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GM BANKRUPTCY: IT AIN’T GONNA HAPPEN
Enough already on General Motors and Bankruptcy. I am tired of the B-word. GM is not going bankrupt this year, GM is not going bankrupt next year, and 2008 is so far off that even Bill Gates could be bankrupt by then. It is dangerous to go three years out, but no, I would not expect GM to go bankrupt in 2008, either. Why not? The company has $19 billion in the kitty and just about $100 billion in the pension fund. But there is more here than the balance sheet. When I was a boy, there was one reason companies went bankrupt: They could not pay their bills. GM can pay its bills.
The new reason for bankruptcy is to break a union contract. That works with airlines because there are always some Navy top guns who owe on their Corvettes and will replace your striking pilots. And there are lots of women left to replace your striking stews. But replacing 150,000 United Auto Workers members is another story. A judge could tell them to work for 10 cents an hour, but it is still a free country; they can strike, and they would. Plus, they are stronger than the company. The workers own paid-up houses, cars and boats and have working wives (or husbands). GM would have to negotiate any change in the contract, so the bankruptcy ploy just does not work here.
So why does it keep coming up? Maybe the short-sellers are hoping to wreck the business and the stock. It has happened before. Maybe the Wall Street analysts just do not understand the business. That has happened before, too. If you still have capital-loss carryforwards on your tax return, that could be because you listened to their advice during the last boom and bust. GM is in deep trouble, for sure. Money is siphoning out, and if there is no turnaround, bad things will happen eventually. But there are a few positive signs, too. This year, 2006, will be a difficult year. The product is better, but the competition is the fiercest ever. “Good” or “better” does not top Toyota. Only “best” does that. If a turnaround at GM is not evident by fall, look for a management change. But enough of the bankruptcy talk.Link here.
HOUSING MARKET: L-END GAME
If you happened to apply for a mortgage sometime in the last year, you may have found that the one deciding factor to getting approved was not annual income, employment status, available down payment, or even credit score. It was simply – Do you have a pulse? Like a parent on its third child, America’s largest mortgage holders Fannie Mae AND Freddie Mac loosened their stance against less traditional mortgage products to create one of the easiest lending environments in history. As a result, 2005 saw banks across the country offer its customers more ARMs options than an octopus. Take your pick: “Interest-only”, “sub-prime”, “no-doc”, “hybrid”, “negative amortization”, “balloon”, and “exotic” mortgages – all raising the limbo pole to home-ownership just high enough for, oh, say, Shaquille O’Neal to walk under.
In case you have any doubts, check this stat out: In January 2003, the Mortgage Bankers Association reported that 13.5% of all new loans were adjustable rate. By that time in 2005, the number had rocketed to 40%. The thing is, while Wall Street and friends were praising the warm-body-only requirement to closing escrow, our analysts saw that the heyday of Fannie Mae was soon to become the nightmare of Fannie MAY NOT. Right at the onset of the mortgage giant’s $11 billion accounting scandal, the July 2004 Elliott Wave Financial Forecast had this to say:
“The psychological aspect” of the next turn in mass social mood will carry the following implications: (1) A backlash against the mortgage giants will build in the form of Congressional, Federal, and Bush administration demands for greater financial disclosure and constraints on Fannie, Freddie and their counterparts. (2) Lenders will change their primary orientation from expansion to conservatism. As creditors become more conservative, they will slow their lending.
In no time, the heat under Freddie and Fannie’s fanny went from matchstick to blowtorch, culminating in the October 2005 bill to install stricter regulations AND cut the government-sponsored entities’ investment portfolios – approved by the House of Representatives. As for a “change in orientation from expansion to conservatism” by our leaders in lending, this January 6 CNN Money alert says more than enough: “Attention homebuyers: getting approved for those popular non-traditional mortgages may be a lot more difficult in the near future.”
Turns out, Federal banking regulators across the nation are “urging”, i.e., demanding that lenders do two of two things in the near term: Give borrowers a heart to heart about the high risks involved in acquiring exotic mortgages BEFORE they sign on the dotted line – and – tighten their standards for issuing such loans. On a good day, removing 40% of the rebar holding up the housing market would be a dangerous job. Problem is, the U.S. housing market has not had a good day in quite some time – with inventories of unsold homes reaching an all-time record AND new home sales falling to a 12-year low this past November. Which has many in the business scratching their heads at why now. “Today,” remarks one voice, “with home prices through the roof and families worried sick about making the house payment, now is not the time to make it tougher on folks.”
Yet we said earlier, it is not a matter of timing; it is a matter of the trend in mass social mood. And when that tide turns, those in charge of making money available to the public will “turn off the spigots” and put the “end” in Lending. According to the mainstream “experts”, in the highly anticipated forthcoming economic recovery home prices will stabilize at their current levels and personal wages will surpass expenses. Thus consumer’s dependency on creative mortgages will decrease right as lenders make it harder to get a hold of them. Do you believe them or not?Elliott Wave International January 13 lead article.
#1 home lender ceo blames loan rivals for eroding earnings.
Brutal competition in the shrinking home loan market has caused “irresponsible players” such as Ameriquest Capital and New Century Financial to spoil mortgage banking profits, the chairman of No. 1 home lender Countrywide Financial Corp. said. Announcing earnings that disappointed Wall Street, Countrywide founder Angelo R. Mozilo singled out the two Orange County-based competitors, blaming “the Ameriquests and New Centuries of the world” for pricing loans too low in a bid to retain market share as business slows. “I’ve been doing this for 53 years, and I’ve never seen that situation sustained,” Mozilo, 67, said during a conference call with securities analysts. “Eventually they gag on it.”
