that it disappears when quarterly data are aggregated to a year. His extraordinary successes are generally attributed to radically new practices in monetary policy. The Financial Times ran a full-page article under the big headline “Greenspan’s Record: An Activist Unafraid to Depart From the Rule.”
It is true Maestro Greenspan disregarded any established rules in central banking. To escape the consequences of the equity bubble that he created in the late 1990s, he generated a whole variety of new bubbles that radically changed the U.S. economy’s growth pattern. What he achieved was the greatest inflation in asset prices in history, which became the economy’s new engine of growth. What about its inevitable aftermath? If Alan Greenspan jettisoned all inherited rules, he nevertheless chose one predominant rule, actually, his only rule: a strictly asymmetric policy pattern. Every central bank has two policy levers at its disposal. The big lever is changing bank reserves, the banking system’s liquidity base. The little lever consists in altering its short-term interest rate. Whenever monetary easing appeared opportune, Mr. Greenspan has acted rigorously with both levers. When it seemed to require some tightening, he always acted hesitantly and only with his little interest lever. He has never seriously tightened bank reserves.
This is most probably occurring because the continuous rampant credit expansion is increasing the banking system’s reserve requirements. Nevertheless, to keep the federal funds rate at its targeted level of 4%, the Fed has to provide the higher reserves. What this means should be clear: The Fed is anxious to avoid any true monetary tightening in the apparent hope that the “measured” rate hikes will softly do the job over time, causing less pain. Most probably, though, this implies more rate hikes and more pain – later. It was, as a matter of fact, precisely the same kind of experience that induced Volcker to abandon such strict funds rate targeting in October 1979 in favor of targeting bank reserves. It marked the fundamental divide in U.S. monetary policy from prior persistent monetary looseness and a strong inflation bias to genuine credit tightening, ushering in a secular decline in the inflation rates.
The Greenspan Fed has returned to dubious interest targeting, while explicitly restricting itself to “measured” – in other words, very slow – rate hikes. The true monetary ease shows in the continuance of the relentless credit deluge. When Alan Greenspan took over as Fed chairman in 1987, outstanding U.S. debts totaled $10.57 trillion. According to the latest available data, they stand at $37.35 trillion. This is definitely Mr. Greenspan’s most conspicuous achievement.
To escape the aftermath of the equity bubble, the Fed created the housing and bond bubbles in 2001 and the following years. It is time, we think, to ponder the aftermath of these two asset and credit bubbles. The big housing bubble and the smaller car bubble too have plainly peaked. Rising interest rates and poor income growth are relentlessly taking their toll. It should be immediately clear that the potential economic and financial aftermath of a bust of these bubbles will be many times worse than the potential aftermath of the earlier equity bubble. Spending and debt excesses have multiplied over the past four to five years to an extent that threatens the stability of the whole U.S. financial system.
Greenspan has emphasized that it is “simply not realistic” to expect the Fed to identify and safely deflate asset bubbles. The right response in his view is for all policymakers to keep markets as flexible and unregulated as possible. Flexible markets, he said, helped absorb recent shocks, such as stock-bubble collapse and the Sept. 11, 2001, terrorist attack. We are not sure what shocked us more, this senseless, arrogant remark or the complete silence on the part of American economists. Exuberance, just by itself, is unable to inflate asset price levels. The indispensable primary condition is always credit excess, and Mr. Greenspan delivered that in unprecedented profligacy. By the nature of things, loose money and credit excess lead, and exuberance follows.
America’s reported economic recovery since 2001 has been its weakest by far in the whole postwar period. For the working population, there never was a recovery. They speak euphemistically of a shortfall of employment and income growth. It is better described as a fiasco for both. “Super-liquid markets” has become the common bullish catchphrase. It should be realized, however, that the existing liquidity deluge in the U.S. and some other countries has its sole source in the monstrous asset bubbles providing the collateral for virtually limitless borrowing. It needs a sharp distinction between earned liquidity from saving and borrowed liquidity accrued from asset bubbles. The latter kind of liquidity can vanish overnight. The sharp surge in inflation rates is forcing the Fed to continual rate hikes. Doing so, it takes enormous risks with the existing bubbles. Bluntly put, it has lost control.Link here (scroll down to piece by Dr. Kurt Richebächer).
Time bombs may await Bernanke.
