Finance Digest for Week of December 26, 2005

WHAT IS THE FED UP TO WITH THE MONEY SUPPLY?

Over the past two days, December 21st and 22nd, the Federal Reserve has conducted one of the largest two-day Repo injections of money into the system since back in September 2001. On Wednesday they added $18.0 billion in reserves and on the next day added another $20.0 billion. Is something high-risk going on behind the scenes here? Let us review some facts at the Fed. On November 10th, 2005, shortly after appointing Bernanke to replace Greenbackspan, the Fed mysteriously announced with little comment and no palatable justification that they will hide M-3 effective March 2006. M-3 has been the main staple of money supply measurement and transparent disclosure since the Fed was founded back in 1913. It is the key monetary aggregate that includes Fed Repo transactions, that mechanism whereby the Fed increases reserves. The date when M-3 will start being hidden also happens to be the exact month that Iran will declare economic war against the U.S. Dollar by trading its oil in Petro-Euros on its new bourse. But there is more.

The Federal Reserve currently has three vacancies within the 19 top Regional Bank and Board of Governor spots. Why? Part of ongoing wholesale resignations. Fed Presidents are treated like gods. They have enormous power, prestige, and presence. Why quit? Over the past few years no less than six Federal Reserve Regional Bank Presidents have resigned. This is highly unusual. An immediate impact is that we are about to have a largely inexperienced batch of individuals conducting monetary policy in the U.S. So of course, the first thing they will do is hide the key money figures. Two positions for the Board of Governors (there are 7)have been open for quite a while. Plus six of the 12 Regional Head spots have turned over during the past few years.

If a substantial amount of oil transactions will suddenly be conducted in euros instead of Dollars, this should put pressure on the Dollar as folks exchange dollars for euros, jeopardizing the dollar’s status as the world’s reserve currency, making it more difficult to print all the dollars the Fed wants to without driving the dollar into the ground. Could the Master Planners be hiding M-3 because they anticipate they may have to monetize the Federal debt, buy our own Treasury Bonds during the coming economic attack against the Dollar? That would require a ton of new fresh money creation – too much to disclose. Could it be some folks at the top of the Fed do not have the stomach to be part of what is about to go down?

M-3 has a direct but lagging impact on financial markets. Look at the chart at the top of the prior page. Whenever M-3 rises, the Dow Industrials rise. Whenever M-3 is flat or declines, the Dow Industrials decline. The Dow Industrials are a bellwether for the economy. If we can monitor M-3, we can better monitor the future path of equities and the economy. Our buy/sell signals were designed to pick up the scent of Master Planner intervention by analyzing supply and demand forces underlying the markets. So with or without a fully disclosed M-3, we will be able to continue to identify coming multi-week trends.

So what about M-3 the past week? The latest figures show that on a seasonally adjusted basis, M-3 rose at a 14.0% annualized clip. Over the past month it grew at a 9.8% growth rate. But those are the massaged numbers. For the raw figures, fasten your seat belt. Are you ready? M-3 was increased $58.7 billion last week (that does not include the huge Repo infusions noted above), a 30.0% annualized rate of growth. For the past two weeks, the Fed added $93.5 billion to the money supply, a 24.0% annual clip. Over the past 6 weeks it is up $192.9 billion, a 16.7% Banana Republic hyperinflationary pace. This is nuts, folks – unless there is an incredible risk out there we are not being told about. That is a lot of money for the Plunge Protection Team’s arsenal to buy markets – stocks, bonds, currencies, whatever. This level of irresponsible money supply growth makes shorting markets hazardous, yet at the same time says markets are at huge risk of declining. Maybe M-3 growth does not stop the decline this time. Should be a fascinating storm in 2006.

The recent rise in Gold catalogued 74 points over about a month, a 16% rally from precisely the day the Fed announced it would hide M-3 from taxpayers and citizens of this great nation. That is no coincidence. Gold sees hyperinflation, monetization of debt, and intervention into free markets.

HOW TO TAP INTO THE THINKING OF THE SMARTEST MUTUAL FUND MANAGERS

The world’s best mutual fund managers work in fishbowls – there is a wealth of data available on how they invest. Two years ago we first took the portfolios of the winningest managers and overlapped their biggest holdings to find a batch of winners. Simple thesis: If a lot of smart guys like the same stock, it must be worth holding. In the first year, 2004, the 10-stock portfolio of four large U.S. companies, three small- or midcap ones and three international names beat the S&P 500 by 2.5 percentage points, returning 10.5%. (Holding that same group through 2005 let you score an additional 14.5% total return.) Over the past year a new set of 10 did even better, up 19% versus an 8% return for the index through November.

To continue the experiment we went back to Morningstar.com and fired up the premium membership tools (comes with the $125 annual subscription). We built a screen to find funds with long-tenured managers who have beaten their peer groups in each of four distinct time periods – 10 years, five, three and one. Out went any fund that has underperformed money market rates over five years. Also axed were sector-specific funds and those that trade a lot. We want stocks to hold for at least a year. Also, the reported holdings of in-and-out traders are not very useful because they may be out of the stocks by the time the reports are filed. This year’s cut: 23 funds that mostly own shares of large companies, 21 that like smaller companies and 19 that invest internationally.

To get to the individual stocks, we subjected each set of funds to Morningstar’s “stock intersection” tool, which shows where fund holdings overlap. The most popular large cap was Citigroup, held by 16 funds. Tyco appeared in 15. ConocoPhillips is in 14, as is Pfizer. As usual the smaller-cap managers show less consensus. The leading pick here is homebuilder DR Horton, which showed up in five funds. Then came WR Berkley (four funds), a small property-casualty insurer. Peabody Energy is one of the world’s largest miners of coal, an ancient commodity given new luster by the shortage of petroleum and by advances in smokestack scrubbers. UBS, the Swiss bank with $1.3 trillion of assets under management (its own and its clients’) came up in seven international stocks funds.

IS HEDGE FUND MANAGER EDWARD LAMPERT TAKING SEARS PRIVATE?

Can Edward Lampert save Sears? Or maybe that is the wrong question. Can he save his investment in Sears? He might do that by taking the $54 billion (sales) retailer private. Lampert smushed Sears and Kmart together a year ago. But the $11 billion deal has so far done little to reverse the sickly retailers’ slide. The December quarter was another horrible one for comparable store sales, down 10.8% at Sears outlets and down 2.8% at Kmart. The future does not look much more promising. Lampert, who noted in SEC filings that recent apparel sales numbers were “disappointing”, prefers not to talk to Wall Street or to journalists.

All the more reason to take Sears private. Acquiring the 60% of Sears that his hedge fund does not own could cost Lampert $12 billion to $15 billion (including assumed debt). Lampert could then slowly sell Sears real estate assets, valued at $10.8 billion, without having to explain himself to public shareholders. So far Lampert has dumped some of Sears’ Orchard hardware stores, slashed costs and sold some credit card receivables, raising $1 billion in cash. Look for Lampert to plow $2 billion annually into stock buybacks (he spent $430 million this way in the third quarter), effectively boosting his control of the retailer. Then, when Sears’s lofty $123 share price eventually falls, Lampert will be poised to buy the rest via tender offer.

THE FOOTNOTE FANATIC

By obsessing over data buried in corners of corporate financial reports, onetime auditor David Trainer has come up with some surprising calls on stock buys and sells. To Trainer, financial statement footnotes are “the decoder key to unlocking a company’s true value.” But to some companies, true value is best hidden. And thus he was not very popular on bubble-era Wall Street. When analyst Trainer pushed employer Credit Suisse First Boston to build a huge database to ferret out hidden problems in stocks, he got in big trouble. CSFB investment bankers were furious, he says, when he used the data to brand clients as sells, thus potentially undermining deals. “Information I was digging up wrecked their accounting ratios, like some phony price-to-cash-ratio [the investment bankers] made up,” says Trainer. The firm fired him in 2000.

Then Trainer hopped to San Francisco investment bank Epoch Partners, where he again made enemies, by slamming such then beloved names as Web-services outfit LoudCloud and telecom gear maker JDS Uniphase. He viewed their made-up earnings numbers, called “pro forma” profits, as funky. Management wanted him to stop talking about discounted cash flow analysis based on footnote data and focus instead on price-to-sales. What kind of accounting is that, he wanted to know, where you ignore expenses? He clearly was not suited to sell-side financial analysis. So when Goldman Sachs bought Epoch in 2001, Trainer gladly took a severance package. He spent six months out of work, doing volunteer jobs for a Presbyterian church in New York.

“I expected to retire from Wall Street after a long and fruitful career,” says Trainer, now 33. “But I came away really disappointed with what a sham it was.” Then a foul wave of corporate scandals started to build. Money managers pressed him to supply footnote-centric research. Trainer, a onetime auditor for now defunct accounting giant Arthur Andersen, had found his proper place. In July 2002 he started New Constructs. Today Trainer oversees a squad of 12 footnote excavators, who compile research he sells to 40 Wall Street investment houses, mutual funds and hedge funds, including Janus Capital and Fidelity Investments. Post-Enron, it is boom time for analysts who can poke through financial statements looking for holes.