Mozilo added that “cracks in the armor” were beginning to appear, citing Ameriquest’s recent decision to lay off 10% of its staff, or 1,500 people, at its Ameriquest Mortgage unit. Another Ameriquest company, Argent Mortgage Co., said it would shed 640 of its 4,000 employees, with layoffs spread across its California headquarters and regional centers in Illinois and New York. Privately held Ameriquest Capital declined to respond to Mozilo. New Century, a public company that will release its earnings this week, issued a statement saying that it had been “responsibly raising rates in order to restore our profit margins to acceptable levels.”
Ameriquest and New Century are the largest “sub-prime” lenders – specialists in higher-cost loans to people with poor credit or other financial issues. Such lending boomed as interest rates fell in 2003 and 2004, with mainstream lenders such as Countrywide embracing it as an important part of their operations. The prospects for sub-prime lenders are uncertain now that most people have already refinanced their homes in the last few years and short-term interest rates have risen sharply. Most sub-prime mortgage rates are adjustable, pegged to shorter-term interest rate indexes.
Mozilo previously pledged that Countrywide would continue its strong growth in the long term, hiring employees away from competitors and increasing its market share, now about 16%. But with its quarterly mortgage banking profit down 80% from 2004, Countrywide too may have to cut jobs in the near term, Mozilo told analysts. Countrywide projects that U.S. mortgage lenders will originate $2.2 trillion to $3.2 trillion in loans this year, compared with about $2.8 trillion in 2005 and $3.4 trillion in the record year of 2003. If the amount is in the midpoint of those projections, “there has to be an adjustment in terms of head count,” Mozilo said.Link here.
Housing’s slide will have ripple effect.
After last week’s existing-home sales report, National Association of Realtors chief economist David Lereah declared that the speculators were “pulling out”. The question for the broader economy is, will the flight crew be limited to the speculators? Last spring, Asha Bangalore, an economist with Northern Trust Co., startled the investment community by attaching a number to the housing boom’s impact on the U.S. job market. The number has been widely quoted: From November 2001 to April 2005, housing contributed 43% of new jobs created.
As it turns out, last spring marked the heyday in housing. In the final three months of last year, sales of existing homes declined at a 17% annual rate, the biggest slide since the second quarter of 1994. And housing starts and permits entered 2006 on a much weaker note than expected. With housing slowing, job creation will follow, unless another industry takes up the slack. Recent months’ data on payrolls confirm job creation has faltered. Payroll growth averaged 114,000 in the last four months of 2005, down from a 197,000 pace in the 18 months prior. These first signs of a slowdown mesh with Ms. Bangalore’s most recent figures. By October of last year, the percentage of jobs created that were tied to housing had slipped to 36%. “I think what we’re seeing is the beginning of the impact of cool-down in the housing market,” Ms. Bangalore said.
Of course, these declines will come off housing’s hottest year on record. Residential debt, in its various forms, now constitutes more than 60% of the loans on banks’ books, a record. This tsunami of underwriting has employed masses of people who will be hurt, as will those toiling in the real estate, home improvement and related industries. But what about sectors not directly associated with housing? Ms. Bangalore noted that it was not happenstance that housing’s weakest quarter in more than a decade coincided with a near 40% annualized decline in auto sales. “This does not speak well of the status of the U.S. economy. The ripple effects of the slowdown in housing will be significant.”
Hard landing or soft?Link here.
California mortgage delinquencies increasing.
The number of default notices sent to California homeowners rose in the last three months of 2005 as the rate of price increases slowed, a real estate research firm said. The delinquency notices serve as an early indicator of possible foreclosures. Typically, about 5% of homeowners who receive such notices end up losing their homes. Lenders sent 14,999 default notices to California homeowners from October through December, according to DataQuick Information Systems. All areas of the state saw a rise in delinquency notices. The counties with the largest annual percentage increase in default notices were Napa, San Luis Obispo, San Francisco, Riverside, Orange and San Diego.
The fourth-quarter total represents a 19% increase over the 12,606 notices sent out in the third quarter and a 15.6% hike over the 12,978 notices sent in the same period in 2004, the firm said. The increase in delinquencies probably is a result of the decline in home appreciation in many markets over the last couple of years, DataQuick analyst John Karevoll said. While home prices were rising, homeowners were able to tap a growing pool of equity for loans or refinancing if they found themselves in financial straits. “But when prices don’t go up as fast, you don’t have that built-up equity like you did before,” Karevoll said. “People won’t have that buffer the way they did a year or two ago.”
And financially distressed homeowners have largely been able to avoid foreclosures because rising real estate prices allow them to sell their properties instead. Although many homeowners in recent years took on adjustable-rate mortgages or interest-only loans that offer a lower initial monthly payment, there is no evidence that those loans adjusting to a higher rate are behind the rising number of default notices, Karevoll said. “We’re not seeing that yet.”Link here.
Why is this legal?
Option adjustable-rate mortgage, or “Option ARMs”, let homeowners decide how much to pay each month, beyond a small minimum amount. All unpaid interest rolls into the balance, which of course gets larger with each minimum payment. Yeah, just like a credit card. Whose idea was this, and who said it was actually okay?
The government finally seemed to say “It’s not okay,” in public remarks by the Comptroller of the Currency, as reported by the Washington Post. The story’s lead was, “Federal financial regulators appear to be on the verge of reining in one of the most popular mortgages in hot housing markets nationwide.” But yesterday’s Wall Street Journal said that fears of a “regulatory crackdown on option-ARM lending practices& turned out to be more bark than bite.” Why, then, did regulators suggest a “crackdown” and then fail to crack down?
