Finance Digest for Week of January 9, 2006

LESSONS FROM 2005 MAY BE FLEETING

Confession time: I am still not ready to let go of 2005. I have gone through my annual ritual of trying to make sense of what went right and wrong on the global macro scene in the year just ended. In the spirit of mark-to-market accountability, it was as dispassionate and honest an assessment as I could muster. But the catharsis that normally accompanies such an introspective endeavor is missing. As I look back, I still have a gnawing feeling in the pit of my stomach that 2005 was a year of suspended animation.

The year just ended most assuredly did not go according to my script. An unbalanced world turned out to be more stable than I had thought. And despite a wide array of serious shocks – from hurricanes to spikes in energy prices – the expansion was both resilient and durable. The broad consensus of investors, businesspeople, and policy makers has taken great comfort from this benign outcome – hoping that a similar scenario is in the offing for 2006. A frothy start in the first few trading days of the new year underscores this hope. While I have learned never to say never, I must confess that I will be stunned if this year unfolds without a hitch.

It is quite possible that we are being too analytical in attempting to discern why it all went so well on the global macro front in 2005. It may simply be that the stars were in near perfect alignment, enabling the world to buy an extra year of time. I think the odds are low that an unbalanced world economy will continue to draw support from such a favorable constellation of forces. Reversals are possible on three fronts – the liquidity cycle, the U.S. property market, or the dollar. Shifts in any one of these areas could well be enough to transform the global outcome from benign to malign. The interplay between these forces could be especially lethal.

A turn in the global liquidity cycle would be the most worrisome development. This will come about only through the conscious design of central banks. Yet that is exactly what now seems to be under way. The world’s major central banks all seem focused on the same objective – a normalization of policy rates. The Federal Reserve was first to embark on this campaign, and some 325 basis points later, America’s monetary authorities are signaling that their mission is just about accomplished. The ECB has just begun the march toward normalization. Even the Bank of Japan, which has gone to extraordinary measures with its zero interest rate policy for nearly seven years, is dropping strong hints that the first step toward normalization. This shift in monetary policy represents a sea change for the global liquidity cycle. Even if persistently low inflation allows central banks to stop short of taking their policies into the restrictive zone, the transition from extraordinary accommodation to neutrality is a big deal. It is important to remember that the impacts of such policy shifts typically hit with 12-18 month time lags. That means that the impacts of the current tightening cycle are only just now beginning to trickle into the system. Moreover, as Andy Xie notes below, the recent deceleration of growth in Asian foreign exchange reserves may be an important early warning sign of a turn in the global liquidity cycle.

A post-bubble shakeout of the U.S. housing market is a second factor that I believe would challenge the extrapolation mindset of momentum-driven financial markets. The ongoing support of the seemingly unflappable American consumer has been heavily dependent on the wealth creation of the Asset Economy. A mere slowing in the rate of residential property appreciation would represent a significant headwind for a still income-short consumer. With most gauges of national house price inflation now looking “toppy” at best, there is good reason to believe that a significant slowdown in the pace of asset appreciation is in the offing. At the same time, a shift in the liquidity cycle points to reductions in home equity extraction – the monetization of property-based wealth creation. With interest rates on home equity loans having risen from 4% to 7% over the past 18 months, that is hardly idle conjecture.

The dollar is a third leg to this stool. Last year’s surprising rebound in the U.S. currency short-circuited much of the market-based venting that normally drives a current account adjustment. In momentum-driven financial markets, currency trends and capital flows tend to be self- reinforcing. The more the dollar strengthened, the more confident foreign investors – private and official – became in U.S. assets. It was the ultimate virtuous circle that then gave foreign investors little reason to seek concessions in the form of real interest rate adjustments that would provide compensation for taking currency risk. In the currency business, circles can quickly turn from virtuous to vicious – especially for economies with massive current account deficits. With the dollar having been under renewed downward pressure over the past couple of months, and with Chinese and Korean authorities hinting in recent days at official shifts in foreign exchange reserve management practices, this is a risk to take seriously, in my view.

Nor should these potential adjustments be treated in isolation from one another. If, for example, the dollar goes and real interest rates are bid up in response, adjustments to the U.S. housing market will undoubtedly be more severe. And with growth in internal private consumption remaining anemic in Asia and Europe, a loss of support from U.S.-centric external demand could deal an especially harsh blow to the global economy. That is when the pitfalls of a U.S.-centric global economy come home to roost. Relative to sanguine expectations, the U.S. economy could well be the weakest link in the global growth chain – underscoring the possibility of another year of under-performance for dollar-denominated assets.

In the investment business, we always caution, “… past performance may not be indicative of future returns.” Yet the broad consensus of market participants seems intent to throw such caution to the wind in extrapolating the experience of 2005 into 2006. The chances of ongoing support from the liquidity cycle, the U.S. housing market, and the dollar are fading quickly. Stars rarely stay in perfect alignment for long. My advice: Don’t rework your life around last year’s lessons – they stand a good chance of being far more fleeting than normal. And, now, I will let go of 2005.

SHANGHAI’S HOT HOUSING MARKET HAS FIZZLED AFTER A RUN-UP FED BY SPECULATORS

American homeowners wondering what follows a housing bubble can look to China’s largest city. Once one of the hottest markets in the world, sales of homes have virtually halted in some areas of Shanghai, prompting developers to slash prices and real estate brokerages to shutter thousands of offices. For the first time, homeowners here are learning what it means to have an upside-down mortgage–- when the value of a home falls below the amount of debt on the property. Recent home buyers are suing to get their money back. Banks are fretting about a wave of default loans. “The entire industry is scaling back,” said Mu Wijie, a regional manager at Century 21 China, who estimated that 3,000 brokerage offices had closed since spring. Real estate agents, whose phones would not stop ringing a year ago, say their incomes have plunged by two-thirds. Shanghai’s housing slump is only going to worsen and imperil a significant part of the Chinese economy, says Andy Xie, Morgan Stanley’s chief Asia economist in Hong Kong.

Although the city’s 20 million residents represent less than 2% of China’s population of 1.3 billion, Xie says, Shanghai accounts for an astounding 20% of the country’s property value. About 1 million homes in Shanghai alone – about half the number of housing starts for the entire U.S. in 2004 – are under construction. “They’ll remain empty for years,” Xie said, adding that a jolting comedown also was in store for other Chinese cities with building booms – including Beijing, Chongqing and Chengdu – though other analysts say the problem is largely confined to Shanghai. Shanghai’s housing bust comes after a doubling of prices in the previous three years, a run-up fueled by massive speculation. With China’s economy booming and Shanghai at the center of worldwide attention, investors from Hong Kong, Taiwan and elsewhere were buying as fast as buildings were going up. At least 30% to 40% of homes sold were bought by speculators, says Zhang Zhijie, a real estate analyst at Soufun.com Academy, a research group in Shanghai. “Ordinary people had no option but to follow the trend,” Zhang said.“qWorrying that prices would be even more unaffordable tomorrow, many of them borrowed from relatives and banks to buy as soon as possible.” The Shanghai government only pushed the market higher, he added. “Many of the officials said Shanghai’s property market was healthy and wouldn’t drop before the World Expo” in 2010.

DON’T LISTEN TO YOUR REALTOR, HOUSING BUBBLE IS REAL

Having lived and worked in San Francisco during the Tech and Dotcom bubble, I had a first hand glimpse into the bubble mentality and the irrational exuberance of your average consumer. From Dotcom companies throwing lavish parties (while reporting negative earnings) to college students investing their school money in the stock market, to the creation of short-lived “paper millionaires”, I easily recognized that this move up in the stock market was not sustainable. In the midst of this bubble, many people would look at their stock options or 401k plans, classify themselves as millionaires, and spend money in the economy that further propelled the rise up in the stock market and further expanded the bubble. The end result was that most of these stock options expired worthless, investors lost millions of dollars in the stock market, and the “paper millionaires” disappeared.

Throughout history, you will find notable examples of manias, Ponzi schemes, and bubbles that have ended up in disasters with investors cutting back on their spending and scrambling to atone for their financial mistakes. This scenario did not happen after the Dotcom bubble. Instead, investors shrugged off their losses as they saw the value of their homes skyrocket. Consequently, the rise up in real estate prices allowed them to continue spending and temporarily delayed the U.S. economy from heading into a major recession. I believe that 2006 will be the beginning of the bursting of the real estate bubble, and that this bursting will have immediate and severe consequences on the U.S. economy as a whole.

As real estate prices have skyrocketed in the last several years, there have been some people that have argued that the move up in real estate prices is sustainable. Mortgage Brokers, Real Estate Agents, Appraisers, and people who lack an understanding of the markets have argued that rising real estate prices are purely based on supply and demand. They point to the fact that the supply of housing is decreasing, while the demand for these homes are constantly increasing. This argument, however, is flawed. In the last several years, homebuilders have been building homes at a record pace. In fact, there are now more housing starts per person than there was 5 years ago. Although there definitely has been an increase in demand for these homes, it has mainly occurred due to the artificially low interest rates and exotic mortgages that have allowed people to purchase homes that were traditionally out of their means. The idea that people have been purchasing homes outside of their means is validated by looking at the average median home price versus per capita income. As you can see in this chart, the valuation of median home price to per capita income is way out of historical proportions. Suffice to say, that the average income has not skyrocketed to the degree that we have seen the real estate market skyrocket.