New Constructs warns its clients away from companies that have a history of heavy use of stock options (which used to be omitted from employee compensation expense), serial charge-offs, off-balance-sheet financing or badly funded pension plans. “Before people break the rules, they bend the rules,” says Trainer. Making a living as a pure short-seller is hard, so Trainer’s firm also looks for stocks to recommend. These are typically firms with a bad earnings report or two that nonetheless exhibit such markers of underlying strength as sustained cash from operations, a healthy balance sheet and (during good quarters) a high return on invested capital. Trainer likes aerospace manufacturer Precision Castparts despite its $1.7 million loss in the March 2005 fiscal year.

PAY A PREMIUM

Just when you thought the season’s gift hunting was over, there is one last, postholiday item that should be on your list: corporate bonds set to mature in the next few years. They offer nice yields that are like a thoughtful gift. These yields are deliciously high compared with the returns from intermediate and long-term issues. There is no reason for taking the interest rate risk on an intermediate term bond, such as a Bear Stearns issue that is maturing on Oct. 30, 2015, to capture a yield of 5.4%, when another Bear Stearns bond, maturing in only two years (Dec. 15, 2007), is yielding 4.9%. The difference in yield is minuscule.

What about future Federal Reserve hikes? Do they not make it too soon to buy? I think the risk of significantly higher short-term rates is minimal. The Fed, which in mid-December raised rates by a quarter-point to 4.25%, is clearly closer to the end of its tightening cycle than the middle. I believe that the next half-point of rate increases is already priced into debt securities. One reason, though it is hard to see it now, is that this economy is just on the brink of slowing. How can I know? From what the pundits are saying. It is wise to bet the opposite. Regardless of what the future brings, you cannot go wrong gaining a little extra income from the high-quality corporates I have in mind.

NEW YEAR’S RESOLUTION: UNDERPAY

Material progress is the story of the modern age. People are living longer, eating better and enjoying more of the pleasures of this life – just as they have been doing, on and off, since the Industrial Revolution. “On and off” is the rub. Life and markets are cyclical. Nothing goes straight up. To protect against the unavoidable intermittent setback, arm yourself with a margin of safety. When investing this New Year, resolve to underpay. A fine resolution, but – like so many – not easy to keep.

You can spot a nonbargain a mile away. The art market, for example, is full of them. An investor in human progress might reason that spreading affluence means rising prices for the creations of the human imagination: paintings, sculpture, furniture, stamps, etc. This would especially be so if the world’s central banks continue so energetically to crank that early icon of human ingenuity, the printing press. But wait. “Contemporary art prices are in fantasyland – they’re near lunacy.” This testament comes from none other than Michael Steinhardt, art collector and retired hedge-fund investor.

Bargains are what we want, but they are all too scarce in the 2006 stock market. Much more common are the quasi-bargains, fine companies selling at almost-cheap prices. Bunge Ltd. (54, BG), the $25 billion (revenue) food company, is an example. Global vendor of protein with a U.S. headquarters, Bunge is a pure play on earthly betterment. It has been around since 1818. Its stock-in-trade is grains, oilseeds and fertilizers. It does a big business in Brazil, where it is the largest producer in the world’s fastest-growing fertilizer market. But there is always a catch. For Bunge, one is Brazil’s currency, the real, whose unexpected strength has depressed corporate dollar-denominated Brazilian earnings. The Brazilian business has been further hit by a drought-induced agricultural slump. Another catch is the Bunge front office, which late last year disclosed a plan to meet earnings expectations by managing the corporate tax rate. In response to the news of this unwelcome fix, the share price sank. Bunge is profitable, well financed and on the move. Paying 13 times earnings, an investor is doing without that best of sleep aids, an obviously cheap entry point. But he is probably not overpaying.

Tata Motors (13, TTM), an Indian vehicle maker with ADRs, offers another investment in global prosperity. If the Indian auto market is destined to follow the U.S. market’s arc, good news is on the way. For instance, most Indian auto buyers pay cash. Maybe one day they will patronize Tata’s finance sub. For Tata Motors, an optimist on the human condition is paying 16 times earnings. A value-seeking optimist might buy only a little now, waiting for an all-but-certain bump in the road to create an opportunity to add more at a better price. Remember your 2006 resolution!

AGE-OLD WISDOM FROM CANTILLON, RAGUET, HAWTRY AND PERSONS STILL APPLIES TODAY

We today face a torrent of disinformation, propaganda, imaginative “analysis” and a slew of wishful thinking when it comes to the true state of our financial and economic systems. At this manic stage of the Credit Bubble, we should expect nothing less. And I guess it is no coincidence that we have a full-fledged monetary quack about to take the helm at the Federal Reserve. But, most fortunately, economic history offers us a wealth of pertinent insight to help keep us “grounded”. I hope readers enjoy tidbits of wisdom from John Law contemporary and profiteer from the collapse of Law’s Bubble, the Irishman Richard Cantillon (1697-1734); a brilliant American merchant and statesman Condy Raguet (1784-1842); the English statesman, monetary economist and Keynes’ contemporary Ralph G. Hawtrey (1879-1975); and little known but clearly exceptional American economist, Charles E. Persons. I wish everyone a Merry Christmas and Happy Holidays!

TAKE IT FROM JAPAN: BUBBLES HURT

14 years ago, Yoshihisa Nakashima looked at the sleepy suburb of Kashiwa, an hour and 20 minutes from downtown Tokyo, and saw all the trappings of middle-class Japanese bliss: cherry-tree-lined roads, a cozy community where neighbors greeted one another in the morning and schools within easy walking distance for his two daughters. So Mr. Nakashima, a Tokyo city government employee who was then 36, took out a loan for almost the entire $400,000 price of a cramped 4-bedroom apartment. With property values rising at double-digit rates, he would easily earn back the loan and then some when he decided to sell.

Or so he thought. Not long after he bought the apartment, Japan’s property market collapsed. Today, the apartment is worth half what he paid. He said he would like to move closer to the city but cannot. The sale price would not cover the $300,000 he still owes the bank. With housing prices in the U.S. looking wobbly after years of spectacular gains, it may be helpful to look at the last major economy to have a real estate bubble pop: Japan. What Americans see may scare them, but they may also learn ways to ease the pain.

To be sure, there are several major differences between Japan in the 1980’s and the U.S. today. One is the fact that property prices rose much faster and more steeply in Japan, partly because speculators used paper profits from a booming stock market to invest in property, insupportably leveraging the prices of both higher and higher. Another difference is that the biggest speculators in Japan’s frenzy were deep-pocketed corporations, and they pumped up the commercial property market at the same time that home prices were inflating. Still, for anyone wondering why even the possibility of a housing bubble in the U.S. preoccupies so many economists, it is worth looking at how the property crash in Japan helped to flatten that economy – 2nd only to that of the U.S. – and to keep it on the canvas for more than a decade. And as American homeowners contemplate what might happen if their property values fell – particularly if they fell hard – there are lessons in the bitter experiences of their Japanese counterparts like Mr. Nakashima.

Japan suffered one of the biggest property market collapses in modern history. At the market’s peak in 1991, all the land in Japan, a country the size of California, was worth about $18 trillion, or almost four times the value of all property in the U.S. at the time. Then came the crashes in both stocks and property, after the Japanese central bank moved aggressively to raise interest rates. Both markets spiraled downward as investors sold stocks to cover losses in the land market, and vice versa, plunging prices into a 14-year trough, from which they are only now starting to recover. Now the land in Japan is worth less than half its 1991 peak, while property in the U.S. has more than tripled in value, to about $17 trillion.

Homeowners were among the biggest victims of the Japanese real estate bubble. In Japan’s six largest cities, residential prices dropped 64% from 1991 to last year. By most estimates, millions of homebuyers took substantial losses on the largest purchase of their lives. Their experiences contain many warnings. One is to shun the sort of temptations that appear in red-hot real estate markets, particularly the use of risky or exotic loans to borrow beyond one’s means. Another is to avoid property that may be hard to unload when the market cools.

Economists say Japan also contains lessons for U.S. policy makers, like Ben S. Bernanke, who is expected to become of the Fed chairman at the end of January. At the top of the list is to learn from the failure of Japan’s central bank to slow the rise of the country’s real estate and stock bubbles, and then its failure to soften their collapse. Only recently did Japan finally find ways to revive the real estate market, by using deregulation to spur new development. Most of all, economists say, Japan’s experience teaches the need to be skeptical of that fundamental myth behind all asset bubbles: that prices will keep rising forever. Like their U.S. counterparts today, too many Japanese homebuyers overextended their debt, buying property that cost more than they could rationally afford because they assumed that values would only rise. When prices dropped, many buyers were financially battered or even wiped out.

ARAB STOCKS, 2005’S TOP PERFORMERS, LURE INVESTORS AS OIL BOOMS

Eight out of the 10 best-performing stock indexes tracked by Bloomberg News are Arab benchmarks this year, led by Egypt’s CASE 30 Index. Most reached records this year. There is no sign the markets will give up their gains any time soon. “Oil and government economic reform in the Middle East is triggering the boom,” said Haissam Arabi, head of asset management at Shuaa Capital, which oversees $2.2 billion in United Arab Emirates, Dubai. The CASE Index has surged 152% this year in dollar terms, while the Dubai Financial Market Index has climbed 130%. Benchmarks in Saudi Arabia and Jordan have roughly doubled. The total market value of stocks in Tunisia, the United Arab Emirates, Jordan, Lebanon, Qatar, Kuwait, Oman, the Palestinian Authority, Egypt, Saudi Arabia, Bahrain and Morocco has more than doubled this year to $1.3 trillion, according to data compiled by Bloomberg and statistics from the Palestinian stock exchange.