After five years or so, Option ARMs can push monthly payments higher by 50% to 100%. Exactly how small was the print in the contract that explained this clause to the borrowers? Borrowers who do know about balloon payments apparently believe that “double-digit appreciation” in home values will continue, and in turn bail them out of the heavy debt load. Why do they assume that past performance is indicative of future results?
Lenders who get the minimum payment on Option ARM mortgages are actually able to book the full monthly payment into their earnings. Why is this legal? “The banks’ loan-loss reserves are low, by historical measures,” even as Option ARMs comprise dramatically higher percentages of their mortgage portfolios. Why is this legal? As much as 80% of recent mortgage loans have been “low documentation”, which means banks know very little about the creditworthiness of borrowers. As many as 13% of these borrowers are NINAs – “no income, no assets”, which means “customers get mortgages without disclosing their income and assets.” Why is this legal?
There is more I do not know, but you get the idea. Here is what I DO know: even the very few people who see the real estate bubble for what it is do not grasp what will really happen to the economy, when that bubble bursts.Link here.
Dot-com bubble boys are now heavily involved in real estate.
They were revered for their entrepreneurial acumen and vilified when the tech boom went bust. More recently former tech execs like Steve M. Case and James Clark have been riding a second wave – the real estate market. Case, former chairman of AOL Time Warner, is now the majority owner in Miraval, a spa in Arizona. Thomas Jermoluk, former head of ExciteAtHome, partnered with Clark, founder of Silicon Graphics, Netscape and Healtheon, to build a pair of luxury condo towers in Miami. They say they learned enough not to get burned twice. That makes us wonder: Are these guys leading indicators of a real estate bust?Link here.
HOW TO REIGN IN EXECUTIVE PAY?
The combined compensation for the heads of America’s 500 biggest companies increased by 54% in 2004. Harvard professor Lucian Bebchuk’s calculations show that the top five executives now collect 10% of the average big firm’s net income, double the percentage a decade ago. This is a problem that affects not just morale but competitiveness. It is devilishly difficult to figure out how much bosses should be paid. Pay too little and your company will not attract quality leadership. Pay too much and you shrink the bottom line.
We do not want Stalinist central planning. But this is an area where the invisible hand of the market works poorly. Executive compensation is determined by a compensation committee of the board. In practice, the committee subcontracts the work to a compensation consultant. Consultants only make matters worse. Although they are supposed to be independent, the reality is that they are more likely to be rehired when the chief executive is happy with the result. Every firm likes to think its boss, like the children of Lake Wobegon, is above average. The problem is that when most firms pay an above-average wage, the average skyrockets.
There is a solution to this mess. To increase the objectivity of compensation consultants, we should give them less information. The consultants should be hired blind. They would be independent because they would not know which side of their bread was buttered. The compensation committee would arrange for a law firm to hire the consultant without disclosing the client. The consultant would be given a list of ten firms in the industry. The consultant would be asked to rank the executives’ performance and suggest salaries for each. Half the chief executives would be ranked in the bottom half and presumably would be paid accordingly.
Shareholders might like to know if the other consultants consistently rank their chief executive below average. Not that it would be any cause for alarm if half of publicly traded firms discovered that their chief executive officer falls in the bottom half. Remember the old joke about what they call the person who graduates at the bottom of the class at Harvard Medical School? The answer is “doctor”.Link here.
STOCKS FOR A WEAK MARKET
In 2005 the stock market performed tepidly but ended up slightly ahead, with the S&P 500 appreciating 3%, not counting dividends. In 2006 I expect to see another such year. There should be little difference except the last digit in the year’s designation. Driving the market will be a good economy that grows 2.5% to 3%, net of inflation. But that growth will be at a less rapid clip than last year’s 4%. So both camps should be pleased – GDP expansion will have slowed enough to calm inflation worriers, but sufficient growth will occur to shake off the fear of recession. (Fellow Forbes columnist Gary Shilling has a different opinion – see “A Dark Year Lies Ahead” below.)
Earnings increases are robust, and I see no hint of any near-term slowdown here. Profit rises have outstripped stock appreciation, and thus PE ratios are falling in this bull market, from 27.5 for the S&P 500 in the fall of 2002 to 18.5 now. Another factor that should help stocks: The Federal Reserve, confident that it has attained economic equilibrium, will stop tightening early this year. A lot of people want to buy stocks, and this appetite will not abate. Among the buyers are many cash-laden companies that are repurchasing their own shares. For last year’s first three quarters, buyback announcements increased 35% to $287 billion. Arguments abound about whether buybacks are a good use of corporate cash, yet they are undeniably good for earnings per share if the shares are bought cheaply enough (the EPS goes up if the earnings yield on the stock is better than the aftertax return on cash). Meanwhile, private equity firms are hauling in tremendous numbers of investor dollars, and their managers are paid to put that money to use, not sit on it. That is another upward force for the market.
In 2005 I had a very good year, with my picks up a collective 14.3%, after deducting an assumed 1% trading cost on new positions. Had you put equal amounts into the S&P at the same times, you would be ahead only 3.5%. As always, I often write about stocks that my company owns. Energy, despite predictions from the naysayers of a price crash, remains attractive. More likely, per-barrel prices will stay in the vicinity of $60. The concern over housing is, I contend, overdone – and provides opportunities. Mortgage rates should stay tame, and an advancing economy will give buyers the wherewithal to afford houses. Assuming the Fed indeed stops raising interest rates, know that historically the groups that do well in the six months thereafter are tobacco, consumer financials and drugs.Link here.