Will “Gentle” Ben Bernanke take over the Fed reins without turmoil, or are there time bombs ready to put the new chairman to the test? Bernanke will only be the sixth new chairman in the Fed’s history. Clearly, the building of double-digit inflation began with William McChesney Martin, Arthur Burns and William Miller, and was tamed by Volcker (1979-87), who took the federal funds rate above 18%. Greenspan successfully navigated the economy in the wake of the 1987 stock market crash, but I believe he took the funds rate too high in 2000, then way too low in 2003, providing the fuel for speculative bubbles that could haunt Bernanke in his first year as chairman. The bubbles I refer to include home prices, energy costs, the twin deficits (budget and trade), and now the explosion in the price of gold, which is at levels that could portend poor stock-market performance.
Bernanke is facing the fact that there are just too many dollars around the world, and the savings rate in the U.S. peaked around 12% in the Volcker years and is now in negative territory. Be careful what you wish for. Conventional wisdom calls for stocks to rally once the FOMC stops raising rates. What if the rise in stocks since June 2004 is already built into this assumption? Recent record highs for the Dow utilities and transports and the Russell 2000 may be due to buying in anticipation that the FOMC will stop raising rates, with plans to sell on the event. A key, of course, is the wording as to why the Fed will stop raising rates. There is no signal for that yet.Link here.
THE MONEY 50
The trick to successful fund investing is to focus less on performance and more on the things you really can control.
That means keeping your costs down, dealing only with money managers who have a record of putting their shareholders first, and making sure you have a well-diversified portfolio suited to the level of risk you can live with. That is the thinking behind the new MONEY 50, Money magazine’s elite list of recommended mutual funds. Only funds with low expenses and a consistent investment approach, plus a history of integrity on the part of management, made the cut.Link here.
WHO WANTS HEALTH INSURANCE?
Policy pundits are unhappy with the state of health insurance. What is the problem? After considering some alternative theories, I believe that the best explanation is simply that most people do not want health insurance. The cost of health insurance has been rising, leading to well-publicized problems in the employer-provided health insurance system and increasing numbers of uninsured. But blaming insurance companies for that is like saying that the calories in a double-fudge chocolate cake are all in the icing. The cake of health care expenses consists of health care services – doctor visits, surgeries, and all the rest. The icing consists of health insurance – administrative costs, profits and all that. In dollar terms, the icing represents less than 10% of the iced cake.
I am willing to claim that no insurance market in history ever arose because of spontaneous demand on the part of consumers. As with maritime, homeowners’, and auto collision insurance, what we call health insurance arose to meet the needs of creditors. In this case, the creditors were doctors and hospitals, who wanted assurance that they would be paid for service. Comprehensive, first-dollar health coverage, which is not really health insurance, protects suppliers, not consumers. During World War II, employers entered the picture. According to Milton Friedman, they offered health care benefits instead of wage increases, because the latter were capped by wartime controls. My strong suspicion is that people like health insurance as it exists today because they mistakenly believe that they are getting something for free.Link here.
THE PERILS OF HYPERACTIVITY
Sometimes the very best trades are the ones you do NOT make … especially in a bull market. “Gold is overbought,” CNBC incessantly reminds us, which means that the precious metal is supposed to “correct” for a while. And so what? What is the smart trade to make in this circumstance? Our guess: No trade at all. Bull markets often correct from time to time, but that does not mean an investor should abandon well-reasoned, long-term investments. America’s public libraries contain very few biographies about individuals who made fortunes by capitalizing on counter-trend sell-offs in a bull market.
Most successful investors position themselves for long-term trends and ignore everything else. If they react to the short-term sell-offs at all, they do so as buyers, NOT as temporary sellers. A weekend conversation reminded me of this reality. “Hey Zack,” a successful investor asked the options trader to my left at a weekend social gathering, “where are you seeing the cheapest options on gold stocks right now? On the XAU Index?”
“Nah,” the broker replied, "XAU options are expensive now. In fact, they’re often expensive. I’d be much more inclined to SELL XAU options at this point than to buy them. Whenever I’m trying to hedge gold stocks, I usually set up some sort of spread trade. Or occasionally, I’ll scout around for inexpensive options on individual gold stocks. But right now, with this big move up in gold, you’re not gonna find a cheap option on anything. Why don’t you just sell short GLD, the ETF for gold?”
“Sell short? I don’t want to sell short!” the gold investor exclaimed incredulously. “I’m talking about going long on any dips. Look, I’ve been holding a large position in gold stocks for the past few years. So I’ve got no interest in trying to trade in and out of it. If I tried to do that I’d be sure to get it wrong.”