Most Arab markets are open to foreign investment to varying degrees. Egypt has the largest market available to international investment, while Saudi Arabia virtually limits all trade to its subjects. Companies in other Persian Gulf monarchies put restrictions on the amount foreigners can hold. Now, some analysts are concerned that the valuation of stocks in the region may lead investors to put their money elsewhere. Stocks in the Egyptian benchmark trade at an average of 20.7 times estimated earnings, higher than the price-to-earnings ratio of stocks in Morgan Stanley Capital International’s Emerging Markets Index, which trade at an average of 13.5 times estimated earnings. “This is a one-off boom,” Anais Faraj, global equity strategist at Nomura International Plc, said. “From here on, there will be a bigger diversification of investments.”

Saudis caught up in stock market mania.

So many people crush the banks to get on board an initial public offering that the police have to be called out. Some Saudis disappear from work during trading hours, and teachers bring their laptops to class to trade stocks. Saudis have stock market mania, and the obsession is as close to gambling as one can get in a kingdom that bans it. Five years ago, about 50,000 Saudis had dealings with the stock market. Today, there are more than 2 million active investors in a country of 26 million people. “For some people, it’s an addiction that’s almost akin to the addiction to the casinos of Las Vegas,” said Prince Mohammed Al-Faisal, a businessman.

The index went up by 85% in 2004, closing at 8200 at year’s end. This year, it has grown by more than 100%. The stock market run began in 1999 when an increasing number of companies began going public. But it really took off in 2003 when oil prices started climbing, eventually tripling to current levels of nearly $60 a barrel. Oil revenues, which were at $61 billion in 1998, are expected to reach $291 billion this year and $305 billion next, said the Washington-based Institute of International Finance.

The boom not only has benefited Saudi Arabia, which has the biggest Arab economy, but other Gulf countries as well. The institute said in August that Saudi Arabia, Bahrain, United Arab Emirates, Kuwait, Oman and Qatar are in the midst of a period of exceptional economic performance. Economists also credit the boom to a shift in strategy that prompted Gulf Arabs to pull their money out of slumping U.S. markets and invest it at home.

Before the September 11 attacks, Middle Eastern oil exporters were plowing as much as $25 billion a year into U.S. investments, according to World Bank figures. In 2001-2003, however, that amount was only $1.2 billion. The Saudi American Bank said in August that the stock market boom was fueled by “Saudi oil production, better-than-expected corporate performance, interest created by new IPOs, and high liquidity. We see no deterioration on the horizon of any of these underlying forces driving the stock market.”

Economists say inexperienced investors are basing their trading not on the performances of companies but on rumors of what big traders – known as “hamour”, a fish found in the Gulf – are buying that day. Most traders manage their own portfolios. Adnan Jaber, economic editor at Al-Watan newspaper, said some people are using the Internet to manipulate investors. A few months ago, an unidentified man began posting messages urging traders to sell or buy stocks based on dreams he had had about them, he said. For some, it is not rumors but the “purity” of stocks that counts. Pious traders in this conservative kingdom consult with clerics or check fatwas – Islamic edicts – to make sure the stocks comply with the Islamic Shariah laws banning the charging of interest or the sale of alcohol.

Even Saudi women, whose activities are heavily restricted, are caught up in the stock market craze. Banks have fitted women-only halls with deep, comfortable chairs and computers. On a recent afternoon, two dozen women in one hall kept their eyes on a giant screen showing the movement of stocks as they sipped tea or cardamom-flavored coffee. Jihan al-Kahtani, a 29-year-old university student, said she has stopped going to such places because they can be noisy and littered with leftover food. Plus, she said, she spent much of her time filling sales orders for women investors who could not read or write. “So now I trade on the Internet,” she said.

YIELD CURVE INVERTS FOR FIRST TIME IN 5 YEARS

An inverted yield curve occurs when short-term maturities pay a higher interest rate than longer-term maturities. Such an event has typically foreshadowed a noticeable downturn in the economy and, usually, a recession. With an inverted yield curve, banks can no longer make money by borrowing short-term money and lending it at longer terms. The inversion first came in European trade when the 2-year note yielded 4.411% versus a 10-year yield of 4.405%. The curve briefly inverted in late morning trades, with the 2-year note yielding 4.377% and the 10-year yielding 4.373%. In recent trades, the yield curve normalized with the 2-year yielding 4.368%, while the 10-year yield stood at 4.376%. Still, a large part of the yield curve was still inverted, with 5-year notes yielding 4.327%, just 8 basis points more than the overnight federal funds rate of 4.25%.

The last time the yield curve inverted was in 2000, before the last U.S. recession and a period of aggressive rate cuts by the Federal Reserve. The yield curve briefly inverted in 1988 during the Asian financial crisis, the only time in the past 30 years that an inverted yield curve has not preceded a recession. Some economists continue to eye the yield curve as a critical economic indicator. Others say it has lost its usefulness because special factors, such as the government shifting issuance to shorter maturities, have distorted the curve’s economic signals. The Fed too has played down the bearish implications of inversion, although “many in the market are much less prone to shrug it off,” said Action Economics.

Too soon to tell what curve inversion means.

The U.S. Treasury yield curve inverted on Tuesday, with two-year notes yielding more than 10-year notes for the first time in five years in a possible signal the U.S. economic recovery is topping out. But many analysts were reluctant to embrace the traditional interpretation of an inverted yield curve, namely the economy is heading for a slowdown or possibly even a recession. They say a buildup of savings around the world has found its way into the U.S. Treasury bond market, helping keep yields at unusually low levels and, according to officials at the Federal Reserve, possibly changing the rules of interpreting yield curve inversions. As a result, all the yield curve is saying is the market believes the Fed’s 18-month campaign to raise short-term interest rates to control inflationary pressures may well be near completion. “This clearly suggests we are very close to the end of the tightening cycle … and is not an indication of a recession,” said Michael Rottmann, strategist at Hypovereinsbank.

Yield inversion just “conundrum” in disguise.

Head-scratching over whether this week’s U.S. yield-curve inversion is a true bellwether of recession is merely a new spin on a hoary old problem that has puzzled economists all year. Rather than some ill omen, the inversion – an unusual rise in 2-year borrowing rates above 10-year rates – has occurred because long-term rates have remained stubbornly low or fallen as the Federal Reserve has jacked up short-term rates. While economists have a plethora of theories, few still have a watertight explanation for why 10-year borrowing costs are lower now than when the Fed began a campaign that has more than quadrupled short-term interest rates.

It is this “conundrum” – the term Fed chief Alan Greenspan coined for the puzzle back in February – that lies at the root of the U.S. economy’s remarkable resilience this year. Until it is better understood, many economists believe that trying to read the tea leaves of this week’s peculiar bond market configuration is a wasted effort. But whether the yield curve predicts recession or not, most economists say it is still critical to heed signals from the bond market.

Ahead of the curve … {inversion}.

During the holidays, one phrase you often hear bandied about among the crowd at office parties, family reunions, or New Year’s Eve bashes is “Who the heck invited him/her?” Tis the season of uninvited guests – crazy old boyfriends, long-lost relatives, shafted bookies – who appear suddenly out of the blue to spread a wet blanket over the festivities. Well, on December 27, the king of unwelcome visitors came a knockin’ on the door of the U.S. bond market – a yield curve INVERSION between 2-year and 10-year treasury notes. Last seen: second quarter 2000.

Gone, yes, but nobody on Wall Street can forget what the arrival of a yield curve inversion generally means for the markets: they have preceded every U.S. recession for the past 50 years, with the exception of one “false” signal – which makes it easy to understand how its presence could take the life out of the party. This time around, though, the bond band played on without skipping a beat, while the mainstream “experts” brushed off the half-century old bearish indicator via every excuse on Earth. For example: “The U.S. economy is in good shape. The curve inversion is just a temporary phenomenon. It cannot last as the Fed raises rates.” (Bloomberg) And: “Globalization has kept yield unusually low and thus altered the meaning of the shape of the yield curve, whereby the long end is being distorted by non-economic flows such as buying by foreign central banks.” (Reuters) Blink twice if you understand the logic behind that second statement! As for the “temporary” nature of the inversion, consider this fact: Two year notes have been yielding more than both the three and five-year notes for the past two weeks.

And to whoever said the Federal Reserve is in control of how steep the yield curve ultimately becomes, we have one word: Wha? Think about it: On June 29, 2004 the day before the Fed started its “measured” policy of lifting rates, the yield on the 10-year bond was 2.8% higher than on the two-year bond. 13 rate hikes and 18 months later, the longer bond’s yield is 0.1% lower than the shorter bond’s. The fact is, “efficacy” of the yield curve inversion as a forecasting tool has NOT diminished “dramatically” (as Alan Greenspan claims). Yet bullish optimism in the future of the U.S. economy has increased “dramatically”, to the very point where time-honored indications of trouble are flat-out denied or disregarded.

Which is fine, if this truly is the start of a New Economy where the old rules just do not apply anymore. Well, this past August we presented a special two-page analysis on the U.S. bond market at a time when the yield curve on the 2-year note was 24 basis points away from the 10-year Treasury. In our words, “An inversion of the yield curve is inevitable” in the months ahead. Now, in the December 28 Short Term Update, we revisit the bond market and reveal how the combination of a yield curve inversion PLUS the current extreme in bullish sentiment “ALWAYS” Equals one thing for the overall market.