HOW TO DIVERSIFY YOUR FIXED-INCOME PORTFOLIO
To most fixed-income investors diversification has three rules: 1.) Do not invest too much in any one issuer. “Too much” is anything over 5% of your portfolio. 2.) Spread your fixed-income investing among securities with different rating qualities. 3.) Ladder your maturities – that is, buy things that come due over a broad time span, from short to long term. The virtue of such diversification, of course, is that it reduces your exposure to loss from inflation and defaults. Alas, this standard approach is not enough. Its weakness is that it is defensive in scope. You need to go beyond the conventional axioms.
Diversification should not be just about seeking safety, but also about getting a lift from an array of economic events. This is not only about interest rates, inflation and credit risk. It is also about stock prices, energy prices and industry-specific occurrences. I will illustrate how my concept works, using this column’s recommendations for 2005, plus some new ones. On the whole, my picks for 2005 were narrowly in the plus column. Although the dividend/interest yield was a healthy 8.2%, the total return (dividends or interest plus capital gains or losses) for someone buying all the recommendations would have been 0.7% after deduction of a hypothetical 1% trading cost for new positions.Link here.
LONG AND OPTIMISTIC
Last year was one of contradictions. Gold prices soared, yet inflation was contained. Stock markets around most of the world exploded, but not in the U.S., where you would have done just as well owning Treasury bills. The natural gas market, in something of a glut as recently as 2002, went parabolic in price, putting Calpine into bankruptcy. Never was sector or geographic selection more important.
A most peculiar contradiction is the plentiful availability of credit and liquidity in an environment where the yield curve is flat to slightly inverted. Treasury rates are close to 4.3% over the entire range of maturities from two to 10 years. Such relative tightness of money at the short end of the spectrum is supposed to signal a liquidity crunch and an impending recession. It is supposed to mean that marginal businesses and consumers are turned away from the credit window and that a downdraft in asset prices will follow.
But there is no credit crunch. Instead we seem to be in a liquidity bubble. In New York Fifth Avenue apartments routinely sell for tens of millions of dollars. A London home was bought last April by steel mogul Lakshmi Mittal for a staggering $127 million. In December Miami Beach hosted Art Basel, a mind-numbing extravaganza of gallery shows and art auctions, where photos of porn stars have sold for $35,000 each. Like the TV show, a rush to buy everything in sight gave the fair its nickname, “supermarket sweepstakes for the rich.” It is the Gilded Age all over again, with gold-plated railway carriages replaced by Patek Philippe watches and hedge fund managers as our modern-day robber barons.
The world’s sea of liquidity is lifting all the boats, not just those belonging to the yachting class. Virtually no one who wants a mortgage or a credit card is refused. If we have a booming equity market with a flat yield curve, it will break all the rules. Could it (shudder) be different this time? I think it will. Corporate balance sheets are awash in cash, meaning either dividend increases or stock buybacks. The heating up of merger activity is only beginning. All this is bullish. I believe that risk is inefficiently priced and that investors overpay for certainty. Uncertain sectors are cheap. As a rule this phenomenon leads me to invest in emerging markets, where fear and unfamiliarity are reflected in low prices. Now it points me to the pharmaceutical industry – which is why I advocate your holding on to Merck and Pfizer.
Adelphia’s bankruptcy brought fear to the cable business. But the business is still sound. The enterprise value – common stock plus debt – of Comcast (26, CMCSA) is only 7.3 times the operating income (EBITDA) it probably had in 2005. Comcast has not been that cheap in a decade and probably will not stay that cheap for long. Private market purchases of smaller, lower-quality cable systems are at much higher multiples. Once an absorber of capital, Comcast has been transformed into a cash generator and is using that cash to buy its own stock. One more bullish sign.Link here.
A DARK YEAR LIES AHEAD
My early 2005 columns ranged over six investment themes, all out of the mainstream: 1.) The dollar would rally against foreign currencies. 2.) Deflationary expectations would further damage GM and other automakers, as consumers waited for lower prices before buying. 3.) The Treasury yield curve would flatten as the Federal Reserve induced higher short-term interest rates while long rates fell. 4.) The housing bubble would burst. 5.) A global recession, resulting from the housing debacle, would spawn a bear market in stocks. 6.) My 25-year favorite, Treasury bonds, were still attractive.
I was right about the dollar and the domestic auto industry. Contrary to the herd’s (and Warren Buffett’s) belief that foreigners had too many greenbacks and would dump them, foreign savers kept buying dollars. Deflationary expectations kept Detroit riveted to profit-killing discounts. That and huge labor costs pushed GM and Ford debt into junk status and their stocks to new lows. I was right on the yield curve, too. My housing prediction was a bit too early but may yet be borne out. In hot markets like San Diego and Miami there have been declines in high-priced houses, but more importantly, inventories of unsold homes are leaping. Sooner rather than later, sellers will lose patience and slash their asking prices. We are still waiting on our forecast that the economy and stocks would follow housing. Note, however, that on a total-return basis, Treasury bonds beat the S&P 500, the Dow and the Nasdaq.
This year I have got 10 investment themes that I will flesh out in future columns. Eight should unfold in this calendar year, while the last two may not start until after 2006.
GOOGLE: VALUE, SHARE PRICE, TROUBLE IN BUNCHES
If I were one of Google’s major shareholders or top executives, nothing would have produced an instant sleepless night as quickly as did the stock forecast of “$2,000 per share” on January 6. That day’s trading high was $470, and three sessions later (Jan. 11) the price peaked at $475. But between then and January 20, Google plummeted back below $400 in a decline of some 18%.
There was more, as Google learned that trouble comes in bunches. The Federal government announced it was suing Google to force the company to turn over search data. Some tried to spin this into Google standing up for Internet users, but that notion became much harder to sell when the next spate of bad press erupted a few days later. It seems that the company whose motto is “Don’t be evil” chose to collaborate with the Chinese government, so that Google users in China will see a blank page when they search on phrases like “human rights”.