Owning gold might be the “wrong” trade for the next three weeks, but we believe it will be the right trade for the next three years. As we noted in an earlier column this week (summarized in “Gold Crosses the Rhine” above), today’s gold market bears a strong resemblance to the oil market of mid-2004. At that time, very few investors expected oil to pierce $40 a barrel … and stay there. In fact, the “smart money” was betting big against oil. When oil busted through $40 on May 12, 2004, the Commercial futures traders (considered the smart money) were sitting on their biggest short position in more than a year. Then when oil jumped through $42 on June 1, the Commercials had amassed an even larger position. The very next day, crude oil tumble $2.37 a barrel, triggering a steep one-month selloff. By the end of June, as oil was flirting with $35, the smart money felt quite smart indeed. But two months later, oil was back up to $44, and climbing. Three months after that, oil was through $55. And the oil bull market continues still.
Coincidentally, today’s Commercial gold traders hold one of their largest short positions of the last 12 months (see chart). This fact may bode ill for the near-term, but holds no significance whatsoever for the long-term, as the oil market’s recent history demonstrates. In theory, a (very) nimble trader who sold short crude oil on the high tick of June 1, 2004 and bought to cover their short position on the low tick of June 29 would have made about 16%. On the other hand, an investor who bought crude oil’s high tick of June 1, 2004 and ignored the intermittent selloffs, would today be savoring a 45% gain. Oil stock investors would have fared even better. OIH, the ETF of major oil-services stocks has doubled since then. Valero Energy has tripled. Bull markets do correct … but they also resume their ascent.Link here (scroll down to piece by Eric J. Fry).
THE DOLLAR BREAKS DOWN
The U.S. dollar, which has staged a counter-trend rally all year, looks like it is finally poised to resume its historic decline. Although the dollar actually weakened this year against several secondary currencies, the headlines have focused principally on its 2005 gains against its two principal rivals, the euro and the yen. However, recent reversals and technical action in both currencies strongly suggests the rally has finally exhausted itself.
Earlier this year it also appeared that the dollar’s bear market rally had come to an end. However, much like a drowning man, the dollar managed to make one more lunge upwards, marginally exceeding its July peak. That head fake was a classic sucker’s rally, as it emboldened dollar bulls, and caused tepid dollar bears to throw in the towel. Speculators, now overwhelming long the dollar, will likely add to the dollar’s woes, as they rush to cut losses on losing positions, or preserve rapidly fading profits.
The problem for those betting on dollar strength is that despite its year long rally, the fundamentals have actually deteriorated substantially. Nothing illustrates that fact better than Wednesday’s release of October’s record $68.9 billion trade deficit, and Thursday’s report that Americans hocked a record $108.6 billion worth of stocks and bonds to foreign investors in order to finance it. America’s unprecedented consumption binge and net accumulation of external liabilities evidences twin economic failures of historic proportions. The unfortunate reality is that as bad as October’s record setting economic failures were, they will likely be exceeded in the months ahead. In order for America’s bubble economy to continue expanding, Americans must continue spending. However, the two key elements required to achieve this, consumer goods and the means to pay for them, are both lacking.
With the ECB now raising interest rates, and the BOJ likely to soon follow, the dollar’s perceived yield advantage will quickly fade. Due to its status as the world’s largest debtor nation, higher global interest rates will hit the U.S. economy harder than any other, putting further downward pressure on the dollar. However my hunch is that this time foreign central banks will not come to its rescue. If that is indeed the case, there will be no buyers for speculators to sell to, and Ben “Crash and” Bernanke might be calling in those helicopters sooner than he had planned.Link here.
U.S. dollar: The shot nobody heard.
It may not have incited a Revolutionary War, but according to a December 11 New York Times, “the shot heard round the internet” did set off a media controversy about the world’s largest on-line encyclopedia, Wikipedia. Turns out, the noise erupted when one Nashville, Tennessee man decided to play a joke on a colleague by editing the Wikipedia biography of a local icon. Specifically, he added material suggesting the man was involved in the assassination of John and Robert Kennedy. Needless to say, nobody was laughing when said icon discovered his role as a murderous conspirator – a plight he vividly described in an op-ed USA Today article that instantly sparked national attention.