BROKEN BENEFIT SYSTEM

Put simply, U.S. corporations are promising to pay their past and current employees more than $150 billion in pension benefits that are not backed by anything except the flimsy assurances of the U.S. Pension Benefit Guarantee Corp., which is itself woefully underfunded. Now comes even more alarming news. New data from Standard & Poor’s, pretty much the final word for research in this widely ignored field, reveals a whole new mountain of dynamite that looks ready to explode. And this explosion could dwarf what lurks in corporate America’s pension crisis.

The new time bomb: American business’s collective promise to pick up nearly $300 billion worth of the medical costs for their retired employees. Until now, the details of the problem have been buried in the footnotes to the financial reports that public companies must file with the SEC. But that is about to change. In 2006, those obligations will have to be pulled from the footnotes and displayed for everyone to see on the balance sheets themselves. And, warns the S&P study’s author, Harvey Silverblatt, “Companies are going to be in for a shock, and so are investors.”

Until now, concerns over retiree health-care costs facing U.S. companies has mostly been confined to the auto industry – General Motors, in particular. That once-treasured stock has lost more than half its value this year, and ended last week at less than $19 per share, reflecting a market value of a mere $11 billion. In effect, Wall Street is saying the world’s largest automaker is worth less than the Wrigley chewing gum company, whose market cap is $15 billion. The main reason: Investors have at last woken up to the fact that GM has no hope of honoring the more than $77 billion in employee health-care obligations that successive waves of management have snowplowed onto the company’s balance sheet over the years to keep the peace with the autoworkers union. As a result, many on Wall Street now see out-and-out bankruptcy as a real possibility.

But the unfunded portion of GM’s retiree health-care obligations, which the S&P research puts at $61.4 billion, is but a small portion of the unfunded health-care exposure of U.S. business as a whole. According to the S&P, that exposure tops a stupefying $292 billion for the nation’s 500 largest public companies, amounting to almost twice the exposure the very same companies face on the retiree pension front. Combine them and you are looking at more than $440 billion of promises that is equal to roughly a fifth of the entire book value of the companies. For the most part, these promises are backed by literally nothing beyond the murmured words of the companies that have made them: “Trust me”.

Pension problems loom for boomers.

The trend by companies to freeze or end their employee pension plans may have a big impact on baby boomers now on the cusp of retirement. Boomers with pension plans have counted on monthly retirement checks at the end of their career, but more employers are ending their plans or halting future benefit accruals. Those at greatest risk include boomers in their late 40s and early 50s, who are still at least a decade from retirement but too old to save enough to make up the difference in their pension benefits.

An August survey by PricewaterhouseCoopers showed that nearly half of companies that expect to change their pension plans in the next year are considering freezing benefits for all employees. More than a third that offered pensions have already pared back these benefits over the past three years. “This will definitely be a problem for baby boomers,” says Karen Friedman at the Pension Rights Center. “You’ve been at a company under the plan and worked for years with that expectation, and then it’s taken away.” When companies freeze a plan, they keep it in place but halt future benefits that would have been earned. Terminating a plan involves closing it down, although accrued benefits are not taken away. Companies often then change to 401(k) plans, which puts more of the risk for managing retirement accounts on employees. Some analysts say some boomers could see the trend away from pensions ebb, especially with stable stock market returns.

BERNANKE, HOUSING IN SPOTLIGHT AS YEAR BEGINS

Ben Bernanke will take center stage in 2006 when he assumes the mantle of Federal Reserve chairman, but he will share the spotlight with the housing market, whose performance is key to the economy’s future. Bernanke takes the central bank rudder from Alan Greenspan as the world’s largest economy rolls into the 5th year of an expansion, with a slowdown in the red-hot housing market posing one of the biggest risks, especially in the second half of the year. Forecasters polled as part of MSNBC.com’s fourth annual economic roundtable generally expect the housing market will avoid a catastrophic crash, although even if prices simply plateau it could remove one of the critical elements supporting growth over the past several years.

“I would say that as housing goes, so goes the economy,” said David Rosenberg, chief U.S. economist at Merrill Lynch. “I think one of the principal risks is whether or not home prices decline and the impact that that will have in terms of influencing the savings rate and personal consumption growth – as we have already seen in the U.K. and Australia.” Ed Leamer, director of the UCLA business forecast, said the housing industry will no longer drive economic growth, but he does not expect prices to collapse. Instead he sees a long period of flat prices and a tougher market for sellers, especially in hot markets like his home state of California. “I’qs going to be a buyer’s market not a seller’s market – possibly for a long period of time,” he said. But he said the downturn would not be enough to throw the economy into recession unless inflation fears send long-term mortgage rates soaring, which he does not expect.

20 years later, buying a house is less of a bite.

Despite a widespread sense that real estate has never been more expensive, families in the vast majority of the country can still buy a house for a smaller share of their income than they could have a generation ago. A sharp fall in mortgage rates since the early 1980’s, a decline in mortgage fees and a rise in incomes have more than made up for rising house prices in almost every place outside of New York, Washington, Miami, and along the coast in California. These often-overlooked changes are a major reason that most economists do not expect a broad drop in prices in 2006, even though many once-booming markets on the coasts have started weakening. The long-term decline in housing costs also helps explain why the homeownership rate remains near a record of almost 69%, up from 65% a decade ago.

Nationwide, a family earning the median income – the exact middle of all incomes – would have to spend 22% of its pretax pay this year on mortgage payments to buy the median-priced house, according to an analysis by Moody’s Economy.com, a research company. The share has increased since 1998, when it hit a low of 17% before house prices began rising sharply in many places. Although the overall level has reached its highest point since 1989, it remains well below the levels of the early 1980’s, when it topped 30%.

In high-profile places like New York and Los Angeles, home to many of the people who study and write about real estate, families buying their first home often must spend more than half of their income on mortgage payments, far more than they once did. But the places that have become less affordable over the last generation account for only a quarter of the country’s population. Elsewhere, families tend to spend far less on housing. In Dallas, the share of income needed to buy a typical house has fallen to 13% this year, from 14% in 1995 and 31% in 1980. In Tampa, it has dropped to 21%, from 26% in 1980. Even in New England, where the soaring prices of the last decades have frustrated many young families, house values have still not reached the heights of the early 1980’s, when calculated as a share of income.

Beyond cost, many families who simply could not have bought a house 10 or 20 years ago find themselves able to do so, thanks to changes in the ways banks lend money. In the past, a home buyer often needed to make a down payment equal to 20% of a house’s value to get a mortgage; today, little or no down payment is common.

Florida builders cut prices to sell homes, also offer cheap financing and free furniture.

Count this among the signs that, even in Southwest Florida, more than just the weather is cooling: Home builders, big and small, are shaving prices and some are offering free furniture, cash discounts and well-below-market, 30-year fixed-rate mortgages. High-powered builders in the region acknowledge the trend, though few are willing to talk openly about it. To counter the softness, in some segments, prices are being slashed, with 10% price cuts appearing regularly in listings.

Since before Thanksgiving, Lennar Homes, the nation’s No. 3 home builder, has been running full-page advertisements in Southwest Florida newspapers offering discounts, cheap financing and even free stuff from Rooms to Go. Lennar and its subsidiary, US Home, have built about 50,000 homes in the region, with about 17 developments in the Sarasota-Bradenton market. The company has built about 900 homes in the region just in the past 12 months. Now they are trying to move them out.

In a year-end push that expires New Year’s Day, Lennar offered a 4.99%, 30-year fixed-rate mortgage on selected slow-moving properties. That kind of mortgage averaged 6.30% nationwide last week, meaning that on a $100,000 mortgage, buyers could save about $1,000 per year, or almost $30,000 during the life of the debt. On other properties, Lennar offers buyers the choice of below-market rates of 5.0229% or “cash discounts”. The discounts run into tens of thousands of dollars, reaching 10% of previously-listed asking prices. It is partially a seasonal issue, but it also reflects what many see as an inevitable plateau after the record gains of the last few years.

Tangible signs of discounting have emerged, and while most builders and brokers are loath to talk about them, the statistics on existing single-family homes tell the tale. The number of unsold Sarasota houses listed for sale has more than tripled from a year ago, local Multiple Listing Service data shows. In November 2004, it stood at 1,025, but by the end of November 2005 the number had ballooned to 3,525. As inventory levels rose, big builders took note and began cutting prices, dragging smaller investors and private sellers along for the ride.

Pardon my premature call on housing.

Two graphs hang in front of my computer. One is old, the other new. Both provide constant inspiration. The old one, titled “Credit Crazy?”, shows total U.S. debt as a percentage of GDP. The most recent update has debt pushing 310% of GDP, burying the record 287% set during the Depression. The new one, “Reset Risk in the Mortgage Universe”, depicts the number of adjustable-rate mortgages that will reset through 2015. The number peaks next fall.

Good old “Credit Crazy?” explains why I have been wrong about housing for so long. I thought the bubble would start to pop long before it did. I called it too early. Never in my wildest visions of the future did I think households would sacrifice their primary asset – their home – to put themselves so deeply into hock, for so long. I blame my naive, misplaced notions about taking pride in homeownership. Lest we forget, 2005 will go down as the year the savings rate turned negative.