Newton’s 3rd Law of Physics states that “for every action there is an equal and opposite reaction”. In a similar manner, I believe that with every bubble, there has to be an equal and opposite burst. Our economy is heading towards a recession; and the bursting of the real estate bubble will be what finally sends it there. Quite honestly, I did not believe that the real estate bubble would last as long as it has. Nonetheless, I know that the longer a bubble lasts, the more dramatic and severe the burst will be.

Without question, the real estate bubble has fueled this US economy in the last several years. I am amazed at the amount of times I have heard about a friend or neighbor who decided to refinance their home, get an adjustable rate mortgage, and take cash out for some type of trivial expenditure. Why not? They would argue. I just made a 200k profit this year. This same irrational exuberance reminds me of the “paper millionaires” in the Dotcom era who pointed to their stock portfolio as a means to justify their spending. Although this spending served to fuel the economy, it also served to further fuel this bubble and send your typical consumer further and further into debt. A much needed recession will force individuals to refocus on savings and the reaccumulation of wealth.

From 1991 to today our economy has been constantly growing. Some Economists might argue that we did go through a recession in 2001. I disagree. Although we did have some characteristics that were indicative of a recession, we also had some glaring omissions. Why would real estate prices continue to rise in a time of less spending and more saving? In either case, the recession that is to come will be a multi-year recession that will serve to slow down this economy that has been wildly expanding over the last decade and a half. Like the recession of the 1970’s, I also expect to see rising inflation and soaring commodity prices.

AMERICANS SAVING LESS THAN NOTHING

Spending could have outstripped income in 2005, which has not happened since the Depression.

When the Commerce Department recently tallied up consumer finances for November, it found that Americans shelled out more money than they took in. It was the seventh such month of red ink during 2005. Kevin Lansing, an economist with the Federal Reserve Bank in San Francisco, tracks the personal savings rate – the Commerce Department’s measure of how much consumers have left after spending is subtracted from income. In November the savings rate was a negative 0.2%. Given how much red ink households racked up in the first 11 months of last year, Lansing said the nation’s personal savings rate could well be negative for all of 2005. That, he added, would be “the first such occurrence since the Great Depression.”

During the 1990s, Americans spent about 95 cents per dollar earned and had a nickel left. The nation ended 2004 with an annual savings rate of 1.8%. The rate has continued down through 2005, attracting the notice of some prominent economic observers. “If we can believe the numbers, personal savings in the United States have practically disappeared,” former Federal Reserve Chairman Paul Volcker wrote in an ominously titled opinion piece, “An economy on thin ice,” in April. But other economists, including current members of the Federal Reserve, say the falling savings rate is not so alarming. They argue that the declining savings rate has been offset by another factor – rising home prices. “A lot of the psychology of savings is that yo’qre prepared for an emergency,” said economist Tim Kane with the Heritage Foundation in Washington. “And if your house is worth 10 percent more, then you feel you’re prepared.”

WILL BANKS BECOME LAND DEVELOPERS?

Bank of America and PNC Financial received approval from federal regulators to own large hotel and office properties. The Office of the Comptroller of the Currency, the branch of the Treasury Department which regulates banks, recently allowed PNC to invest $122 million in a complex that will include a 30-story building for offices, a 150-room hotel and at least 30 condominiums. Bank of America, likewise, received permission to develop a 150-room, 15-story Ritz-Carlton hotel as part of its headquarters complex in Charlotte. It is a move that could make it easier for banks to compete within the commercial real estate market. In the past, banks were only allowed to develop commercial real estate if the buildings were to be predominantly occupied by employees doing bank business.

Regulators traditionally limited banks to lending activities and prohibited them from owning and developing commercial real estate due to concern that a bank with a large concentration of loans could put its bank capital at risk if there was a sudden downturn in the real-estate market. There were also concerns that banks, which have access to cheaper capital, could gain a monopoly in the market and control rents.

HIGHER TAXES RAINING ON CALIFORNIAN’S NEW YEAR (AND HOUSING MARKET)

Among the big issues for 2006 will be how the housing market performs. What will happen if prospective buyers have to pay higher mortgage rates? What will happen as ARMs, option ARMs and other exotic mortgages taken out over the last three years start to actually “adjust”? We agree these are important issues. Fortunately, they are all widely reported elsewhere. We are here to talk about issues unique to Silicon Valley. And what do you know, there are a bunch we think will impact Silicon Valley in 2006:

2005 was the first year of the millionaire tax. Anybody getting a seven-figure W-2 in 2005 will be required to pony up an extra 1% (so $10K+) earmarked for “mental health” in 2006. Having successfully taxed “that guy under the tree”, 2006 may see a copycat. This time it is $2.5 billion raised via a 1.7% tax at $400K income ($6,000, $800K/$13,600 for couples) earmarked for “universal day care.” Of course, the children of the people funding this program will, by definition, not actually be eligible to use it.

As predicted awhile back, the bar for new taxes will continually be lowered to tax more and more “rich” people, perhaps until there are none. (I keep flashing back to Ayn Rand’s Atlas Shrugged and the guys who invented the perpetual energy engine. Instead of being lavishly rewarded, they were expected to work even harder while all the other employees went off on picnics to wait on another breakthrough invention. The picnicking employees were stunned when the inventors moved away and their company went bankrupt.)

Our illustrious governor has a couple feel-good deals on the table: $50 billion in bonds for road improvements. Not only would this solve a(nother) couple years’ worth of budget problems but “increased roads spending leads to increased jobs.” I guess our off-shored IT and manufacturing people can all go into road construction? Counting new income taxes, new and increased parcel taxes, increased public employee salary and pension costs, increased debt service, additional sales taxes, increased minimum wages and utility costs, Silicon Valley residents will see literally billions of new costs in 2006. Will we be able to pay all these new and increased bills and also hold up the price of housing?

PENSION CRISIS COULD HIT BALANCE SHEETS

The pension system is heading for a crisis, or maybe two. The first is the most worrisome for workers: Too many pension plans are not adequately funded or are already in default. The companies in the S&P 500 with traditional pension plans need to put aside another $40 billion this year to fully fund the plans, according to S&P. The second impending crisis is an accounting change that may make pension issues more painful for corporations. Accounting regulations for both pensions and retiree health care costs are poised to change in the next five years, in what could be the largest shift in accounting rules in more than 30 years. “We believe this project will have a significant impact on evaluations, income and balance sheets, and will become the major issue in financial accounting over the next five years,” said Howard Silverblatt, equity market analyst at Standard & Poor’s.

The Financial Accounting and Standards Board (FASB), the arbiter of the nation’s accounting rules, has said it will require companies to add their net pension and retiree-healthcare costs to their balance sheets within the next year. Then, over the next three or more years, the accounting methods for pensions and retiree-healthcare costs will also change. The first change, which will move pension and retiree-healthcare costs from financial footnotes to balance sheets, could be dramatic, increasing companies’ leverage and changing computed returns, book value and shareholder equity ratios. These ratios are closely watched, since many loans and bonds deals cap a company’s leverage ratio. And the changes could be eye-popping. The aggregate drop in shareholder equity, for instance, will be 10%, Silverblatt wrote in a December report.

If the company’s pension plan defaults, the Pension Benefit Guarantee Corp., which guarantees pensions for 44 million people, will pay retirees up to $45,614 a year. But retiree healthcare-costs are a muddier issue. Of the companies in the S&P 500, 337 offer some kind of medical benefits for retirees. According to Silverblatt’s analysis, only 282 companies provide sufficient information for estimates about their retiree-healthcare plans. Those plans are scarily underfunded: Companies would have to set aside $292 billion to meet current obligations, according to his analysis. The state of these funds “is extremely unsettling,” Silverblatt wrote. Unlike pensions, retiree health care costs are not a clear-cut legal obligation, unless they are part of a contract, which is the case at Ford and General Motors, where retiree healthcare-obligations are underfunded by $94 billion.

THE COMEBACK KID OF 2005

Looking back at 2005, forex market reviewers are overwhelmingly calling the “unexpected strength of the U.S. dollar” one of the year’s “biggest surprises” (FT). We all know why. Defying the “crash and burn” forecasts so popular in late 2004, “the greenback enjoyed its best year against the euro and yen since 1999 and 1979 respectively.” So unexpected was the dollar’s rally that even Warren Buffet, the Sage of Omaha, who famously bet “$20 billion or so” against the buck a year ago, was caught off guard by its sudden and sustained turnaround. In December 2004, the dollar hit a low of $1.356 against the euro and Y102.58 against the yen. By the end of 2005, the USD gained 14.6% on the EUR and 15.2% on the JPY. Quite a comeback.