In no time, the debacle caused the writer of the entry to lose his job, Wikipedia to lose a chunk of its credibility, and the entire Internet to lose one large battle in the fight to keep its privacy laws intact. Too harsh OR Too humane? That is a matter of opinion, although most of us would agree that deliberately spreading erroneous information is wrong (prank or not) and those responsible should be accountable. Thing is, when the mainstream financial media misleads investors, you do not hear a peep; and it happens not once but nearly every day, when they use fundamentals to “explain” a financial market’s direction. These errors are obviously not purposeful nor meant to be practical jokes. They are, however, just as misleading.
Take, for example, the recent flurry of news stories relating the drop in the U.S. dollar to the December 14 Labor Department report revealing a 4.4% increase in the U.S. trade deficit. In case you missed it, these headlines capture the shot NOT heard round the net:
• “Crushed by a record trade deficit, the greenback fell against the majors in New York action. The Bears pummel the dollar on a record deficit.”
• “Dollar drops most in four months after the U.S. trade deficit unexpectedly widened to a record.”
• “December 14 Labor Department report showed the difference between exports and imports widened to $68.9 billion in October. It is a genuinely bad number. It’s a negative situation for the dollar.” (Bloomberg)
• “The dollar suffered today. A new record deficit is a surprise and adds to the soft dollar sentiment.”
Problem is, the supposed cause-and-effect relationship between the deficit and the dollar is about as factual as the Nashville newspaper editor’s connection to the infamous conspiracy. And nothing made this fact clearer than the December 2004 Elliott Wave Financial Forecast. In that publication, we plotted the past three decades of the U.S. Trade Weighted Dollar vs. the U.S. Current Account Deficit/Surplus (as a percentage of GDP) and recorded our finding in this very chart. Our adjoining analysis observed, “From October 1980 to February 1985, as the deficit emerged as the largest in well over a decade, the dollar surged 50%. From April 1995 to December 2000, the deficit took another huge leap and the dollar rallied 34%.”
Anyone with a grain of scents can see there is no basis in the media’s claims today. As for the recent downtrend in the greenback – we saw the move coming days BEFORE the deficit data hit the airwaves, AND we let subscribers to our Short Term Update know as much in the December 9 issue. In our own words, “The US Dollar index has made no upside nor downside progress since November 28. All trading since then has essentially been between the upper and lower range of that day. A solid break of [a certain level] would indicate that a deeper and more protracted downward correction was unfolding.” 48 hours later, prices broke through our cited area and have been falling since.Elliott Wave International December 14 lead article.
THE ECB RAISES INTEREST RATES. NOW WHAT?
On December 1, the European Central Bank did something it had not done in five years: It raised the euro zone’s interest rates a quarter point. Since July 2003, the ECB kept rates at 2% to “stimulate the economy”. Now that the euro zone economies – especially Germany – have shown a lot of improvement, the ECB has started to move the other way – “to counter inflation risks”.
The rumors about the ECBs coming rate hike have been flying for months. No one knew exactly when it would happen. Neither did we. But we knew it was imminent because of one particular market indicator that is been known to predict central banks’ interest rates decisions with a high degree of certainty. That indicator is bond yields. Bond yields change daily, and central banks do not have control over them. Yields (and prices) are set by the market. And after years of observing the timing of central banks’ monetary policy decisions, we have noticed one surprising fact: Central banks are almost never proactive when it comes to changing interest rates. Usually, they only react to what the market dictates. For that reason, central banks’ decisions generally lag the bond market.
Regular readers of this column will remember the following chart – we showed it here a few weeks ago. It compares the timing of the U.S. Federal Reserve Bank’s interest rates decisions with the action in the U.S. Treasury bills. As you can see, the Fed’s interest decisions come only after the bond market starts to move. The Fed usually plays catch-up with the bond yields.
We have not yet made a similar chart comparing the timing of the ECB’s interest rate decisions with the action in German Bunds (European equivalents of the U.S. Treasuries). But it is reasonable to expect a similar lag in the ECB’s decisions, too. In fact, when it comes to the December 1st rate hike, that seems to be the case. Bund prices have been falling since July. Consequently, Bund yields have been rising. And it is only now, after a 5-month lag, that the ECB has finally been prompted into action. ECB President Jean-Claude Trichet said that the “interest rate increase was unlikely to be the first in a series”. But, if history is any guide, should Bund yields keep rising, it probably will not be the ECB’s first and only rate hike. The surest way to know is to watch the action in German Bunds.Link here.
THE WEIRDEST CEO MOMENTS OF 2005
Just when we thought we had seen it all – $241,000 at a strip club?