Now, none of Google’s recent troubles have anything to do with the company’s value – its share price least of all, which long ago defied any rational explanation. Yes, it has a first-rate search engine. I use it nearly every day. But $2000 per share, dear reader? Fantasy must finally give way to the simple reality, which is that Google’s revenue comes from a single source: advertisements. Period.
Even at $475, does anyone really believe Google’s price reflects value? Well, obviously so. They are the same people who bought Amazon for $100 a share in 1999, in pursuit of the famous “Amazon $400” forecast – probably right before their first Amazon book purchase, which went by the title Dow 36,000. Yes, history repeats itself – but the pattern really does have a certain “look” to it. This is why Google serves as an example of something much larger.Link here.
“Hopes and dreams” in the stock market?
Definitions can be tricky, in that the trick is balancing the abstract and the actual. Take a word that is commonly used in finance and economics – “overpriced”. Without checking a dictionary, I could play it safe and say, “Overpriced means the dollar amount of an asset exceeds its true value.” Not bad in the abstract, but that is downright lame in the actual. What kind of “asset”? Tangible or intangible? And “true value” according to whom? A buyer? A seller? Somebody’s opportunity cost estimate?
No, if I am doing the defining, I am going to err on the side of “actual” – the practical, if you will. So let us try again. “Overpriced is when a company announces a quarterly earnings increase of 82%, and instantly sees its share price PLUMMET BY 16%, WHICH WIPES OUT $20 BILLION DOLLARS VALUE.” That is how I define “overpriced”. But, if someone has a better example than what happened to Google shares in the past day or so, I am all ears.
But wait, there is more. Not only was Google’s earnings “not enough”, but the same announcement cited the fact that the company’s quarterly revenue had increased by 86% – and unlike the earnings increase, this jump in revenue did meet published estimates. Alas, meeting revenue estimates is not the same as meeting investor expectations, a truth which produced my favorite quote yet about this fiasco: “Consensus expectations are not reflective of the hopes and dreams of Google investors,” said one Wall Street analyst.
“Hopes and dreams” are about as close as three words can come to explaining why Google ran up to $475 recently, and why it has fallen so hard more recently still. And the illusory of investors is exactly why the February Elliott Wave Financial Forecast has plenty to say about Google, and its reflection of stock market psychology overall.Link here.
VANISHING “DARK MATTER” TO WIDEN U.S. CURRENT ACCOUNT
The so-called “dark matter”that some economists believe is holding together America’s external accounts – and warding off a painful adjustment of global financial imbalances – is disappearing fast, according to new economic studies. Two Harvard economists had suggested in a November study that America’s ability to earn more income on overseas assets than it pays to foreigners on their U.S. assets shows the U.S. to be a net creditor – even though the official balance of payments data suggest it is the world’s biggest debtor.
Using a term borrowed from physics, economists Ricardo Hausmann and Federico Sturzenegger explained this conundrum by means of “dark matter”: U.S. assets abroad that generate income but are not accounted for in official data. They argued that “once assets are valued according to the income they generate, there has not been a big U.S. external imbalance and there are no serious global imbalances.” But recent studies by the Federal Reserve Bank of New York, Deutsche Bank, and Goldman Sachs dispute that theory and warn that the increasing weight of America’s indebtedness to the rest of the world will soon put a huge strain on the current account deficit.
These economists argue that America’s net liabilities, which totaled $2.48 trillion at the last official count, will soon cost more in interest payments than America earns in investment income. In the 1990s, foreign investors flooded into American stock markets and bought U.S. companies. But now most of what foreigners own in America is interest rate-sensitive debt, and U.S. interest rates have been rising since June 2004. As a result, the day is fast approaching when income earned by American companies on the businesses they own abroad will be swallowed up by interest America pays to foreigners holding its debt.
“Thus far, the longer-term implications of the buildup in net liabilities for U.S. net investment income have been masked by the superior rate of return the United States earns on FDI (foreign direct investment) assets and the (relatively) recent drop in global interest rates,” wrote Matthew Higgins, Thomas Klitgaard and Cedric Tille in the New York Fed study published last month.Link here.
THE BEST WAYS TO BUY GOLD
Some advisers tout gold as a way to diversify a portfolio and protect against inflation and a decline in the value of the dollar. The conundrum for investors is that gold can be owned in different forms. Some are riskier than others. Liquidity varies, as do the costs associated with each form of the asset. Here is a look at just a few of the more popular ways to participate in today’s gold rush, including bullion and coins, exchange-traded funds (ETFs), stocks, mutual funds, and jewelry.Link here.
A SHORT LOOK AT SHORTS
The traditional way to make money in the stock market is to “buy low and sell high”. But many investors ask us about another way to profit called “shorting”, where the trick is to “sell high and buy low”. Selling short is a way investors make money on stocks that they believe are going to decline in price in the near future. The important rule to remember is that shorting, while offering a smart way to make bearish bets, carries significant downside risks.
To sell a stock short, you borrow the shares from your broker, then sell the shares and hold the money and wait for the stock to fall. If it does fall, you buy the shares at the lower price and give them back to your broker, who gets a commission and interest for his troubles. E.g., you borrow 100 shares of IBM at $100 a share (a hypothetical price to make the calculation easier) from your broker, then sell them for $10,000. Let’s say the stock drops 20% to $80 a share. You buy the shares back for $8,000, then return them to your broker and pocket your $2,000 profit – minus your broker’s commission, which is the same as what you would pay on a stock purchase, and interest.
But if you short a stock whose price rises, things can get hairy. You can wait to see if the stock will decline, or you buy the stock back at a higher price than you sold them and give them back to your broker (along with the other fees), and take the loss. Those are the basics. Now let us go over the specifics regarding short sales and execution rules. Before you decide to short a stock, understand these topics.Link here.