What is interesting is that the current consensus among analysts is again bearish on the dollar. The majority of the analysts polled by Reuters think that some time in 2006 the buck’s upward trend will certainly … well, buck. The thinking is that by the year’s end, the EURUSD will stand at $1.27 and the USDJPY at Y108. Some even say, it may happen sooner. Why? Well, the two main incentives that allegedly drove the dollar’s rally are expected to disappear in 2006. The first one is the Homeland Investment Act, “a one-year tax break designed to encourage U.S. multinational corporations to repatriate overseas cash holdings,” which will expire at the end of Q1. End of the dollar repatriation – end of the dollar rally, goes the reasoning.

The second likely hindrance may be the disappearance of the “rate differential” between interest rates in the U.S. and the EU. If the Fed stops raising rates (it recently hinted it might), and if the European Central Bank keeps raising them (like it said it would not), pretty soon dollar-denominated assets will lose their appeal in favor of euro-denominated ones. End of the interest rate advantage – end of the dollar rally, say the analysts.

While this year’s bearish consensus is not as uniform as it was in December 2004, it is a consensus nonetheless. Back then no one liked the dollar because of its “bad fundamentals”. Well, the “fundamentals” have not really changed since then, and neither did the analysts’ reasoning for staying bearish. They can keep analyzing “bad fundamentals” until they are blue in the face, but the bottom line is this: “Fundamentals” obviously did not matter in 2005, so why should they this year? And do not let them tell you, “this time it’s different” – we have heard that before, too.

An Elliott wave explanation of the dollar’s yearlong rally is much more straightforward: “A five-wave decline [in the Dollar Index] that started in July 2001 ended in December 2004 necessitated an upward correction by the rules and guidelines of the Wave Principle. Everything else, from U.S. and foreign interest rate differentials to overseas earnings repatriation to low U.S. inflation, are nothing more than fundamental rationalizations for a psychologically-based rally, which few outside of Elliott Wave International predicted ahead of time.” And predict we did. Right as the dollar was hitting its lows in December 2004, we published this chart, forecasting what forex analysts now refer to as the “biggest surprise” of 2005.

Not believing in the trend … until the trend is over.

The 2005 rally was U.S. Dollar Index’s biggest bull market in eight years. By itself that qualifies as a “knockout”, though this one punch from the dollar actually put two adversaries on the canvas: other currencies, plus the entire universe of commentators and analysts who predicted a freefall decline for the buck in 2005. Still, do not hold your breath waiting for the peddlers of conventional wisdom to face up to their mistake – which is why conventional wisdom is usually mistaken.

I do give credit to the Wall Street Journal as the only major news source that I have seen mention this story, under the Jan. 3 headline “Dollar Strikes Back, Confounding Naysayers”. Alas, the story’s flaw was to make it sound like the conventional wisdom had learned something: “Despite some dollar selling in the final weeks of the year, a broad consensus on Wall Street still holds that the dollar could maintain or even build on its gains early this year, primarily because of the U.S. interest-rate advantage.” The “some dollar selling” phrase reveals the problem – in truth the Dollar Index saw its 2005 high back on November 16, and has trended mostly lower ever since, to the tune of some 4%. It is as if the “broad consensus on Wall Street” did not wake up to or believe in the dollar’s rally until it was over.

GREAT EXPECTATIONS

A whole raft of economic data is supposed to tell us this week what we can expect from stocks and the economy. New construction spending, the Fed’s last meeting notes (what will they do next?), auto sales, payrolls, factory orders, hourly earnings … all new grist for our analytical mill. And all a waste of time. Mostly. You can learn everything you need to know about the American economy by sitting at the gate of a terminal at Los Angeles International Airport for two hours. On the one hand, diversity. You will hear Chinese, Spanish (seemingly the co-official language of California), French, and dialects from the subcontinent that sound musical. A lot of people are coming to America, or at least passing through it and spending money.

But do not expect to find any good service. The bars and pubs were packed with people and trash, much like the concourse. The service everywhere, almost without exception, was uninspired and shoddy. Now, don’t get me wrong. I have not become an elitist in my travels. After all, you are reading a scribbler who paid his way through college manning the till at a Texaco station. What I am getting at are the extraordinarily exaggerated expectations in America over what it takes to get and stay ahead. “States Take Lead in Push to Raise Minimum Wages,” reads a New York Times headline. Do these states not know that 3 billion people are competing with Americans for jobs? Can they not understand that by that math, wages will fall until Americans catch down with their global brethren?

As a would-be economic missionary over the last few years, I have found that the American economic gospel is flawed, maybe even heretical, if you ask Dr. Kurt Richebächer. The economic pagans of the world do not worship the god of consumption. No American will be left unchanged by our inevitable encounter with the ambitions of the rest of the world. Granted, not all jobs can be outsourced. But what is really amazing when you travel outside America and then come back is the expectation that the American standard of living is a birthright that does not have to be earned by hard work. I am generalizing. Of course, there are exceptions. Lots of people work hard every day. But I wonder if most people have any inkling of the great global wealth migration I described in The Bull Hunter, the one that will punish nonsaving, nonindustrious, debt-laden consumers, but reward certain investors.

“Despite high debt levels,” we are told, “it is still safe to say that Americans will somehow continue to buy on credit, and with energy prices falling, wages now diverted to gasoline purchases should be freed up to spend on the array of goods and services that drives the economy.” Sure. Energy prices will fall. Higher interest rates will not dent consumer spending. And higher interest rates will not deter businesses from borrowing either. Rather, businesses will spend! Spending and consuming rather than saving and producing will be vindicated as the surest way to wealth in a competitive world. People who think like this are the same kind of people who took videos of the 2004 Boxing Day tsunami as it rolled toward them. They are doomed.

Now is a good time to become an exception to the rule. If American markets are down, look to foreign markets. If real wages are falling in America, look to higher stock market returns from overseas to drive your portfolio. And when all else fails, buy gold and energy investments. They are going up as a consequence of the tectonic shifts in the global economy.

FEDERAL RESERVE NEEDS ENGLISH ELOCUTION LESSONS

Some of the smartest people in finance have spent the first days of 2006 parsing the minutes of the Federal Reserve’s most recent policy meeting, trying to gauge the outlook for monetary policy in the world’s largest economy. It is a ridiculous exercise. There is no lexicon to divine the syntax and inflections of phrases such as “some further measured policy firming is likely to be needed,” or“qthe number of additional firming steps required probably would not be large.” Once Ben Bernanke becomes Fed chairman after the bank’s January 31 meeting, a top priority should be ending the textual semaphore that is become the central bank’s way of not quite communicating with the world.

For pointers, he could do worse than look across the pond, where the Bank of England has been at the forefront of eliminating obfuscation from best practice in central banking. The minutes of the U.K. central bank’s meetings are rich in detail and economic statistics, examining the global outlook as well as the domestic scenario. By contrast, the Fed’s minutes are stunningly parochial, and almost number-free. There is no mention of where we are, where we are going, or what we will pass during the journey. Much as actors flinch from mentioning “Macbeth”, preferring to call it “the Scottish play”, the Fed cannot bring itself to say what the inflation rate is, or might be in the future. The only references to the economic world outside U.S. borders come in relation to whether international demand for the dollar will exacerbate the U.S. trade deficit by crimping its exports.

The lack of specificity illustrates the Fed’s mindset under Alan Greenspan. It is old-school thinking. If you understand his speech, the central banker has not done his job properly. The Fed’s attitude to the millions of people whose finances are intimately linked to the bank’s interest-rate decisions is akin to how mushroom farmers treat their crops: Keep them in the dark and feed them manure.

The philosopher Ludwig Wittgenstein came up with a thought experiment to illustrate the role that rules play in determining outcomes. In his example, two children throw stones at a target. In the first game, both can see the target. In the second, only the first can see the target. In the third, the target is defined as wherever the first child’s stone lands. As things stand, the Fed is at best playing the second kind of game, at worst the third. It would do better to emulate the Bank of England, publish its forecasts, adopt an explicit inflation aim, and tell the world what target it is aiming at with its interest-rate stone-throwing.

WEALTH IS NOT ALL IT LOOKS LIKE TODAY

Have the soaring home prices of the last several years made America stronger? On balance, have they improved Americans’ financial security? You would think so. It is hard to complain when most people’s biggest financial asset is rising in value year after year. But a rise in value is not the same as a growing asset – not when you are withdrawing that increased value and spending it. 2005 was a year for the record books – record-high housing starts and home sales as the housing bubble peaked; record-high levels of consumer debt, and record-high levels of home-equity withdrawals in the form of cash-out mortgage refinancings.

Equity withdrawals have not just burned through a key financial cushion for Americans. Studies show that the average person borrows more after running through the check from the mortgage company. Insulting debt gets added to financial injury because this easy cash makes the holder feel richer. There was just such a wealth effect in the late 1990s, too, thanks to soaring stock prices. The sad thing is, many of those people got hurt because they watched that paper wealth rise and then fall. They did not extract their profits.

The current wealth effect is worse. People think they are extracting profits, but what they are really doing is extending the loan against their home, which will come back to bite them when they sell – especially if they have to sell into a falling market. Any objective financial adviser will tell you that your home equity is a critical form of savings. Burning through it does you no good in the end. Bubbles are not healthy. Soaring home prices have not been good for America.