CLOSED-END FUND MELTDOWN
In the closed-end fund world, 2005 has been a banner year, at least when it comes to initial public offerings. 45 closed-end funds have launched so far this year, raising over $20 billion in proceeds for their delighted issuers and yielding hefty fees for their even happier underwriters. Closed-end fund shares are listed on securities exchanges, are actively managed and trade intraday on the open market. They typically trade in relation to, but independent of, their underlying net asset values, or NAVs. That means that unlike open-end mutual funds, shares of closed-end funds can trade at premiums or discounts to their underlying NAVs, a feature that many investors find attractive.
For investors, however, the quality of these new offerings has failed to live up to the voluminous quantity, especially for those unlucky souls persuaded to purchase the funds at the offering price. Of the 45 IPOs released since January, only four as of the beginning of this month are trading above their offering price, and 24 are down 10% or more. Perhaps even more distressing than the amount of the decline from the IPO price is the rate at which some of these funds fell off the table.
In his December newsletter, closed-end fund specialist Thomas Herzfeld recommends against buying a fund on its initial offering. He instead suggests waiting for it to begin trading at a discount, which he says can occur as soon as a month after its launch, when the underwriter stops supporting the new issue. Herzfeld offers a trio of reasons why share prices on IPOs drop so soon, calling them his “Three Strikes Against New Issues”: 1.) “Lack of imagination, or bringing to market too many similar funds.” 2.) Underwriting fees and start-up costs. “These expenses, which generally amount to 4.5% of the initial offering price, are taken right out of the initial NAV of the fund, meaning the new fund starts life trading at a premium – a valuation hard to maintain,” says Herzfeld. 3.) The belief among investors that bigger equals better. “The bigger the fund, the more money the underwriters make; however, if a deal’s size is increased to the point that demand is satiated, once the issue starts trading, the only participants remaining in the market are the sellers.”
“Unfortunately, closed-end funds come into existence whenever brokerage firms believe they can sell them,” says Dr. Richard Shaker, portfolio manager for Shaker Financial Services, which deals primarily in closed-end funds. “They take advantage of the latest fad as a hook to sell. Typically, by the time brokerage firms have settled on the latest fad, stocks in that sector are significantly overpriced.”Link here.
THE WAVE PRINCIPLE, CONDENSED VERSION
A local theater company staged a play last year that promised to condense all of Shakespeare’s plays into one night at the theater. It was a fast-paced romp, all right, fun for audience members who had seen many of the plays full-length and just as fun for those who had not.
Those who study the Wave Principle and use it for trading appreciate all it can do to provide a framework for making trading decisions – notwithstanding the fear and trepidation or other emotions that come out when trading. Learning how to use the Wave Principle in all its rich complexity can be so satisfying, but sometimes it is fun to read the condensed version. In this excerpt from Bob Prechter’s question-and-answer book, Prechter’s Perspective, he explains in short, easy-to-understand answers exactly what the Wave Principle is.Link here.
JUMPING ON BUNGE, THE LARGEST OILSEED PROCESSOR IN THE WORLD
Dan Denning likes Bunge Ltd. So does James Grant. And so do we. Yet, despite this three-way love-fest for Bunge (NYSE: BG), the stock has gone nowhere for more than a year. For all we know, the stock will go nowhere in 2006. But it does not lack for reasons to go up. “Bunge is a vast, globally integrated middleman between farmers and eaters,” Grant explained in a mid-summer issue of Grant’s Interest Rate Observer. “The eaters to whom it increasingly caters are the billion or so Chinese who aspire to diets richer in chicken. The commodity in which the company mainly deals is soybeans, which – when crushed into meal – make chicken feed.”Links here (scroll down to piece by Eric J. Fry) and here (scroll down to piece by Dan Denning).
THE BIG BET
Why the U.S. will not solve its economic, educational, health, retirement, energy, and other major structural problems until it suffers a major financial crisis.
In his recent Newsweek article “Sputnik Was Nothing”, Louis V. Gerstner Jr. asks, “How much longer will the United States be a superpower? Not much, if we do not wake up to the fact that our economic strength, which has underpinned our political and military might for two centuries, is decaying. In the 21st century, economic power will be derived from skills and innovation. Nations that don’t invest in skills will weaken: it is that straightforward.” Gerstner’s message is not new – not for him, nor for other “enlightened” (read: already got theirs) capitalists such as financiers Robert Rubin, Paul Volcker, and Peter Peterson, and respected technology executives like Intel’s Andy Grove and Craig Barrett – all of whom have been calling for various reforms for years.