SUGAR AND CORN INFLATING TOO
While the precious metals and energy sectors have garnered most of the media and investor’s attention in the past year, sugar has quietly doubled in the midst of increase demand for a cheaper and more environmentally friendly fuel alternative. As oil prices continue to rise in the midst of global demand and geopolitical uncertainty, I expect sugar prices to rise substantially over the next several years. In fact, I believe the agricultural sector in general will provide some of the best performance in this multi-year commodity bull market.
Since early December, sugar has moved up over 50%. Although part of this move up has been pushed up by speculative interests entering the market, I also believe that it represents a further break out in a commodity that will benefit from higher oil prices, stricter fuel emission standards, and the demand for sugar as a food product. Without question, the recent move up in sugar has been propelled by increasingly rising energy prices. Although some analysts believe that the price of oil is overvalued, I believe that oil is still tremendously cheap at these levels. Once again, you cannot compare the price of oil in 1980 to the current levels that we have today. If you adjust the price of oil for inflation, you will have an all time high that is closer to $100 barrel – see this chart.
Although there has been a recent focus on ethanol as an alternative fuel, this concept has been successfully implemented by Brazil over the last 30 years. Brazil was reliant on other countries for the majority of their fuel. Today, Brazil is on the verge of becoming energy independent. Because of Brazil’s profound success and the cheaper cost of ethanol, a number of countries have looked to implementing ethanol programs. The demand for sugar will increase dramatically. As it stands, the current sugar supply will not be able to fill the increase demand for the commodity, and this demand will continue to increase as oil prices continually head higher. Going forward, I expect to see sugar prices trend in tandem with higher oil prices. Notice this chart.
While the demand for Sugar will come from a need for a cheaper fuel alternative, it will also come from a need for a more environmentally cleaner fuel. Already, countries like Japan and Sweden have embarked on ethanol programs that will help them meet their emission requirements. I expect this type of demand to increase. Coinciding with this demand for a cheaper and cleaner fuel alternative is a demand for sugar as a food product. In the last 50 years, we have seen a steady increase in world sugar consumption, and I expect this consumption to continually increase with the world population. Furthermore, I also expect exponential demand for sugar as a food product to come out of China, India, and other emerging economies. The wealth creation in these countries will trickle down into a greater consumption of food products often associated with Western economies. The increase demand for sugar as fuel source coupled with the increase demand for sugar as a food product will ultimately resulin new historical highs for sugar. As you can see from the chart below, sugar is still cheap at these levels.
Although I have specifically talked about sugar in this article, I also believe that we will experience record corn prices in the near future. Corn is also used to make ethanol, especially in the U.S. This past August, the U.S. energy was signed into law which would require the Ethanol consumption to double by 2012. Unlike sugar, corn prices have still remained at historical lows. In fact, it has been one of the worst performing commodities in this bull market. Going forward, I expect corn prices to stage a vicious rally in 2006.Link here.
THE MAD SCIENTIST AND THE IRRATIONALLY EXUBERANT FROG
Once upon a very recent time, in a land very, very near, lived a central banker named Dr. Greengloss. That was not his real name of course. People just called him that because he was in the habit of regularly making Panglossian pronouncements about the economy. Whenever the denizens of this fair land became a little anxious about their financial future, Dr. Greengloss would trot out his favorite expressions … tame inflation, strong productivity growth, dynamic, resilient economy, and so on. Everything was for the best in this best of all possible nations!
Like other central bankers of his era, Dr. Greengloss believed that the economy was like a car and the job of the head banker was like that of its driver. If the economy was growing too fast, it could be in danger of “overheating” (inflation) and he would slow it down by tapping on the brakes (increase the Fed Funds rate). Conversely, if the economy was sluggish or in danger of stalling, he would step on the gas (cut the Fed Funds rate) and get it moving smoothly again. That was it! In more than three centuries of evolution, the dismal science had not progressed beyond this simple, mechanical model.
By 2002, Dr. Greengloss had completed 15 years in the job of the “Chief Engineer”. … By the end of 2005, on the eve of his retirement, he was getting close to the completion of his third full interest rate cycle … each of them approximately six years long. As Americans completed the last frantic days of holiday shopping and eagerly looked forward to the delightful tsunami of food, drink, and football games, the media became rife with prognostications about 2006. … As usual, the crystal ball gazers fell into two camps. …
So what is your guess, dear reader? Will the Maestro pull off the ultimate maneuver of central bankers … a “soft landing”? Will the consumer’s current “irrational exuberance” merely simmer down to “rational optimism”? Or will he slow down so much that the economy runs into a ditch? As the mad scientist turns up the heat at a “measured pace”, will the irrationally exuberant frog jump out of the hot water, or will it boil to death, not feeling the cumulative impact of the temperature increases because each increase was so “measured”?
* * * * * * * * * * * * * * * * * * * * *
Let us start our discussion with a pop quiz. Alan, the head of a central bank, said the following recently: “People need to stop using their homes as source of cash. That is why we will keep making these warnings and if necessary, take further action. [The Central Bank] can increase interest rates and we can do it in a way that really hurts.”
Which central bank was Alan the head of? (a) U.S.A., (b) Eurozone, (c) U.K., (d) Australia, or (e) none of the above. If you picked (e), congratulations. The above quote is attributed to Reserve Bank of New Zealand Governor Alan Bollard. Too bad we do not have the right Alan!