S&P CITES RISE IN CREDIT DOWNGRADES

Last year the number of fallen angels – companies whose credit rating was knocked down from investment grade to speculative grade – exceeded the number of such companies for the previous year, according to a new report from Standard & Poor’s. What is more, in 2005 fallen angels lagged rising stars, S&P’s term for companies that were upgraded from junk to investment grade. In fact, fallen angels outnumbered rising stars by 19 – the highest margin since 1997.

Worldwide S&P counted 41 fallen angels in 2005 on rated debt worth a total of $520.6 billion, compared with 25 companies and $55.2 billion of debt in 2004. Last year, 27 of the fallen angels were U.S.-based, with debt worth $499.2 billion, including the worldwide leaders in this category, General Motors and Ford Motor. S&P defines potential fallen angels as companies rated “BBB-” with either a negative outlook or ratings on CreditWatch with negative implications.

According to S&P, 2002 was the historical peak for fallen angels; 146 such companies accounted for 4.65% of the 3,139 investment grade-rated issuers in that year. The previous peak was in 1986, when 56 fallen angels constituted 4.21% of issuers. The ratings firm pointed out that over the long term, the number of fallen angels mirrors broader trends in credit quality, as measured by the ratio of downgrades to total rating actions. In addition, added the report, “fallen angel incidence generally increases during periods of weak real GDP growth and declines when GDP is growing strongly.”

The main reason: Companies frequently take on more leverage at the top of the economic cycle, making them more vulnerable to potential credit downgrades when economic conditions deteriorate. Other important factors that increase the number of fallen angels include industry deregulation as well as technological change within an industry. At present, wrote S&P, the media and entertainment, capital goods, high technology, and retail/restaurants sectors are most vulnerable to generating fallen angels.

WHY ALL CLUES POINT TO A BIG HIT IN COCOA

Cocoa has been sinking recently in New York – literally and figuratively. Like so many pairs of cement galoshes, five freight railcars filled with the stuff slid off a barge into East River oblivion on Sunday. Yet despite the hit to supplies, NYBOT cocoa futures also fell hard Monday: the soft commodity’s prices gave back almost all the ground they covered during last Friday’s 3% single-session upsurge.

The East River cocoa party may have made the AP wire, but the market’s quick reversal is the real news. Even for a market as traditionally volatile as cocoa, consecutive back-and-forth sessions of this size are not common. But then again, neither is the opportunity that the latest price action has just revealed. …

THE DOW BREAKS 11,000 AND …

The Dow broke through 11,000 on Monday, January 9, the first time since June 2001. Two months ago, Bob Prechter wrote this in his November 2005 Theorist: “The rapidity of the move over the past two weeks is compatible with the case for a thrust out of a triangle. If the triangle interpretation is correct, the Dow will rise to above 11,000 before turning down again…. We also know that a thrust out of this pattern is the last display of upside fireworks that the market can show.” Since this near-term bullish call, he returned to his previous bearish stance, which he detailed in his December 2005 Theorist.

Calling a turn is the most useful art in technical analysis, and the wave patterns of Elliott wave analysis are well suited to helping call turns. But it is not always possible to call the turn right on the dime, particularly in large degrees of trend. In this excerpt from Bob Prechter’s question-and-answer book, Prechter’s Perspective, he explains exactly how hard it is and why he keeps doing it.

Real chart, real index … care to guess?

This is a real chart of a real index. Care to guess which index and what time frame? Correctamundo – it is a monthly chart of the Dow Industrials for the past seven years or so. As for its performance over this period, I would say “unremarkable” is the most generous description, though “downright homely” is nearer to the truth. Now, 7-plus years is a long period in the financial markets, even for people who “invest for the long term” – and longer indeed for those who imagine that “stocks always go up,” such as the millions of folks who bought the high in 1999-2000.

Yes, buying the low in 2002-2003 would be a different story. That is, IF you can find anyone who can plausibly claim to have done so; yet even from that point the rise was short-lived, with the past two years stuck in a trading range. All of this is to show how much and how easily the media and Wall Street are willing to forget about the Dow, if it only pokes its nose above a nice round number it has not seen for a while. For months, no one has asked “What is wrong with the Dow Industrials?”, least of all when it kisses 11,000. Even less does anyone wonder how this meaningless round number managed to produce so much self-congratulatory bullishness. No one except us, that is.

Slim movie pickings, and a record made to be broken?

If you love good movies, and you also love real-life tales of epic business intrigue, you probably know about the slim pickings which combine the two. Business folk are either ignored by Hollywood or appear as cartoonish stereotypes who mouth clichés (look no further than The Aviator, with DiCaprio’s vulgar portrayal of Howard Hughes). Michael Milken’s larger-than-life story has yet to be told on the big screen, though it includes more good and bad than 1,000 average lifetimes combined. Liar’s Poker and When Genius Failed were great books about stories that were epic indeed, but where are the screen adaptations?

Okay, there is Rogue Trader with Ewan McGregor as Nick Leeson, though the one shining exception was Barbarians at the Gate, about the RJR-Nabisco merger in 1988. The book was excellent, as was the movie starring James Garner (produced by HBO) – the script did not do violence to the facts, and the acting proved that you can portray colossal egos without making them look like buffoons.

And speaking of colossal, size above all is what distinguished the RJR deal, as the dollar amounts eclipsed even the egos of Henry Kravis and Ross Johnson – 18 years later the $25.1 billion remains the largest private equity LBO of all time, and would be valued at “$41.9 billion in today’s dollars,” according to the Wall Street Journal. As for why the WSJ saw fit to run a story about the famous LBO, the headline says it all: “Big Deal: Records Were Made to Be Broken”, and the story goes on to say that “2006 may be the year that the RJR record finally falls.” This reflects the sort of bullish psychology that speaks for itself, at least on this page.

THE SWEET SMELL OF DIESEL

More than a century has passed since Ransom Eli Olds introduced the first mass-production vehicle, the Curved Dash Oldsmobile, in 1901. (Ford was hot on his heels.) A hundred years later, developments in automotive technology have not slowed down. Electronic gadgets may capture most of the “Ooohs” and “Ahhhs” at auto shows, but these modern marvels are of small consequence compared to what is happening under the hood … and inside the tailpipe. Corning – the “fiber optic company” – has developed an exhaust-filtration technology that could dramatically boost demand for diesel-powered vehicles. This is a long-term play on an exciting, and perhaps inevitable, development in the automotive world.

Even without Corning’s innovative exhaust filter, diesel is superior to conventional gasoline in two key respects: It releases 15-20% less carbon dioxide per mile driven than regular gasoline and gets about 30% more miles to the gallon. These advantages were long hidden by a few nasty drawbacks. The diesel engines of old were loud, dirty and smelly. You could hear a diesel truck coming from a quarter mile away, see the soot half a block away and smell the exhaust as it rolled past. But after years of research and refinement, the vast majority of diesel’s problems have been licked. European refineries have long since removed the sulfur from their diesel production, allowing for a sharp reduction in smell and smoke. And the rising price of gasoline has made fuel efficiency all the more important, offsetting the extra cost of building a diesel engine.

These elements give diesel an edge in capturing global market share. But diesel also benefits from a much bigger, and potentially decisive, factor: the existence of petroleum alternatives. As it turns out, you do not need crude oil to make diesel. You can make it from coal, plant mass, cooking oil, or even spare turkey parts. Biodiesel has taken off in Europe: Germany is in the lead, raising output 40-50% a year. Drivers love biodiesel, because it saves them money at the pump; governments love biodiesel because it offers some justification for the countless billions gone to farm subsidies. It seems diesel can be made from just about anything with semi-organic origins.

All well and good. But the final hurdle for diesel dominance can be summed up in a three-letter word: “NOx”. Short for nitrous oxide, NOx is one of the soot-causing pollutants emitted by diesel engines. While engineers have figured out how to thoroughly “scrub” diesel exhaust through the use of catalytic converters and particle traps, getting out the last bit of NOx has been tricky. In embracing diesel so many years ago, Europe chose to accept the tradeoff. But now, the U.S. Environmental Protection Agency will require a 90% reduction in the amount of soot by 2007. Europe has committed itself to a similar mandate. The American trucking industry, which depends on diesel, is in a tizzy. A 92% NOx reduction is no small thing, and yesterday’s pollution technology is not quite up to snuff. Tailpipes must be upgraded.

Corning may be the one to come to the rescue. The company has done groundbreaking work in everything from light bulbs, Pyrex dishes and test tube beakers to space shuttle windows, missile nose cones and spy satellites. Although most folks know Corning as the leading pioneer of fiber optic technology, the company has also pioneered environmental technologies. More than three decades ago, Corning introduced the honeycomb-type material at the heart of catalytic converters. Now, this innovative company is preparing to take the automotive world by storm yet again. Corning sold off its conventional glassware business in the late 1990s to make way for a major research and development push. As part of that effort, Corning focused on diesel-exhaust technology. So Corning’s management decided to take a risk and invest close to half a billion dollars in a new factory and new materials research, even as the bursting dot-com and telecom bubbles were savaging company’s core fiber-optics business.