No doubt, I would rather have called the bubble minutes before it popped. Better early than late. Mark this: Care of the Federal Reserve, starting now and peaking when the leaves change, millions upon millions of adjustable-rate mortgages will reset at much higher interest rates. Housing’s apologists have had little trouble whistling past bulging inventories. I doubt the same will occur with the coming spike in delinquencies and foreclosures.

Key homebuilder and retail charts to be resolved soon.

Going into the New Year, there are some key charts highlighted tonight, that may provide some opportunity to either make money or avoid risk in the stock market. It is best to keep your eye on the long term trends, and know the difference between a bull, trading range, and a bear market. It will be important for the U.S. Consumer to keep spending money on homes and retail goods if the economy is to continue to stay “healthy” in the way that it has over the last few years. There is the potential that the charts of the homebuilders and retailers may provide some insight into whether the U.S. consumer led boom will continue well into 2006. Many of these charts are at key technical levels where their intermediate direction is likely to be resolved soon.

The 2-year chart of the DJ US Home Construction Index shows that the index may have topped in July of 2005. From July to October of 2005, the index suffered some serious technical damage as the homebuilder index suffered a drop of about 30%. Since that time the homebuilders recovered only about one-half of the drop off the summer high. The index now sits just above its 50 and 200-day moving averages and is at a critical technical position. What is different in the action of the homebuilders now versus a few months ago is that there is a difference in performance between the builders. This disparity in performance ranges from healthy and bullish charts to strictly bearish as depicted in the chart of Beazer Homes (BZH), versus that of William Lyon Homes (WLS). There may be some regional effects that are being reflected in the stock charts as Lyon Homes primarily operates in Southern California, San Diego, Northern California, Arizona, and Nevada. These areas are generally those most associated with the real estate bubble in the western U.S.

Some better perspective on the homebuilders may be gleaned by viewing the long term chart of the index from January of 2000 to the present. As with the shorter term chart, it is clear that 800 is an important technical level for the homebuilders. A decisive break below the 800 level would signal the end of the bull market in homebuilding stocks. Yet, it is also relevant that in their bull run from 200 to over 1000, the homebuilder’s index has suffered several corrections that were similar in magnitude as the recent correction off of the summer of ‘05 high.

The Retail Holders ETF sits about where it did in early 2002 at about 97 – a key technical level – which has acted as resistance three times in the past between 2002 and the present. If 97 acts as support, that would be bullish for retail. Within the retail sector, major department stores have been a consistent market leader. There are now several department stores, including Federated Stores (FD), JC Penny (JCP), Nordstrom (JWN) and Sears Holdings (SHLD) that are now at or near key technical levels where their near term action may prove crucial to the behavior of entire retail sector.

DARWIN VS. GOD: NOW, A GERMAN DEBATE

Right in time for Christmas, Germany got a dubious “present”: A debate on the issue of “intelligent design” vs. evolution. “A small group in Germany,” writes Deutsche Welle, which “believes that an ‘intelligent designer’ created life, is claiming that evolution is not the scientific explanation for our planet’s existence.” In the U.S., “intelligent design” has been a hot public topic for several years. In this country, the debate has gotten so heated at times that courts have had to interfere. In Germany, it seems, things are just getting warmed up. Germany’s most vocal group advocating “intelligent design” is Wort und Wissen (“Word and Knowledg”q). The head of Wort und Wissen is a German microbiologist and a co-author of a controversial book Evolution – A Critical Textbook, which the group has been donating to libraries as “additional informational material for teachers and students.”

One key ingredient for creationism to become a prominent topic in Germany seems already in place – namely, society’s growing polarization. German scientists strongly oppose the “intelligent design” theory, calling Evolution – A Critical Textbook “a successful piece of German neo-creationist propaganda.” It is not the goal of this column to take sides in public discussions. When it comes to analyzing social trends, we do not focus on “why?” as much as we do on “why here?” or “why now?” And we think it is quite telling that, although Wort und Wissen has been around since the early 1980s, “public and media interest in its work has only developed recently.”

Why only recently? We think it has to do with the state of Germany’s social mood. It suffered from a major bear market in 2000-2003, as indicated by the losses in German stocks. Stocks in other countries got hit hard five years ago as well, suggesting a global downshift in social mood. And with it, came polarization, a trait that intensifies in bear markets. As our own Elliott Wave Theorist once observed, “There is a moral polarity developing in the world. On one hand are the anything-goes amoralists and artists pushing the envelope, and on the other are the we-want-to-control-you moralists – religious, social and economic – and the soaring popularity of fundamentalist religion worldwide. Even creationism is making a comeback.”

Will the German “intelligent design” debate intensify or subside? The long-term trend in Germany’s social mood is the answer. And since its best indicator is the German stock market, a quick look at the DAX’s long-term Elliott wave pattern can tell you volumes.

INVESTORS LOOK HIGH (RISK), LOW FOR RETURN

The great tech bubble of the ‘90s taught us that red-hot markets will burn you. But ice-cold ones can hurt, too. Long periods of low returns are to the financial system what the warm waters of the Gulf of Mexico are to tropical storms. They breed catastrophes. Low returns turn up the heat on investors to earn better returns. Pension funds fear they will not meet their obligations. Retirees fret they will run out of money. Insurers worry they will not be able to meet future claims. Some of them start to toy with more sophisticated investments: hedge funds, emerging markets, derivatives. As managers stray further afield to score higher returns, risk rises.

The major stock averages have not even beaten Treasury bills the past five years. T-bill yields are still near 4%. In recent months, some market observers have noted a worrisome surge in institutional money – perhaps even your pension money – flowing into risky investments. This month, the Bank of England’s semiannual Financial Stability Review warned that institutional investors seeking higher yields were starting to defy risks. No problem so far. But if the economy slows – or some unforeseen event rocks the market – those sophisticated bids for higher returns might not look so smart. Legendary investor Warren Buffett has called the growing market in financial derivatives – complex agreements among investors – a “ticking time bomb”.

Returns do not get much flatter than they have been the past five years. The S&P 500 has gained less than 1% a year the past five years – and that is only if you include reinvested dividends. Three-month Treasury bills have averaged 2.1% annually. Only bonds have fared decently. The Lehman Bros. Aggregate Bond index has gained an average of about 6% a year in the past five years. Investors seeking higher returns have a whole menu of alternatives – and they are using them.

In theory, adding alternative investments such as commodities, derivativesand real estate can reduce big price movements and add performance. But everyone might not understand the risk. For example, one popular alternative investment is private equity funds. These funds buy private companies, often with borrowed money, a technique called leverage. Leverage amplifies gains. But it magnifies losses, too. “A publicly traded company that used extreme leverage to buy other companies would get downgraded by the credit-rating agencies,” says Kenneth Heebner, manager of CGM Capital Development. “But private equity has a cachet to it. So when they do it, it’s considered smart.”

Worldwide, institutional investors are expected to allocate record amounts to alternatives through 2007, according to the Russell Investment Group, a research firm. Investors have plenty of other alternative investments available, many of them carrying similar risks, including hedge funds, derivatives, and emerging stock markets.

Not everyone is worried about alternative investments. Scott Abel, senior investment consultant at Hewitt, says pension funds might be exploring alternative investments, but few are heavy users of them. “The average pension fund exposure to hedge funds is less than 5%, and that hasn’t moved significantly in the past three years,” Abel says. The most popular alternative investment in pension funds: commercial real estate, which doesn not tend to be as risky as other unorthodox investments. Other institutions, such as college endowments and foundations, might be heavier users of alternative investments, CGM’s Heebner says. Though some institutions might get burned, he does not think that would cause an economic meltdown. “There’s a huge excess, but it’s spread around,” Heebner says. “When the chickens come home to roost, it won’t be overwhelming to any one sector. When a college endowment is down 10% and the market is up 5%, it means tuition will go up – not that the Fed will have to get involved.” But Mark Kiesel, a portfolio manager at Pimco mutual funds, thinks disaster could creep up on those who overuse alternative investments, particularly derivatives.

CHINA LAYS DOWN GAUNTLET IN ENERGY WAR

On December 15, the state-owned China National Petroleum Corp (CNPC) inaugurated an oil pipeline running from Kazakhstan to northwest China. The pipeline will undercut the geopolitical significance of the Washington-backed Baku-Tbilisi-Ceyhan (BTC) oil pipeline which opened this past summer amid big fanfare and support from Washington. The geopolitical chess game for the control of the energy flows of Central Asia and overall of Eurasia from the Atlantic to the China Sea is sharply evident in the latest developments.

Making the Kazakh-China oil pipeline link even more politically interesting, from the standpoint of an emerging Eurasian move towards some form of greater energy independence from Washington, is the fact that China is reportedly considering asking Russian companies to help it fill the pipeline with oil, until Kazakh supply is sufficient. Initially, half the oil pumped through the new 200,000 barrel-a-day pipeline will come from Russia because of insufficient output from nearby Kazakh fields, Kazakhstan’s Vice Energy Minister Musabek Isayev said on November 30 in Beijing. That means closer China-Kazakhstan-Russia energy cooperation – the nightmare scenario of Washington. Simply put, the U.S. stands to lose major leverage over the entire strategic Eurasian region with the latest developments. The Kazakh developments also have more than a little to do with the fact that the Washington war drums are beating loudly against Iran.