Anyhow, here is how we expect the future to unfold. First of all, we expect the economy to slow in 2006. Why? Because that is exactly what has happened every time in the past following a Fed tightening. After all, one could argue, that is the very purpose of raising the interest rates. Higher cost of money leads to less borrowing, and consequently, less spending. However, this time is somewhat different. Today’s consumer exuberance is powered by the unprecedented convenience of ATMs lodged in a hundred million American homes! It will not yield to a little “measured” tightening by the Fed.
So what we expect instead is the following in 2006. 1.) As a consequence of the increased costs of money and energy, combined with unparalleled debt burdens, consumer delinquencies and defaults will start rising dramatically. 2.) The regulators, alarmed by these trends, will lean on lenders to raise lending standards. This will diminish the flow of credit to marginal borrowers. 3.) Restriction of credit at the margin will finally put a crimp in the borrow and spend dynamic. But it will be the end of 2006 before an appreciable GDP slowdown becomes visible. However, during 2006 house prices will fall, especially on the two coasts. The stock market will also decline due to the earnings pressure on financial stocks exposed to consumer defaults.
By the end of 2006, while presumably Sir Alan is watching a glorious sunset on a warm tropical island, pina colada in hand, he will finally be able to proclaim an end to the decade of irrational exuberance he unleashed.Link here.
Prince Of Paper Ascends The Throne
Former U.S. Chief Economist, Department of Labor 2001-2, Ph.D. Economist and Professor Emeritus at Texas A&M University Morgan Reynolds issues an open letter to the public.
Name the three most important issues in politics: War in Iraq? Abortion? Domestic spying? None of the above. Nothing is more important than money, money, money – its quality and who controls it. We all know it in our gut – money means our livelihoods, our retirements, the life-blood of commerce plus an obese government feasting on newly printed moolah daily. Money is “the most important thing in the world,” as playwright George Bernard Shaw said, yet it is wrapped in mystery because politicians and the Fed do not want the people to understand it.
On February 1, Ben S. Bernanke, the Prince of Paper, succeeds Alan Greenspan on the throne at the Federal Reserve Board, the cabal that has mismanaged the U.S. dollar and banking since 1913. Bernanke has the power to screw things up royally and he is off to a fast start: gold has gone up over $100 an ounce since Bush nominated him.
Bernanke’s resume is unmarred by real-world experience, so he is perfect for the job. He will be a disaster because he is wrong about virtually everything. He claims devotion to “long-run price stability” and “continuity” with the policies of the Greenspan Fed. He cannot be both. Greenspan’s inflationary policies have boosted the government’s consumer price index by 67%. That is the opposite of “long-run price stability”. Consumer prices have risen every year for a half-century. I detect a pattern here, it is called a rip-off of the consumer’s purchasing power.
Before B.S. Bernanke is done, he will make Greenspan look like a tight-money man. Bernanke’s paper trail tells us because he fears falling money prices as the biggest risk of all, so he stands ready with “an invention called the printing press” to combat this evil. He promises faster inflation in response to the next financial crisis, supplying the “liquidity” the system needs. “Helicopter Ben” has even promised to drop money from the air, but he will not drop any on you or me. Insiders get it first.
Mr. Ph.D. does not understand why a bust happens. That makes him extra dangerous. Every bust is caused by the preceding boom and its excesses. The bust is curative. And what caused the credit boom? The Fed! Its artificial pumping of money and credit through the banking system induces boom-bust cycles. When Bernanke fights the market by injecting new credit in the next crisis he will sustain unsound debt, weak debtors and lousy companies, prolonging depression. That is the opposite of “putting it behind us”.
Voltaire said every currency returns to its natural value. For paper money, that is nothing. How can you protect yourself? First, shift investments toward hard assets like silver, gold, oil, timber. Second, shift from the prince’s paper toward hard money in your transactions. Hard money has meant silver and gold since the dawn of civilization. We want good money and we want it now, before the greenback tanks. Government separated gold and silver completely from its unbacked paper dollars, so we have the freedom to use any money we want. With each individual choosing what currency to use, the superior money will triumph.Link here.
Contesting the accepted view of Bernanke.
This was the week that was – Alan Greenspan stepped down from his chairmanship of the Federal Reserve and was replaced by Ben Bernanke. The earth did not stop spinning, nor did the markets crash (yet). But unlike most commentators who think that Bernanke has what it takes to keep U.S. monetary policy and the economy on an even keel, Bob Prechter sees problems for the captain of this ship of state. Here is an excerpt from Bob’s November Elliott Wave Theorist.Link here.
How to appropriately celebrate Alan Greenspan’s retirement?
When a great man retires, there is no suitable rite of passage. There are few precedents. The most powerful men in the world do not usually walk out of office. They are usually carried out … or thrown out. Lincoln was shot in the head by a member of a famous family of actors. So died Roosevelt of natural causes. Wilson lost his mind, though no one seemed to notice much difference. Caesar, of course, was cut down on the Capitol steps. Louis 14th died of old age. The British turned on Churchill and voted him out of office. One great exception to the rule was Emperor Diocletian, who retired in good health and good grace from his post and spent the rest of his life raising cabbages. It seems a shame that Alan Greenspan should be turned out with no more than shallow newspaper articles and empty-headed hagiographies to mark the day. Here, we offer some suggestions.
A very happy hour: What more suitable honor could George W. Bush bestow on Alan Greenspan than to open the nation’s bars and offer free drinks to everyone? Alan Greenspan never took the punch bowl away. George W. Bush kicked his drinking problem years ago, but he still likes to have a good time spending other peoples’ money.