The big bet looks like it will soon begin to pay off. Thanks to up-and-coming regulations, diesel tailpipes are projected to be a $1 billion market by 2008 – an over 80-fold increase from the year Corning first took the plunge. Corning dominated fiber optics through a relentless combination of smarts, guts and know-how. The firm is taking risks and leaping ahead while competitors stick to the status quo. Between technological savvy, early-stage initiative and already recorded progress, Corning has a strong shot at dominating this lucrative new market space.

THE REAL CULPRIT IN THE WALL STREET ANALYST SCANDAL

It was over three years ago that the analyst scandal of the late, great bull market of the 1990s reached its denouement, when Wall Street firms agreed to pay $1.4 billion to settle charges from Eliot Spitzer that their research misled investors. The hero was Spitzer, and the villains were the craven analysts and the investment bankers who bullied them into issuing sunny reports. If that is the story line, you might well believe that Spitzer’s settlement, by pretty much forbidding one side to have anything to do with the other, fixed research.

But actually, the real culprit in all of this has gone unpunished. The real culprit, of course, is corporate America. After all, it is corporations who told investment bankers that they would not get any business unless their firm’s analyst told investors to buy the stock – the investment bankers only cared because the companies cared. Spitzer’s reforms have made it difficult for companies to exert that particular form of leverage. But never fear. They have others. Indeed, over the last few years, the worry about the ways in which companies punish non-sycophants has been growing. According to a memo written by Richard Colby, the deputy director of the SEC’s division of market regulation, the agency did an informal survey of brokers, and concluded that retaliation by companies – as well as by others including large investors and venture capitalists – “continues to be a problem”.

The real challenge is how do you do anything about it? After all, overt acts are one thing, but subtler intimidation is very difficult to police. And no matter how tough analysts are, it is hard to always be immune to this. In other words, there are still plenty of reasons to have a little caution about the “research reports” you read.

WALL STREET BONUSES TOP $21.5 BILLION IN 2005

The financial industry awarded $21.5 billion in bonuses at yearend, a 15% increase over 2004 and the highest bonus pool since the bubble year, 2000. The average bonus on Wall Street was $125,500, up 10% from the previous year with top bonuses going to mergers and acquisitions bankers who saw deal volume rise 28%. Bankers generally earn base salaries of $150,000 to $300,000, according to estimates. The record bonuses also come amid a year in which revenue at Wall Street firms surged 44.5% during the first three quarters of 2005 above the same period the previous year.

COMPANIES WARM TO FREEZING PENSIONS

IBM, Verizon workers stop accruing benefits, a sign of things to come.

Now we know what a dead pension looks like – frozen in place. The death knell has been sounding for the defined-benefit pension plan for years. Less clear was how companies would go about it: Would they cut you a check and pat you on the back? Make a deposit into your 401(k)? Buy you an annuity? Experts say the recent freezing of pension plans by corporate giants Verizon and IBM has set the path that many companies will now take – where current employees accrue no more benefits, future employees get none, and companies instead make more generous contributions to their 401(k) accounts.

“If IBM and Verizon can do it, everybody is going to say, ‘Why not me?’”, said Karen Ferguson, director of the Pension Rights Center in Washington, which advocates for workers’ pension rights. “The implications for everybody else are amazing. It’s going to be a race to the bottom if it doesn’t stop.” The number of corporate pension plans has fallen by more than two-thirds since their peak in 1985, as global competition and an evolving employer-employee relationship have prompted new companies to eschew pensions, some healthy companies to freeze their plans, and troubled companies to dump theirs on the federal insurer, the Pension Benefit Guaranty Corp.

In December, the PBGC issued its first comprehensive study of frozen pension plans. The study found that 9.4% of company plans had halted participants’ benefit accruals as of 2003, the most recent year for which complete data were available. That represented only 2.5% of participants, since most of the frozen plans were small. “While anecdotal evidence suggests that the number of frozen pension plans has increased since 2003, reports of a mass exodus from the defined-benefit pension system appear to be overstated,” said Bradley Belt, PBGC executive director.

However, that was before Verizon’s announcement last month and IBM’s last week. The fact that two healthy, prominent companies – both are among the 30 Dow Jones industrials – froze their pensions with little backlash so far could not have gone unnoticed in corporate boardrooms. “More and more companies are discovering that defined-benefit plans are not well-suited to their business realities, their future and the nature of their workforce management,” said James Klein, president of the American Benefits Council in Washington, an employers group. “We’ve had a lot of companies terminating for quite some time, and freezing activity has gathered steam as well.” Companies favor freezing a pension over eliminating it altogether, because in the near term it can be much cheaper, particularly if the plan is underfunded. To eliminate an underfunded pension, a company would have to inject millions of dollars into the plan to make the assets match the estimated future obligations. Freezing allows companies to deal with an underfunded pension over a longer time period.

U.S. STOCK PRICE VOLATILITY TO RISE FROM 12-YEAR LOW

Traders in U.S. stocks can be forgiven for falling asleep at their desks these days. With price fluctuations in the market near the lowest in more than a decade, the Standard & Poor’s 500 Index has not notched a 2% daily gain or loss since 2003. They had better wake up. Forecasters such as Merrill Lynch’s Richard Bernstein and Miller Tabak’s Philip Roth predict that those variations will become more pronounced this year. Volatile markets are more likely to fall, they say. Both men are bearish on stock prices in 2006. “Fear tends to manifest itself much more quickly than greed, so volatile markets tend to be on the downside,” said Roth, a New York-based technical analyst. “In up markets, volatility tends to gradually decline.”

Since the end of 1999, a quarterly rise in volatility has coincided with a decline in the S&P 500 80% of the time. Volatility may pick up this year as the Federal Reserve raises interest rates for longer than investors expect, according to Bernstein, Merrill’s chief U.S. strategist. Investors should stick with health-care stocks and makers of consumer goods, because companies such as Johnson & Johnson and Altria Group are less sensitive to higher rates and market fluctuations, according to Bernstein.

Traders’ most-watched indicator of market swings is down. The Chicago Board Options Exchange’s Volatility Index, or VIX, which measures the expectations for volatility that are built into the prices of options on the S&P 500, closed yesterday at 10.86. That is 43% below its average of the past 15 years. During the bear market from March 2000 to October 2002, the index averaged 25.29 and reached a peak of 45 in August 2002. In the subsequent bull market, volatility sank as investors became more complacent. The index has averaged 17.43 in the rally of the past three years and fell to 10.23 in July, the lowest in almost 12 years. John Kosar, president of Asbury Research LLC, is concerned about the VIX, because it represents “an extreme in investor complacency,” he wrote.

While recent history is on the bears’ side, a decline in the stock market has not always accompanied an increase in volatility. From 1993 to 1999, the S&P 500 and the volatility index rose in tandem at a better-than 80 percent rate on a quarterly basis. Money manager James Awad is betting 2006 will look more like the 1990s than the 2000s. “Volatility has been historically low for so long that it’s unlikely to go lower,” said Awad, who manages $1.4 billion at Awad Asset Management in New York. He says the S&P 500 may still gain as much as 10% this year, boosted by corporate spending.

NEW YORK FED PRESIDENT SAYS ASSET PRICES TO HAVE “MORE IMPORTANT” ROLE

The rise and fall of asset prices such as stocks, bonds and homes will probably play a larger role in setting U.S. interest-rate policy in the future, Federal Reserve Bank of New York President Timothy Geithner said. “Policy, in some circumstances, will need to respond to asset price movements when those movements alter the central bank’s assessment of the risks to its outlook,” Geithner said in the text of a speech to the New York Association of Business Economics in New York. “That change in the assessment of the risks to the forecast should be part of the central bank’s communication with the public.”

The U.S. central bank currently focuses on so-called wealth effects, or how rising or falling asset markets may effect consumer and business spending. Geithner’s comments suggest the Fed should be more explicit about including these effects in its rate decisions and forecasts, and communicating them to the public. “As financial markets continue to broaden and deepen, the behavior of asset prices will play an important role in the formulation of monetary policy going forward, perhaps a more important role than in the past,” Geithner said.

Fed officials were criticized by some economists for not responding more aggressively to the surge in stock prices in 1999 and 2000. In December 1999, the Federal Open Market Committee’s chief forecaster, Mike Prell, warned policy makers of a “financial locomotive” that was causing demand to overheat and distort the U.S. economy. Policy makers left the benchmark interest rate unchanged at that meeting.

IT’S ALL ABOUT TIMING

What will 2006 be like? On the one hand, discussions of the economy and the markets should be for amusement purposes only. Since it is impossible to know what the finances, motives, constraints, and desires of six billion people might be, it is impossible to know what they are going to do, or when. On the other hand, there is such a thing as human nature. Actions do have consequences. The madness of crowds exists. And both history and markets exhibit definite trends over time. Like many things in life, looking at the markets can lead you to paradox.

When establishment economists prognosticate, their guesses are typically gussied up with convoluted theories and complex mathematical formulae. Their predictions are overwhelmingly bullish, partly because they are really just extrapolations of the prevailing trend, and partly because that is the politically savvy view to hold. This is not to accuse most economists of being idiots, even though I think most of their theories and formulae are idiotic. On the contrary, it is highly intelligent to be bullish – because throughout history things have always gotten better (albeit punctuated with setbacks, ranging in length and depth from the recent recession to the Dark Ages). Clearly, the longest trend in existence is the ascent of man, and it is likely to continue. Indeed, despite my cynicism on the world as it is, I think the ascent will likely accelerate.