Given the nature of the Bush administration’s rush to war in Iraq in 2003, where China had a major stake in oil development, and the subsequent U.S. blocking of other Chinese attempts at securing energy independence, including Unocal, it is not surprising that Beijing is taking extraordinary measures to secure its long-term oil and gas supply. Energy is the Achilles’ heel of China’s economic growth. Beijing knows that only too well. So does Washington. A decision by Washington to take military action against Iran now would pull a far larger cast of actors into the fray than Iraq.

CEREBRAL STRIPTEASE

Sorry ladies, there will be no “Boys of the Rude Awakening” calendar this year. Instead, we bring you an extended email debate among the Boys of the Rude Awakening … just to expose a small slice of their sexy minds. For more than three weeks, Chris Mayer (editor of Capital & Crisis), Justice Litle (editor of Outstanding Investments), Dan Denning (editor of Strategic Investments), Byron King (contributing editor of Whiskey and Gunpowder), William Bonner (editor of the Daily Reckoning) and Addison Wiggin (co-editor of the Daily Reckoning) have been debating the gravity and the implications of America’s titanic current account deficit. Based on the latest data, the U.S. current account deficit is running close to $800 billion per year, or more than 7% of GDP. Those are very big numbers.

Traditional macro-economic thought considered massive current account deficits to be undesirable, if not catastrophic. But the “new think”, advanced by folks like Charles and Louis-Vincent Gave in their book, Our Brave New World, asserts that current account deficits – even great, big American-style deficits – reflect economic vitality. In other words, they are a good thing. “The current account,” the thoroughly modern authors assert, “in countries with well developed financial markets (US, UK, HK etc.) should always be in deficit, and massively so.” Continuing this line of thought, Prof. Thorsten Polleit writes, “Under the prevailing flexible exchange rate regime, the US trade deficit should not be viewed as a worrisome economic ‘imbalance’ that will inevitably have to be corrected. So far, the US trade deficit seems to be a reflection of the US economy’s strength vis-à-vis its trading partners. And it might well be that the US trade deficit will continue to widen in the coming years – which would be the case if the United States’ trading partners prove to be unsuccessful in making their economies more conducive to investment and growth compared with the status quo.

“So the essential issue about the future of the US trade deficit is whether and how the current relative growth performance constellation in the world trading system will be changing in the coming years. As long as the United States keeps its preference for a free market regime, it might well retain, or even increase, its competitive advantage in allocating scare resources more efficiently than currency areas where relatively wide-spread government interventions have become a characteristic of societal organization. In today’s world of flexible exchange rates, the United States’ competitive edge is reflected by a capital surplus, i.e., a trade deficit.” (Rest of Prof. Polleit’s article here.) Um … okay.

Notwithstanding their clever arguments, Messrs. Paillet, Gave and Gave failed to persuade your New York editor that large current account deficits have become desirable national attributes. But the trio did succeed in inspiring an impassioned debate among the Boys of the Rude Awakening. So without further ado, let the cerebral strip-tease begin. …

$300 FLIP-FLOPS AND CYBER FEUDALISM

“Check out the spread between Coach and Wal-Mart (COH/WMT),” suggests Dan Denning. “Coach sells $300 flip-flips, Wal-Mart sells $3 flip-flops.” Who earns more per pair of flip-flops? Whose stock is going up? Dan thinks he sees something more than passing consumer preferences. What he sees is a New World.

In this New World – this post-industrial society in America – the average working man is losing ground. He has no way to force employers to pay him more money. They can just move his job to Asia! For the last 20 or more years, he has hidden this horrible truth from himself and his family – by going further and further into debt. He goes shopping at Christmas time … and each year he brings home more iPods, PSPs, home entertainment centers and other paraphernalia he does not need and cannot afford. He pays on credit, counting on rising house prices to keep him going.

But the rich are making real progress – all the numbers show it. They are buying $300 flip-flops and $3 million beach condos. They can do it, because their own sources of revenue are less threatened by Asian competition. They are judges and lawyers, managers, hacks and bureaucrats, entrepreneurs, psychologists and political fixers. They are the people the average man will come to hate. But they are the ones who benefit from the New World. They are able to keep up with the international class of rich people, while their slower countrymen fall behind. It does not seem to matter where they live; their work is protected from low-priced competition … and their financial assets become more valuable. The companies they own (at least theoretically) can hold down labor costs and become more profitable. Their land and houses rise in price. So they bid against each other for prestige and bragging rights – for seats in fancy restaurants, for designer flip-flops, for exclusive beach houses, expensive sports cars and ugly modern art. Luxuries are soaring in price while Wal- Mart continues to offer the lumpen Everyday Low Prices.

Justice Litle describes this New World as a kind of “Cyber Feudalism”. Feudalism was a system of Lords and Serfs. The Lords were Knights who could afford the expense of expensive horses, stables, armor, etc. The “Lord” equivalent today is the capitalist who can afford a rapidly increasing cost of living in an inflationary global environment. The serfs of old were trapped by a lack of skills and a lack of base from which to build assets. The same is happening to today’s left-behinds, who are forced to mortgage their lives and souls to the banks. In the feudal system, the Lords were collectively more powerful than the King – and the King thus had to deal with the Lords gingerly, bargaining whenever possible. In modern parlance, the Kings are governments. Today’s Lords wield their power via globetrotting companies, which are growing ever more powerful. This is the New World. We are not sure we like it. But we know which class we want to be in.

SECRETS OF THE NEAR DEAD

If the dead have secrets, what about those who are almost dead? We read an interview with Sir John Templeton. The great old man said he thought shares and houses in America were too expensive and that the United States was cruising for trouble with its trade deficit and U.S. federal deficit. He said he anticipated a long bear market in shares, falling residential real estate prices and a serious slump in the economy. Implicitly, he advised investors to hold cash. The person who wrote the article then asked local analysts and stockbrokers what they thought of Templeton’s opinion. One challenged Templeton’s competence, saying that because of his advanced age (Templeton was 92), he might be “out of touch” with current thinking. Templeton was not even dead yet, and already they were shoveling the mud on his face. But being out of touch is precisely what made his opinions valuable.

We like old things. Old buildings. Old ideas. Old trees. Old rules. Old investors. The older the investor, the more confidence we have in him. He has seen good times and bad times. He has seen bulls and bears. People who have been around for a long time have had an opportunity to see several cycles. An American born after 1960, on the other hand, barely came of age when the 1982 to 2002 boom began. He has never seen a sustained bear market or a period when the nation was downcast or desperate. Templeton was a young man when Wall Street crashed in 1929. He was an adult in the Great Depression. He recalls the dark days of World War II, when it looked as though the allies might lose. During his life span, there have been booms and busts, mass murders, the worst wars in history, famines, hyperinflation, and national bankruptcies. Dozens of currencies and at least five empires have gone defunct. Dozens of coups and revolutions have taken place. Ideologies have come and gone. Thousands of banks and businesses have gone bust. Prominent careers have been ruined and reputations lost. A man who has seen so much and still has his wits about him is a great treasure. If he is still solvent, that is even better. Somehow, he must have avoided the bad ideas, bad investments, and bad advice.

A young man has access to information. With the Internet, he can get all he wants. What he lacks is the “high-proof” distilled information – the wisdom – that comes with age. Distilled information tends to be expressed as moral interdictions. Do not steal. Do not lie. Do not buy expensive stocks or sell cheap ones. Do not expect to get something for nothing. Do not neglect your spouse, spend too much, eat too fast, drink before 6 p.m., or mess around with the boss’s wife. Each don’t represents lessons learned by previous generations. For every moral, there must be a million sorry souls burning in Hell. Undistilled information, on the other hand, is nothing more than noise – newspaper headlines, TV babble, cocktail chatter, the latest innovation, the latest business secret, the latest fashion. It is public information, backed by no real experience or private insights. It is not useless. It is worse than useless, for it misleads people into thinking they know something.

An entire American generation has grown up being told that it could spend its way to prosperity. Snow, McTeer, Greenspan, Bernanke – they all still believe it. Debt is no problem, they say. Spend, spend, spend. American spending created a boom in China, where the average person works in a sweatshop, lives in a hovel, and saves 25% of his earnings. Meanwhile, in the U.S., the average man lives in a house he cannot pay for, drives a car he cannot afford, and waits for the next shipment from Hong Kong for distractions he cannot resist. He saves nothing and believes the Chinese will lend him money forever, on the same terms. That this cannot go on forever hardly seems worth pointing out. Whether it will go on much longer, we cannot say. But that it will end badly seems a cinch.

We can barely wait to find out how it all turns out. Maybe a year from now. Maybe 2 … 5 … 10 years. We want to know the precise date on which the imperial consumer credit economy stops muddling through. For it must shake, rattle, and roll over some day. Everything does. The day may come and go without notice. The world created in the pax dollarium era may end with scarcely a whimper and no bang whatsoever. But it will end. Then the dead will cluck: “I told you so.”

THE SPECIOUS STORY OF THE YEAR AWARD FOR 2005

“Bad writers are nearly always haunted by the notion that Latin or Greek words are grander than Saxon ones,” or so said an author I admire. Still, there are exceptions to the plain-instead-of-fancy rule: A student who needs to beef up a feeble essay may try to impress the teacher by choosing a word like “specious” over “fake”, for example. Not that I ever did such a thing – yet I have become especially fond of “specious”, having seen all its synonyms via the Thesaurus tool in Microsoft Word. The complete list includes false, hollow, erroneous, baseless, inaccurate, unfounded, fallacious, phony, sham, bogus, incorrect, untrue, unsound, wrong, spurious, misleading, and deceptive. “Why all these words?”, you ask? Because words are all I have to tell you what I think about the market-related story of 2005 which is MOST deserving of the title SPECIOUS and all its synonyms.