In the 1990s, Gerstner led the big turnaround of IBM from an aging computer maker into the largest global IT services corporation in the world. Now he is chairman of the Carlyle Group, the well-connected private equity firm that included President Bush I, whose friends Brent Scowcroft and James Baker have voiced serious concerns about the foreign policy direction of the current Bush II administration. Thomas Friedman, a cheerleader for “globalization” in his New York Times columns, his recent book The World is Flat, and his appearances on “The Charlie Rose Show” has wondered aloud why CEOs and political leaders do not speak out even more emphatically about the obvious economic threats facing America.
To us, the reason is straightforward. All these leaders understand, but never admit, that the motivation and incentive for Americans to resolve these critical problems – to improve our education, healthcare, and energy systems; to control our debts, live within our means, and so on – have been gradually reduced by the U.S.-dominated global speculative financial system that they themselves have helped create. Welch of GE, in his book Winning, describes how pleasantly surprised he was to learn (in the late 1970s and early 1980s) how easy it was to make money in financial services as he sold or shut down GE’s industrial businesses. He not only became very wealthy by doing so, but also came to symbolize an entire era.
The reality is, why should Gerstner really care to do anything about education, when his private equity firm can buy a public company, “fix” it via financial leverage and layoffs, and then sell it for a quick profit to individuals and pension funds made both desperate for yield (by years of accommodative Fed rate policy) and oblivious to risk (from decades of Fed bailouts every time a poorly conceived, high-risk investment failure threatens the so-called “real economy”)? For that matter, why should ambitious American students study physics, engineering, and math (except perhaps to become Wall Street “quants”), when it is so much easier to make money speculating in real estate, stocks, and everything else, including untenable IPOs for companies that are unlikely to ever be profitable?
For obvious reasons, no one in power ever makes the simple link between the U.S.-dominated global speculative financial system and the diminishing motive for Americans to innovate and create new goods and services. This is the reason why clearly needed economic, social, and political changes are not forthcoming. Instead, the so-called solutions to the problem have become a shell game of retraining and social safety nets. While the global speculative financial system shifts U.S. assets and productive capacity (and thus wealth-generation capabilities) overseas, the average U.S. household is losing its ability to generate real income in the domestic economy.
Meanwhile, the global speculative financial system has pushed income inequality to all-time highs, with over 50% of 2004 income going to the top fifth of U.S. households, and the biggest gains going to the top one percent. The growth in billionaires has leaped dramatically since the early 1980s, when the U.S.-dominated global speculative financial system started to develop. The average net worth of individuals on the Forbes 400 was $400 million in 1980. 25 years later, their average net worth is $2.8 billion.
The reason America does not change is that there is no incentive for it to do so. Not as long as the U.S. can keep getting more “wealthy” by printing more money to inflate already existing assets (such as real estate) with impunity, compliments of foreign creditors and the Fed. But printing money to inflate asset values creates no new real wealth. True wealth creation can only come from real income generated by the real production of innovative, new, real goods and services that improve productivity and generate domestic savings, which are in turn reinvested into the economy.
The global speculative financial system continues to operate as a kind of perpetual motion machine, propped up by the “moral hazard” of central bank policies and the willingness of foreign lenders to support U.S. consumption on credit, in order to fund their own economic expansion at home via export income and domestic savings. As long as the global system works this way, profit incentives, asset markets, and resource allocation will remain distorted. The system will continue to reward speculators with great wealth while it offers scraps to the inventors. The U.S. educational system will cater to speculators, who pay the endowments, and ignore the inventors, who cannot help them much at all.
After more than 25 years of this, is it any wonder that the entire U.S. economy has organized itself to conform to this financial model: a gigantic, risky, one-way bet that uses trillions of dollars of credit and massive leverage, relying on the savings of foreign workers to fund the bet and the foreign central banks to cover the risks? Can the U.S. transition to a more balanced and less dysfunctional global economy, so that these domestic problems get fixed? Not as long as the global speculative financial system is running. Until a new system is in place, there will never be enough incentive and motivation to fix the problems that Gerstner, Sachs, Stiglitz, Grove, Gates, and so many others care about. Not until it is too late.
It was only after learning the horrible lessons of the 20th century’s own “Thirty Years War” that the U.S. elites created the global financial and political institutions (after WW II) that helped to rebuild war-torn Europe and Asia. Unfortunately, it may take another crisis to once again drive home the point that we are all in this together.Link here.
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