So, all this having been said, what do I think? As you know, I think the U.S. is riding for a serious fall; that opinion has historically constrained my ability to capitalize on domestic stock, bond, and property bull markets. At the same time, I like to play to the strong suits in any game. That has led me to the opinion that over time, some foreign countries will do better than the U.S. And that it is only common sense, considering the fate of the dollar, to keep a close eye on commodities in general and precious metals in particular. It is just a question of timing.

So what about 2006? I rather expect to see gold well over $700, silver closing in on $20, oil at where it now is (but likely closer to $100). The stock market resuming the downtrend it started in 2000, interrupted since October 2003. Interest rates will be heading up decisively. And the U.S. property market is headed down decisively – along with the dollar. All of which should result in a quintuple whammy on Americans’ standard of living, which will likely be compounded by a turnaround in the balance of trade (fewer free goodies from abroad in exchange for paper money) and higher domestic inflation (as some of the trillions of dollars Americans have shipped abroad come home, to be redeemed for real goods). I am not necessarily expecting the Greater Depression to be announced on CNN this year, but I will be surprised if the average American does not become more concerned about his standard of living and financial future.

The big X factor, as always, remains the government. Frankly, I never expect anything good from government. And here I refer to the institution itself. How can you, considering that its main products are wars, pogroms, prosecutions, persecutions, taxation, regulation, inflation, and assorted idiocy. America’s long slide towards authoritarianism has greatly accelerated since our version of the Reichstag fire on 9/11, and I see no prospect of it even slowing, much less reversing. What is likely to happen with the wars they have started? My guess is that they will grow and spread. The generational theory of history I outlined in the International Speculator seems to be developing fairly accurately, and truly titanic war would seem to be in the cards in the decade to come. Maybe with the Islamic world, more likely with the Chinese. I guess my bottom line prediction is that you should rig for stormy weather. But you will be well able to afford it with the profits you will make in selected gold and gold stocks in 2006. Which should be an excellent year for us, even if not the world at large.

BANKS BOOST CREDIT DERIVATIVES STAFFING

The biggest credit derivative dealers boosted staff numbers by nearly a quarter last year and spent a third more on technology as they invested heavily to keep up with the ferocious growth of the market. A survey of 23 leading participants in the credit derivative market found that the average number of credit default swap trades rose by 89% over 2004. The big dealers responded to the sharp growth by increasing the average headcount in credit operations by almost 25% over the last year. The number of so-called flow traders, who execute trades in standard products such as single name CDS and related indices, rose by 75% as banks hired externally and moved staff from other business areas. The report did not distinguish between external hires and internal staff moves.

The growth was in part driven by the rising interest in credit derivatives indices, such as iTraxx in Europe and CDX in the US. Index trades accounted for a quarter of the transactions compared with one in every eight transactions in 2004, according to the survey. The volume figures did not include trading in tranches of synthetic structured products, such as collateralized debt obligations, which are repackaged portfolios of credit derivatives. The sharp growth of the credit derivative market has raised concerns about the backlog of paperwork stemming from the heavy deal flow. Leading dealers came under pressure last year from the Financial Services Authority in the UK and the Federal Reserve Bank of New York to improve practices in credit derivatives processing.

The spending appears to have had an impact on processing transactions already. In early October, 14 leading credit derivative dealers told regulators they would reduce by 30% the number of confirmations outstanding more than 30 days after executing a trade. They gave themselves until the end of January. By the end of November the average reduction among the 14 banks was 24%. That bears out other reports that the industry is on track to meet its initial targets, as leading dealers prepare to meet the New York Fed and other regulators again next month.

FED RATE INCREASE HALT COULD HURT YOU

On January 3, the stock and bond markets decided that the Federal Reserve was near the end of a string of interest rate hikes that have taken short-term rates from 1% in June 2004 to 4.25% today. Investors and traders cheered the thought. On the day, the Dow Jones Industrial Average climbed 130 points. If the financial markets are right – a big if that I will look at in a minute – what does the end to the Federal Reserve’s interest rate increases mean for you? My best guess at the five most likely effects: 1.) A weaker dollar and higher prices at the store. 2.) Higher gasoline prices. 3.) Higher mortgage rates. 4.) A continued rally in gold stocks and new life for financial stocks. And 5.) And an end-of-the-year surprise: interest-rate cuts from the Fed.

SEMICONDUCTOR STOCKS ARE NO BARGAIN

Over the past two years, the chipmakers have gone from having too much inventory to not having enough capacity to meet demand. Consumers around the world are purchasing the latest consumer electronic devices – PCs, cell phones, digital cameras, flat-panel televisions and MP3 players – to such an extent that the Semiconductor Industry Association (SIA) said on January 3 that worldwide sales of semiconductors reached $20.4 billion in November, up 7.2% year over year, and up 1.7% sequentially.

However, semiconductors are no longer cheap. In fact, the semiconductor industry, which was 32.9% undervalued in April when I made my bullish call, is now just 7.6% undervalued. This makes the highly speculative tech sector a tough place for the long-term investors to begin new positions. The benchmark for the semiconductors is the Philadelphia Semiconductor Index (SOX). Back in July I tracked the bullish crossover, where the 5-week modified moving average crossed above the 200-week simple moving average for the first time since November 1998. This was a reason I cited for projecting that the chipmakers would lead a tech rally. Now the weekly chart profile for the SOX has become overbought, with the five-week MMA at 498.33, well above the 200-week SMA at 418.05. This week’s strength has the index approaching my monthly risky level at 535.41 as I write this column.

To further illustrate the risk, some of the chip names I profile today have become dangerously overvalued, and are trading to new 52-week highs for reasons that only the disciplined trader can decipher. Many of the chart patterns have become parabolic and reminiscent of six years ago. Investors should consider exit strategies, and traders should just beware that trees do not grow to the sky. My theme in columns published in December was that it would be wise to use the market’s year-end strength to reduce holdings. I know that a few of these stocks exploded to the upside as 2006 began, but I stand by my guidance to reduce holdings by 25% and then review again in early 2006.

DANGER TIME FOR AMERICA, SAYS THE ECONOMIST

Despite his rather appealing personal humility, the tributes lavished upon Alan Greenspan, the chairman of the Federal Reserve, become more exuberant by the day. Ahead of his retirement on January 31st, he has been widely and extravagantly acclaimed by economic commentators, politicians and investors. After all, during much of his 18½ years in office America enjoyed rapid growth with low inflation, and he successfully steered the economy around a series of financial hazards. In his final days of glory, it may therefore seem churlish to question his record. However, Mr. Greenspan’s departure could well mark a high point for America’s economy, with a period of sluggish growth ahead. This is not so much because he is leaving, but because of what he is leaving behind: the biggest economic imbalances in American history.

One should not exaggerate Mr. Greenspan’s influence – both good and bad – over the economy. Like all central bankers he is constrained by huge uncertainties about how the economy works, and by the limits of what monetary policy can do (it can affect inflation, but it cannot increase the long-term rate of growth). He controls only short-term interest rates, not bond yields, taxes or regulation. Yet for all these constraints, Mr. Greenspan has long been the world’s most important economic policy maker – and during an exceptional period when globalization and information technology have been transforming the world economy. His reign has coincided with the opening up to trade and global capital flows of China, India, the former Soviet Union and many other previously closed economies. And Mr. Greenspan’s policies have helped to support globalization: the robust American demand and huge appetite for imports that he facilitated made it easier for these economies to emerge and embrace open markets. The benefits to poorer nations have been huge.

So far as the American economy is concerned, however, the Fed’s policies of the past decade look like having painful long-term costs. It is true that the economy has shown amazing resilience in the face of the bursting in 2000-01 of the biggest stockmarket bubble in history, of terrorist attacks and of a tripling of oil prices. Mr. Greenspan’s admirers attribute this to the Fed’s enhanced credibility under his charge. Others point to flexible wages and prices, rapid immigration, a sounder banking system and globalization as factors that have made the economy more resilient to shocks.

The economy’s greater flexibility may indeed provide a shock-absorber. A spurt in productivity has also boosted growth. But the main reason why America’s growth has remained strong in recent years has been a massive monetary stimulus. The Fed held real interest rates negative for several years, and even today real rates remain low. Thanks to globalization, new technology and that vaunted flexibility, which have all helped to reduce the prices of many goods, cheap money has not spilled into traditional inflation, but into rising asset prices instead – first equities and now housing. The problem is not the rising asset prices themselves but rather their effect on the economy. By borrowing against capital gains on their homes, households have been able to consume more than they earn. Robust consumer spending has boosted GDP growth, but at the cost of a negative personal saving rate, a growing burden of household debt and a huge current-account deficit.

Ben Bernanke, Mr. Greenspan’s successor, likes to explain America’s current-account deficit as the inevitable consequence of a saving glut in the rest of the world. Yet a large part of the blame lies with the Fed’s own policies, which have allowed growth in domestic demand to outstrip supply for no less than 10 years on the trot. Part of America’s current prosperity is based not on genuine gains in income, nor on high productivity growth, but on borrowing from the future. The words of Ludwig von :: “It may sometimes be expedient for a man to heat the stove with his furniture. But he should not delude himself by believing that he has discovered a wonderful new method of heating his premises.”