The winner is … Energy Prices, which U.S. newspaper and broadcast editors named the top business story of 2005, in a survey by The Associated Press. A full telling of this story includes a lot more than prices – imaginary shortages, unnecessary lines at gas stations, shameless politicians, ignorami testifying before Congress about “peak oil”, junk forecasts of $100 per barrel crude, not to mention a media establishment still talking about the importance of energy prices three months and a 1/3 decrease in price later.

Not that a “full telling” will be told by anyone in the “top story” crowd, obviously, so here is another story to consider. The Wall Street Journal just published a “top story of 2005” list of its own, based not on guesswork and opinion, but on a measurable result: the clicking habits of subscribers to the newspaper’s online edition. Naturally, not ONE story in this list of 25 was remotely related to energy prices. For what it is worth, two iPod stories were on the list, as was the decision by Google executives to purchase Boeing’s 767 for the company jet. If the contrast between click-throughs and energy prices as top story helps you understand the disconnect between reporters/editors and their readership, well, so much the better. There really is no mystery to why newspaper circulation has fallen off a cliff.

“TIMING IS NOTHING”?

Last decade, most investors considered technical market analysis rather ludicrous. Why waste time studying charts when you can just “buy and hold”? Most stocks you bought were on their way to new highs anyway, and market timing was decidedly out of favor. Well, now it is back in. Rather than relying on the good old economic fundamentals, more and more market professionals “battling difficult trading conditions in increasingly sophisticated and crowded markets” are turning to technical analysis. Why? “After the stock market bubble burst in the late 1990s, people realized that timing really does make a difference” (Reuters). And timing is what technicals are all about.

What is interesting, we have noticed that historically, the popularity of technical analysis changes with the broad trend in stocks. In bull markets like the one we saw last decade investors use it less. In bear markets, technicals always seem to make a comeback. As Robert Prechter says in the current issue of The Elliott Wave Theorist, “In 1982, after 16 years of sideways markets (and four recessions), the majority of interviewees on Financial News Network were technicians. By the late 1990s, after many years of advance, the vast majority of interviewees on CNBC were economists and money managers. In November 1998, an ad in The Wall Street Journal read, ‘Timing is NOTHING.’ Thirteen months later the S&P lost half its value.”

The number of available technical tools goes far beyond the popular “candlesticks, trendlines and bollinger bands”. All of these methods do a good job of illuminating the way for traders, yet most fall short for one reason or another. For example, some studies are great for identifying the trend, but they do not tell you if the trend is new or old, or how far it may go. Elliott wave, of course, is also a technical tool – but a far more comprehensive one than most. It helps you to identify the broad trend, the countertrend moves, maturity of trend, price targets, stop-loss points and high-probability trades. And, it works in any market with mass participation, in any timeframe. Of course, economic fundamentals still matter. But “everybody is working together these days because the market is just too tough.” Having a good technical perspective really helps, and the pros know about it.

COCOA’S “CONTRACTING TRIANGLE” – SET TO BEAR FRUIT?

The television program 60 Minutes recently broadcast a segment about last yea’s devastating Tsunami. We just passed the disaster’s one-year anniversary, so the story is one of many. But this one is uniquely significant for traders – because inadvertently, it sheds light on the current situation in the cocoa market. The relevant bits of the segment are easy to summarize. On a remote island off the coast of Thailand, a village of “sea gypsies” was utterly swamped by the wave. The island was one of those the Tsunami hit hardest. Yet not a single soul in the tribe died, thanks to their intimate understanding of the ocean and its signals.

When the surf receded beyond normal low tide levels, the villagers noticed and took action. Those on land quickly moved to higher ground, and those at sea paddled farther out to avoid the biggest swells. The wave hit coastlines throughout the Indian Ocean; 275,000 died, yet this tribe suffered no lasting casualties, because its members knew the water’s unusual contraction was a sign of something much larger, before the Tsunami appeared on the horizon.

The surge we expect to see in cocoa prices pales in comparison with the scope of this disaster. But if you deal with soft commodities, you will want to see and understand cocoa’s current “contracting” price pattern before the next Elliott wave gets underway. On December 1, cocoa prices thrust through a trendline that had held for eight months, but the market has not exactly moved in breakout fashion since then. Instead, prices have been hovering just above that key level for weeks. But this sideways action is not simply “consolidation”. All the while, the market psychology behind price moves has been tracing out a pattern R.N. Elliott dubbed a “contracting triangle”.

Senior Analyst Jeffrey Kennedy spells out the reasons why this pattern is significant in the latest Monthly Futures Junctures, which features a similar but much larger triangle in sugar: 1.) You know exactly where you are in the larger wave sequence: “A Contracting Triangle can only occur in the wave four, B or X position.” 2.) You know the quiet back and forth probably precedes a storm: “Contracting Triangles are exciting wave patterns, because they portend swift, sizable moves in price.” 3.) You know whether to be bullish or bearish about the upcoming move: “The ‘thrust’ out of a Contracting Triangle moves in the direction of the larger trend.”

ORANGE JUICE: A NEW YEAR’S TREAT?

Even the kids get to stay up past midnight on New Year’s Eve; some older souls will be up to welcome the first dawn of 2006. By breakfast time on January 1, few will have much energy leftover, but the wise ones will make the most of their leftover champagne – by adding a little orange juice, mimosa style. Yet you need not be a lush to enjoy the prospects for orange juice on New Year’s Day. Look back on the past year in O.J. futures and you will see the kind of bullish price action that makes for sensational copy this time of year. Juice prices closed out 2004 near 86 cents per pound; they were pushing 122 when Friday’s (Dec. 30) NYBOT session ended.

Skim over the commodity “year in review” report in your favorite mainstream news source, and you will find explanations aplenty for the whopping 42% surge. They may mention crop damage from citrus canker in Florida or increased demand for juice from the ever-thirsty Chinese. And hurricanes Katrina and Wilma are sure to show up as the prime culprits in this episode of the supply-and-demand blame game. Each of these factors starred as the explanation du jour several times over the course of the rally. As usual, this game and its attendant rationalizations often appear to make sense because they follow what has already happened in the market. Hindsight is a luxury enjoyed by reporters, but unfortunately one that is far less helpful for traders.

Yet long before the devastating hurricane season, before the weeklong winter swing from 87 to 100 cents per pound, the Elliott wave pattern in orange juice suggested that we were about to witness a dramatic rally. In the February Monthly Futures Junctures editor Jeffrey Kennedy surmised that the mid-2004 low was a significant long-term bottom, and that O.J. was ripe for a move that would leave no doubt about the trend. Our long-term “Wave Watch” feature in the latest MFJ suggests O.J. may make a move in 2006 to rival the size of the past year’s rally. But the more pressing Elliott patterns appear on the daily and intraday charts. Though the scope or “degree” of the upcoming impulse means that this thrust will take prices a fraction of the distance they have traveled these past months, the basic characteristics should be the same: swift and sizable.

THE 2005 “SPEND LIKE A DRUNKEN SAILOR AWARD”

In 2005, the political party in power presided over the largest-ever Federal budget and largest-ever budget deficit. Meanwhile, the opposition party said these spending levels were deficient and heartless. Thus you might think it is easy for me to identify a specific example that has earned my 2005 “Spend Like a Drunken Sailor” award, but rest assured: I do not always choose the path that is “easy”. This is why I am presenting this year’s award to – drum roll please – “Cuts” in Government Spending!

Now, I was sorely tempted to disregard this year and jump ahead to the award for 2009. Yes, I already know what that year’s award will be, since Congress hath dictated ‘09 as the time when TV station broadcasts must be 100% digital – which leaves analog TV owners plum outta luck … ummm, okay, not really. Uncle Sam has a plan for analog TV owners, via a $40 voucher (or two, if you need them), so that you can still use your obsolete technology. Please do not ask any questions, I am not bothering to spell out the details. As for folks who say forty bucks is only fair because the government should not take away something without giving something back, well (as one wag asked), “Ever heard of taxes?”

Where were we? Oh, right – cuts in spending!! You may have read about “cuts” in spending recently, but just so we are clear: There have been NO cuts in Federal spending for coming fiscal year, nor will there be. Spending will go up. The only point of debate is over the rate of increase. Say, for example, the budget for XYZ program is $50 billion in this fiscal year, with a budget of $58 billion projected for the coming fiscal year. But if the actual budget allocation ends up at $56 billion, it is called a $2 billion “budget cut” – and so it goes.

“Cuts” are code language for a slower rate of increase. Which is why “Cuts In Spending” get the “Spend Like a Drunken Sailor Award” for 2005.

NATURAL GAS PRICES: COOLING DOWN OR HEATING UP?

If one or more of the following items were on your wish list this Holiday season – a dozen pairs of wool socks, candlesticks, an energy “gift card”, or the official Boy Scouts guide to building fires by rubbing two sticks together – Chances are, you spent a lot of time with your nose in the mainstream financial news stories on natural gas. Thing is, come mid-December, natural gas prices had soared to an all-time record high beyond $15. And, according to the “experts”, this energy market’s upside potential was far from limited, due to the bullish fundamentals of cold weather and supply shortages.