While Mr. Bernanke is even more opposed than Mr. Greenspan to the idea of restraining asset-price bubbles, he seems just as keen to slash interest rates when bubbles burst to prevent a downturn. He is likely to continue the current asymmetric policy of never raising interest rates to curb rising asset prices, but always cutting rates after prices fall. This is dangerous as it encourages excessive risk taking and allows the imbalances to grow ever larger, making the eventual correction even worse. If the imbalances are to unwind, America needs to accept a period in which domestic demand grows more slowly than output.

Irrational exuberance over Greenspan.

Alan Greenspan, now in his final weeks as the chairman of America’s Federal Reserve, has been proclaimed “the greatest central banker who ever lived”. Among ordinary Americans he enjoys almost rock-star status. He has been awarded the Presidential Medal of Freedom, a British knighthood and the French Legion of Honour. Does he really deserve such uniform praise? And after the accolades have faded, what will economists conclude about his tenure?

It is ironic that when Mr. Greenspan took over from Paul Volcker, his inflation-busting predecessor, in 1987, some questioned whether he was really up to the job, and he went through some rocky times in his early years. The stockmarket crashed within two months of his taking office, and America’s growth fell behind that of Europe and Japan for several years. For the past decade, however, he has been viewed as possessing almost magical powers. He is credited with saving the world economy – from the stockmarket crashes of 1987 and 2000-01, and from Russia’s default and the near collapse of LTCM, a hedge fund, in 1998 – by pumping in liquidity when it was vulnerable. At a dinner for the members of the G7 in December, Mervyn King, the football-mad governor of the Bank of England, presented Mr. Greenspan with a cartoon depicting him as a goalkeeper saving one penalty after another.

On the surface, America’s economic performance has been remarkable on his watch. Not only has inflation been reduced, but America has enjoyed the two longest expansions on record, marred only by two mild recessions. The previous 18 years, by contrast, suffered four recessions, including the two severest since the Great Depression of the 1930s. On closer inspection, however, Mr. Greenspan’s record looks less impressive. The drop in America’s core rate of inflation has in fact been no greater than the average for all the industrialized countries in the OECD. Global disinflationary pressures have made fighting inflation easier for all central banks.

Nor has Mr Greenspan done a much better job than foreign central banks at smoothing the business cycle. It is true that America has enjoyed faster GDP growth than other big OECD economies, but that should not be attributed to the Fed. An analysis by Martin Barnes, of the Bank Credit Analyst, finds that if America’s growth performance is instead measured by the gap between actual and potential output, it looks much less stellar. America has on average had a slightly larger negative output gap than the rest of the OECD.

The Greenspan fan club claims that the chairman’s skilful policies have not only reduced economic volatility, but may also, at least temporarily, have increased America’s potential growth rate. Spotting the spurt in productivity growth in the late 1990s before almost anybody else was one of Mr. Greenspan’s greatest achievements. Recognizing that this would allow the economy to grow faster without fuelling inflation, Mr. Greenspan allowed the boom to continue and unemployment to fall, dragging many disadvantaged workers back into the labour force.

However, this short-term gain came at a long-term cost. His faith in the productivity miracle may have blinded him to the dangers of excessive monetary growth. On Mr. Greenspan’s watch, America has also experienced the biggest stockmarket and housing bubbles in history. Presiding over one bubble could be seen as bad luck; presiding over two smacks of carelessness. The Greenspan era will not end on January 31st. Instead, his legacy will linger in the shape of the biggest economic imbalances in American history: a negative household saving rate and a record current-account deficit. Until these imbalances unwind – a process that could prove painful – it is too soon to applaud Mr. Greenspan’s record.

In December Mr. Greenspan was made a Freeman of the City of London. One of the traditional perks of this honor is that he can be drunk and disorderly without fear of arrest. The snag is that his policies have also encouraged drunk and disorderly asset markets and intoxicated consumers. When the party ends, Mr. Greenspan will not be there to clean up the mess. But end it surely will.

IF HISTORY REPEATS ITSELF, IS IT TIME TO PANIC?

Call it the 99-year cycle. If it continues, then this year may not be an enjoyable one for investors. William Draves, co-author of Nine Shift, a book looking at parallels between the first years of the 20th century and the first years of the 21st century, points out that the stock market over the last 9 years resembles the market in the years beginning in 1898. He suggests that in both periods the economy was just beginning to deal with the changes wrought by new technologies that would change the way business was done: The automobile in the early 20th century changed the economy from an agrarian to an industrial one, and now the Internet is changing it from an industrial to an information economy.

A look at the Dow Jones industrial average from the end of 1897 on shows that it rose nicely for three years, then had three down years, two years of recovery and one year when not much happened. At the end of the nine years, the Dow was up 91% for the period. The closest comparison now seems to be in the New York Stock Exchange composite average, which measures the performance of every stock on the Big Board. Since the end of 1996, it is up 87%. And the annual pattern has been similar. A chart showing the performance of stocks in the two eras indicates that the matches are not perfect, with the market showing a little less enthusiasm as the 19th century ended than it was to show 99 years later, and a little more enthusiasm in the rebound of 2003 and 2004 than it evidenced nearly a century earlier.

There is, of course, no reason to think that such a pattern is bound to continue. But if it does, this year will be a bad one. The Panic of 1907 caused banks to fail and provided evidence that the existing monetary policies of the U.S. were inadequate. When the U.S. Treasury was unable to put up enough money to calm scared depositors, J.P. Morgan did so, a fact that appalled those who deemed it risky and humiliating for the government to have to rely on an investment banker to prevent disaster. The reaction led, in 1913, to the establishment of the Federal Reserve System to avert future crises.

Today, faith in the Fed is high. The Fed’s prompt action after the crash of 1987 and again after the technology bubble burst in 2001 are deemed to be proof that even if there is a housing bubble about to burst, there is little to fear in the broader economy. But a look at The New York Times of 99 years ago shows that the government thought similar confidence was deserved by the system that involved the Treasury withdrawing money from banks when cash was plentiful and depositing it when seasonal demands for credit pushed interest rates to unreasonably high levels. Not, one might say, the most comforting historical precedent for Ben Bernanke, who is on track to replace the long-serving Alan Greenspan as chairman of the institution that, in no small part, owes its existence to the Panic of 1907.

THE MARVELS OF GOOGLE-MART

Last spring, Google’s share price topped your editor’s slightly elevated cholesterol level. At the time, he expected Google to slip back below 200 well before his cholesterol would. But he was quite wrong. Google has advanced from triumph to triumph, soaring through 50-point price levels like a balloon-catheter through a coronary artery. The stock flew through $300 in July, $350 in October and then $400 in the early part of this year, in the process topping the market capitalizations of Cisco Systems, IBM and yes, even Berkshire Hathaway (price chart here).

Not surprisingly, Wall Street pretends that Google’s amazing run is only just beginning and, of course, thoroughly justified by the “fundamentals”. In the past week alone, Goldman Sachs raised its 12-month price target on “GOOG” from $400 to $500, while Piper Jaffray issued an even more brazen $600 target. At its current quote of $472 a share Google sells for 98 times trailing 12-month earnings – a valuation that would attract very few value investors. Is the stock worth such a seemingly preposterous valuation? We have no idea. With respect to the Google’s of the world, we admit to a paralyzing combination of befuddlement and awe. We behold the stock’s amazing ascent like we would watch a bull fight: simultaneously impressed and horrified.

We observe its feats from the sidelines with the same range of emotions and reactions we make experience at a bull fight: We are simultaneously, impressed by the skills on exhibition, terrified to participate and horrified by the spectacle of it all. Google may not be worth anything close to 98 times earnings, but then it again, it might not, not be. Justice Litle, editor of Outstanding Investments, and Bill Bonner, editor of the Daily Reckoning, recently exchanged a couple of emails about the New Era in which Google operates … and thrives. Read on …

GAME SHOWS, ACID TRIPS, AND ECONOMICS

“Mr. Post is studying the show to see whether it might help explain why people make irrationally risky economic decisions.” That would be Thierry Post, who happens to be a professor of finance in the Netherlands. He is part of “a small, intense cadre of economists who study ‘game theory,’ seeking to explain the situational choices contestants make, and the clues those choices may hold for economic behavior in everyday life.” A worthy pursuit, that, especially if knowing the “why” can reduce the frequency of irrational economic decisions.

So exactly what are Mr. Post and cadre studying to gain this knowledge? Well, the answer depends on which night of the week it is: Some nights it is “Jeopardy”, on others it is “The Price is Right”, or maybe “The Weakest Link”, or perhaps “Deal or No Deal”. In other words, these guys look for clues about irrational choices by watching game shows.

GAME SHOWS? Dude!! Watching someone on an ACID TRIP go through the check-out at a grocery would come closer to duplicating “economic behavior in everyday life”. Now, I did read about this in the center column of the Wall Street Journal’s front page, which is dedicated to offbeat stories. But I looked a bit deeper and saw that this “cadre” consists of real economists who take this stuff seriously. So I have just one simple question: If you were doing serious research into “irrationally risky decisions”, would you study: 1.) A relative handful of people who make choices in a context that 99.999% of the general population never experiences, or 2.) Data that includes the choices made by millions of people over many decades, in a context that half of U.S. households still experience to this day. In other words, would you watch games shows& or study investors and their stock market returns? We take choice “2”.

WHERE DOES ALL THAT “WONDERFUL MONEY” COME FROM?

“House Prices Seen Slowing,” says the LA Times. And more news from Contra Costa, also in the Golden State: Christopher Thornberg, senior economist with the UCLA Anderson Forecast, told a business group that he believes a drastic deceleration in home sales is coming. “You are starting to see a slowdown in housing market activity, and that says loud and clear that things are starting to break,” Thornberg said. Thornberg believes house prices are about 30% to 40% overvalued. But a return to normal is not an easy matter, he explained. “If you have a big decline in unit sales, you’ll have mortgage brokers and real estate agents and construction workers all losing jobs. And what’s driving the California job market right now? Construction, finance and real estate jobs. Those will go away … all that wonderful money is going to disappear. Suddenly, the house isn’t going to be able to pay for the kids’ education, it’s not going to pay for your retirement in Bermuda and it’s not going to pay for that face-lift at age 74.” Thornberg adds, “… we have peaked. And beyond that is a downhill run.”

We have wondered about that. Everywhere we look, there is so much “wonderful money”. On our street in London there is a Ferrari dealer and a Lamborghini dealer. It seems as though every other car is a Porsche or a Mercedes. And, looking around this past weekend, we saw an ordinary house for sale – three bedrooms, three baths, parking space. It was ordinary in every sense but one: it is priced at about $9 million. A pretty far run downhill for someone.

Also in yesterday’s news, Bloomberg reports that Wall Street will hand out $21.5 billion in bonuses. All that wonderful money! Where does it come from? What does Wall Street do to earn it? The masters of the universe on Wall Street tell us that they “allocate capital efficiently”. They must be doing a heckuva job allocating capital. We are surprised that there is so much money to be made in “allocating capital”. But we are suspicious. We do not even know what allocating capital is. How is it different from helping the fool part company with his money? Is it what you do when you entice speculators into Google at 117 times sales and 350 times earnings? Well, get it while you can. And enjoy it as long as it lasts. These bonuses will probably disappear, too, along with all that other wonderful money from the housing bubble.

Meanwhile, our old friend, Marc Fabersays that the best place for your money now is in Asian property (see article summary here). “There is a speculative element to everything in the present time. We live in a world of inflated assets,” he says. Yes, we do. Realtors in California, stockbrokers in New York, car dealers in London – a lot of very nice people have made their fortunes as assets took on air. Shame it has to disappear some day. People who have been walking on water are going to have to learn to swim.

HITTING THE SKIDS

A year ago, I believed three investment themes would work in 2005: a rallying of the dollar, spreading deflationary expectations, and a flattening of the yield curve. Three more might commence in 2005 but could start later: a bursting of the U.S. housing bubble, falling American stock prices and a hard economic landing in China. So what happened? The dollar did rally. Deflationary expectations spread beyond autos and into appliance stores, department stores, computers and recreational vehicles. The yield curve flattened and, late in December 2005, inverted. While the housing bubble did not burst, that market has definitely cooled. U.S. stocks did not decline like they did in the 2000-2002 bear market, but major stock indices last year registered only tepid gains, if at all. And China’s efforts to cool her overheated economy ran into difficulties.

What is ahead for stocks and the economy in 2006? Setting aside unknown elements like major terrorist attacks, natural disasters or a bird flu pandemic, I believe six phenomena are shaping the investment climate this year. The world is awash in financial liquidity mainly due to rising house values, the negative U.S. corporate financing gap and the American balance of payments deficit. Inflation remains low despite higher energy prices. As a result, investment returns are low. Speculation remains rampant despite the earlier bear market. So, investors are accepting more risks to achieve expected returns. And then there is the insatiable U.S. consumer, who, thanks to the booming housing market, continues to spend freely.

In this climate, I foresee 10 investment themes, seven of which are likely to unfold in 2006, while three will probably work – but maybe not until next year:

1. The housing bubble will burst this year. If house prices collapse, that could change the good deflation of excess supply I foresee to the bad deflation of deficient demand.
2. The Federal Reserve will tighten until the housing bubble bursts, and seriously invert the yield curve in the process. Once housing is in a shambles, either falling from its own weight as I expect or due to central bank action, the Fed, of course, will do its patriotic duty and ease as the economy hits the skids.
3. U.S. stock prices will fall this year, perhaps below their October 2002 lows, in the midst of a major recession.
4. China will suffer a hard landing due to domestic cooling measures and the U.S. recession. Of course, a Chinese business slump this year does not mean an actual decline in real GDP there. A cut from the current 9%-10% growth rates to 4% or 5% would be severe since more than those growth rates are needed to employ the hordes that continue to stream in from the hinterland to the coastal cities in search of better jobs and incomes.
5. The weakness in U.S. and China will spread globally, dragging down stocks universally.
6. Treasury bonds will rally. The yield on long-term Treasuries is now about 4.5% and I expect it to decline this year and reach 3% when deflation becomes irrefutably established, as I will discuss later.
7. The dollar will remain strong – primarily because in times of trouble, the U.S. is a safe haven. America, with all her speculative excesses to be corrected, will probably remain the best of a bad lot.
8. Global and chronic deflation may commence in 2006. With a global recession collapsing commodity prices and the robust deflationary forces already at work, major goods and services price indices in the U.S. and abroad, such as the CPI, will no doubt fall this year. I foresee the good deflation of excess supply, driven by new tech productivity and excess capacity, as in the late 1800s and in the 1920s, not the demand-deficient deflation of the 1930s. Unlike inflationary periods, when the real value of debt falls, it rises in deflation.
9. U.S. consumers could start a long-run saving spree this year, reversing their 25-year borrowing and spending binge, as a renewed bear market in stocks and a collapse in house prices will eliminate the two major sources of consumers’ buying power.
10. Deflationary expectations may surge and spread widely in 2006. Deflationary expectations spread and intensified in 2005 as consumers waited for lower prices for cars, airline tickets, telecom fees, even general merchandise before buying. That leaves producers with excess capacity and inventories that force them to cut prices. Those cuts only fulfill consumer expectations and encourage them to wait for even lower prices.

CHINA’S SECRET METAL: PALLADIUM

Gold is grabbing all the headlines today, but palladium may be grabbing all the headlines tomorrow. That is because demand for this precious metal is picking up a head of steam. I sometimes refer to palladium as “China’s secret metal” because Chinese consumption of this rare metal has soared in recent years. Palladium is vital to the automotive, computer, biotech, pharmaceutical, and glass-making industries. In fact, palladium and platinum are becoming so valuable, the St. Louis Post Dispatch reports, that they are become the target of thieves, who are stealing cars in order to extract these precious metals from catalytic converters. “Police say this particular crime is on the rise,” the Dispatch reports, “as more thieves discover the value of the hot part and learn how to dismantle it.”

If I am right about the developing bull market in palladium, car thefts in St. Louis could become increasingly popular. The fundamental argument for owning palladium is growing stronger by the day, because industrial demand is growing stronger by the day. (And it probably does not hurt that commodity funds are continuing to pour money into the precious metals sector). I expect industrial demand to continue booming, as long as the price spread between platinum and palladium remains as wide as it is currently.

Palladium can perform many of the same industrial uses as its sister metal, platinum. Therefore, whenever analyzing the palladium market, it is important to pay attention to the price relationship between these two metals (see chart). If, as is currently the case, the platinum price strays far away from the palladium price, certain industrial consumers will begin using palladium instead of platinum, thereby boosting demand for palladium. Throughout the late 1990s, these two precious metals tracked each other pretty closely. But in 2000, the price of palladium spiked due to supply disruptions from Russia. As the palladium price soared, many industries began substituting other cheaper platinum group metals. So by the time Russia resumed shipping palladium, industrial demand had disappeared. The palladium price plummeted from more than $1,000 an ounce in 2000 to less than $200 an ounce by 2003. But palladium finally started inching up again late last year. This appears to be the start of something big.

Today, with platinum at $1,030 per ounce and palladium at $270 per ounce, the price differential between the two has reached a record-wide spread. Consequently, it seems very likely that either the price of platinum will fall, or the price of palladium will rise – or both metals will rally together, but with palladium rallying more. Whatever the case, the spread between the two seems likely to narrow, to the benefit of palladium. Another way (besides stealing cars) to play the bull market in palladium (and in platinum) is to invest in one of the two North American companies engaged in mining for palladium: Stillwater Mining Company (SWC), and North American Palladium (PAL). Not surprisingly, the share prices of these two companies display a remarkably close correlation to the price of palladium (e.g., see this chart).

If we are truly in the early stages of a bull market move for palladium, I expect we will see the metal surpass the $325 peak of 2004. And, I expect we will also see the shares of both of these companies appreciate by at least 100%.