These headlines from the time say more than enough: 1.) “This is the winter of our discontent and also of our discomfort. We are seeing the cost of natural gas heading for the moon. How are your survival skills?” (The Rock River Times) 2.) “Cold weather and supply interruptions could push natural gas as high as $20 per thousand cubic feet. Predicting natural gas prices for the rest of the heating season is largely a matter of forecasting the weather.” (MSNBC) 3.) “Traders are really starting to realize that this cold weather is just not going away anytime soon. Look for more record prices to be posted in the weeks ahead.” (Associated Press)

Freezing rain, sub-zero temperatures, and ice storms in the dead of winter – is it just us or are these not pretty standard for this time of year? Last we checked, the song does not go: “Oh the weather outside is BRIGHTful.” Not to mention the fact that basing a short-term trade strategy on weather patterns is about as smart as painting with watercolors in the wind … as the energy market proved in no time. Check the charts: Since peaking on December 13, natural gas prices have plunged 23% to a 4-month low. Observe this December 28 explanation for the steep selloff in natural gas: “We’ve got a lot of above-normal temperatures forecasted form now into January and it’s hard to get people to step up and buy.” Need we say more?

As for the idea that natural gas inventories are in danger of depletion, consider this December 20 Energy Department report: supplies of natural gas are 6.3% above the average for the past five years. No matter the reading on the thermostat, the fact is, traders who followed the word on Wall Street regarding the future of natural gas were left out in the cold. And no amount of wool socks can take that kind of chill off. So, the question is: are natural gas prices set to cool off or heat up again in the days and weeks ahead?

U.S. GROWTH IN 2006 MAY HINGE ON BUSINESSES

The housing market is gradually fading as a prop for the economy, eroding a source of increased wealth that allowed consumers to borrow and spend avidly in recent years. Meanwhile, the bond market, where short-term interest rates are now slightly above long-term rates in what is known as an inverted yield curve, suggests that the economy is headed for a sharp slowdown, perhaps even a recession. The stock market rally earlier this year has petered out. So why do most forecasters predict that economic growth will remain relatively strong next year? Perhaps because they are counting on other sectors that have been relatively weak – particularly stepped-up business investment – to help sustain the robust expansion of the last 30 months.

“I think the surprise will be that housing prices and housing sales will decelerate, but the economy will do just fine,” said Richard Berner, chief domestic economist for Morgan Stanley. Mr. Berner is not alone in his optimism. Despite some worrisome indicators, only a handful of the 53 economists surveyed by Blue Chip Economic Indicators predict that the growth rate in 2006 will drop much below the 3.7% average so far this year. That outlook also assumes that consumer spending, deprived of the lift from rising home prices and mortgage refinancing, will not drop very much.

Forecasters are notorious for missing major turning points in the economy. Still, as home construction and home sales subside and consumer spending eases off, most experts see a different powerhouse kicking in to keep the economy on its upward path. The prime candidate is capital investment – the spending by business on all the equipment and facilities needed for production. Business contributed powerfully to the boom of the late 1990’s by investing generously in high-tech machinery and computers, but then cut back sharply in the dot-com bust, helping to weaken the economy. Now an upturn in this spending in the spring and summer months has raised expectations that corporate America has finally begun to replace aging and outdated equipment, drawing on record profits to do so. “Business has tons and tons of capability to spend,” said James W. Paulsen, chief investment strategist at Wells Capital Management in Minneapolis. “The longer the recovery keeps going and stock prices go up, the more and more confident business is going to become and the more it will spend on its operations.”

The anecdotal evidence is mixed on this score. For the economy as a whole, matching last year’s outlay, no matter how hefty, adds nothing to economic growth. There must be more investment, and a new survey of chief financial officers, sponsored by Baruch College and Financial Executives International, suggests that there will be. Two-thirds said their companies planned to increase capital spending in 2006 by 8 or 9 percent, a rise reminiscent of the late 1990’s. But Haas Automation in Oxnard, California, a big manufacturer of the machine tools installed in factories to cut and shape metal, expects sales to be only marginally better next year. Apart from capital spending, many forecasters expect contributions to growth from other sources, such as exports.

CORPORATE HEADLINERS CONJURE ‘70S FLASHBACK

Boy, for a while there the business headlines of 2005 started sounding uncomfortably like those of the 1970s. Oilmen had not been looked upon with such scorn since the days of J.R. Ewing, as the outrageous price of gas was overshadowed only by the outrageous price of designer jeans. Luckily, it appears the worst of it was only a temporary flashback. By the end of the year, we were blissfully back in the brave new world, stuffing stockings with 21st-Century gadgets and stocking up on Tamiflu in case our true love gave us a partridge in a pear tree. But many of the big winners and losers of the business world in 2005 still have a noticeably retro feel, perhaps because some are old enough to have entered early retirement in the 1970s. So forgive us if we cannot get some of those ‘70s tunes out of our head.

JACK WELCH SET THE BAR TOO HIGH?

Jack Welch, the former CEO of General Electric, is known far and wide as a brilliant business executive. But the December 26 issue of Barron’s reveals that some of his apparent success may have been due to other factors:

Jack Welch, General Electric’s demanding former chief executive, delighted in setting the bar high. When he stepped down a few days before Sept. 11, 2001, he left his successor, Jeffrey Immelt, the challenge of matching a remarkable string of years of strong profit growth. What was most remarkable about those years, however, wasn’t apparent to anyone outside the company until recently. The bar might have been set artificially high.

During the last five years of the Welch era, ended in 2001, GE’s reported earnings jumped from 72 cents a share to $1.37, a rise of 65 cents a share, or 90.2% – spectacular for a behemoth like GE. But without a massive under-reserving at its reinsurance unit, the company would have shown a cumulative earnings gain of just four cents, or 5.6%.

Those who follow corporate finance know that there is a big difference between a cumulative gain of 65 cents vs. 4 cents over five years. But numbers can be tricky, and even the best fundamental analysts cannot ward against this sort of fudging. That is just one reason why it is useful to be knowledgeable about technical analysis, which follows patterns in price charts, rather than depending on fundamentals, such as a company’s reported earnings. For a fuller discussion of why technical analysis becomes more fashionable than fundamental analysis when it does, read this excerpt from Bob Prechter’s current December Elliott Wave Theorist.

RESTATEMENTS OF EARNINGS IN 2005 TO BREAK RECORD

According to Glass Lewis, which provides research to institutional investors, 971 public companies restated their earnings in the first 10 months of this year, vs. 619 for all of 2004. Although final figures for the last two months of the year are not in, the total number of restatements for the year could hit 1,200, says Lynn Turner, managing director of research at Glass Lewis – “… an all-time record, by a long shot.”

Earnings restatements tend to be bad news for companies and their investors, since they raise the question of whether management has been manipulating the numbers. Stock prices often drop when companies acknowledge a restatement is required. As a result, companies try to avoid restatements at all costs. The main reasons for the record-breaking number of restatements this year are implementation of Section 404 of the Sarbanes-Oxley Act, greater sensitivity on the definition of “material” differences in earnings due to accounting errors, and newfound assertiveness among auditing firms.

WE ARE AT THE PRECIPICE, SAYS A COMMUNITY BANK PRESIDENT

We are about three years into a debt fueled economic and market recovery, measuring from late 2002 or early 2003. Borrowing became cheaper than at any time in 40 to 50 years as the Federal Reserve, in panic mode from 2001 to 2004, shoved short term interest rates to historic lows. The Fed’s solution to the stock market decline of 2000 to 2003 was to encourage debt accumulation and punish savers. Consumers responded with enthusiasm by borrowing money as though there was no tomorrow. Household debt payments as a percentage of income and total consumer debt each reached new extremes. Banks and other lenders responded to the Fed’s initiative by lending to most all willing borrowers. Standards for creditworthiness were relaxed time and time again. While real estate prices soared average home equity declined as mortgage debt accumulated faster than property values.

Throughout this burgeoning debt bubble savers lost out, especially those retirees relying on interest income form their hard earned savings. Those of us in community banks saw first hand how dismayed savers were to renew their 5% certificates of deposit at rates of 1.5% to 2.0%. The Federal Reserve Board members could not have been unaware of the devastating effect their decisions would have on such savers. While the debt bubble served to mitigate some of the fallout of the implosion of the stock mania, it also resulted in a bubble in a different asset class: property. After several years of rising real estate prices we are beginning to see this bubble, too, on the precipice of implosion. Mortgage applications are declining in number. Property prices are beginning to erode in some markets while the inventory of unsold homes has increased substantially.

The average consumer has become so debt saturated that there is reduced capacity for additional borrowing. Bankers are turning cautious for the first time in years. True to form for government bureaucracies, bank regulators are issuing new “guidance” which will restrict real estate lending. They hasten to close the barn door as they belatedly realize the cattle have already fled. Many of the above assertions are mere statements of what has transpired in the past several years. What will occur during the next few years will determine the fates of pension funds, stock owners, governments and consumers. Personally, I think we are in for turmoil in the markets and the economy. Below are my best guesses.

One of the reasons the stock market bubble of the late 1990s was not widely recognized is we were living inside the bubble. Living within the times of momentous events, in my opinion, restricts our ability to gauge the significance of such events. I think we are now within the debt and property bubbles.