Or, a boisterous parade. Yes, we can see it … a marching band, making a lot of noise. Clowns – many, many clowns – jugglers … yes,lots of jugglers. We also need freaks, elephants – a whole circus of extravagant and grotesque forms. The circus acts would be followed by organized groups, but not the Shriners, nor the Free Masons. We suggest a contingent of economists – Alan Greenspan’s own league of mumblers, fumblers, equivocators and prevaricators. And yes, how about the guild of mortgage brokers, or real estate appraisers? And do not forget the lenders: Fannie Mae and Freddie Mac ought to have a float – lots of float – enough floats to get them from here to the moon. Surely, they would all turn out for a parade honoring Alan Greenspan! All of Wall Street’s finest – twanging colorful suspenders, and waving fat bonus checks! And let us not leave out the grifters, flimflam artists, conmen, safecrackers, croupiers, bookies and shysters, for whom Alan Greenspan is practically a living saint.
Who are we leaving out? We cannot forget the members of Congress, re-elected several times thanks to Greenspan’s easy-money policies. And bringing up the rear, finally, the Maestro himself. The beloved chief of the Fed, would be carried along on a throne of papier-mache, an immense chair formed of $100 bills and U.S. Treasury notes. It would balance on the shoulders of a squad of credit-drunk working stiffs – like an Egyptian pharaoh on a golden throne raised up by Nubian slaves. Oh, how the crowds would love it. But only we would see the delicious irony, dear reader, of that papier-mache throne … and those bent-over debt slaves carrying it. For, the poor lumps still do not get it. They never understood what was happening then and they still do not understand now. They would be thrilled to carry him.
After the parade has passed by and the bars have closed up, when the street sweepers are gathering up the confetti and paper beer cups, perhaps one final tribute could be offered, a genuine testament to Greenspan’s fulsome Reign of Error at the Fed. It could be framed as a bit of advice: Let a lone airplane cross against the sky, towing a banner where anyone can read: GOLD … BUY IT!Link here.
THE “HANDOVER” FALLACY
Flexibility is one of the greatest strengths of the free-market system. The U.S. economy is widely viewed as the platinum standard in that regard – the mountain that reformers around the world all aspire to climb. With that flexibility comes the seemingly innate ability of the free-market economy to rotate from one source of growth to another – by moving from sector to sector, from market to market, or even from one technology to the next breakthrough. I fear, however, that there is a good deal of confusion over this concept of the macro “handover” that could have a critical bearing on the global economy and world financial markets in 2006.
The capex handover is at the top of everyone’s list these days. That is especially the case with respect to the U.S. economy. There is a presumption that consumer fatigue is about to give way to support from the business sector. Awash in record cash flow and profitability, the wherewithal of Corporate America to spend on new plant, software, and equipment has never been greater. And so, there is hope that the baton of economic leadership is likely to be passed from consumption to capex – a seamless transition that could well lead to another upside surprise for U.S. economic growth. Recently reported data on new orders for capital equipment seem especially encouraging in that regard.
There is, however, a potentially serious flaw in this argument – reverse causality. The macro models that work best in explaining business fixed investment treat the sector as a “derived demand”, with the need for capacity expansion judged against forecasts of future pressures on operating rates. Those expectations are very much dependent on the likely path of end-market demand, or expected consumption growth. To the extent that businesses fear consumer consolidation, capital-spending plans should remain cautious. By contrast, due largely to their inherent cyclicality, the backward-looking profitability and cash-flow models have not worked nearly as well in explaining prospective trends in business fixed investment. The anemic pace of consumer demand in the final period of 2005 was even weaker than that recorded in the aftermath of 9/11 and, in fact, was the second weakest quarter of consumption growth of the past decade. If this is, in fact, the beginning of the end for the wealth-dependent American consumer – hardly idle conjecture as the housing sector now starts to roll over – hopes for a capex handover may be dashed.
There is also a good deal of hope that a global consumer handover is about to occur – that accelerating consumption in Japan, China, India, or maybe even Europe will lift the burden off the backs of increasingly fatigued American consumers. Don’t count on it - the arithmetic of this particular handover is daunting. U.S. consumption totaled $8.7 trillion in 2005 – about 25% greater than European consumption (at market exchange rates), 3.3 times the level of Japanese consumer demand, 8-9 times the size of Chinese consumption (depending on data revisions), and fully 20 times the size of overall consumer spending in India. That means it would be a tall order for any one of these economies to compensate for a shortfall in U.S. consumer demand. Some combination of offsets might do the trick, but in the end, it probably boils down to timing. Down the road – say another 3-5 years – I am far more optimistic about the prospects for a broadening out of global consumption. The bottom line is that an imminent slowing of the American consumer probably spells a weakening of global consumption and world GDP growth.
Finally, there is the ritual of a Fed leadership change to contemplate, as the Maestro turns over his baton to Ben Bernanke this week. Many argue that forward-looking financial markets have already discounted any risks associated with this historic event. With unusually tight credit spreads and low equity volatility pointing to an absence of risk in the price of risky assets, I find that assessment hard to buy. But I also think it misses the basic point. Alan Greenspan will take his books, his papers, and his pictures off the wall – and nearly 18½ years of confidence that he has earned in the financial markets. Ben Bernanke walks in as a very smart and talented man – but with a clean slate on the confidence front. As I have noted previously, financial markets have an uncanny knack of quickly testing a new Fed chairman. This is not a handover to take lightly either.
There are a lot of moving parts to the macro outlook for 2006. As I see it, most, if not all, of these handovers will have to go very smoothly in order to keep an unbalanced global economy running without a hitch. That may well be wishful thinking. I suspect at some point over the course of this year, both the global economy and world financial markets will have to come face to face with the handover fallacy.Link here.
A LAW-ABIDING BULL MARKET
The “peak oil” debate keeps raging on the message boards and blogs of the Internet. Some folks argue that we are running out of the precious black goo. Others advance a more hopeful forecast, or predict that innovation will spare future generations from the pain of exhausted hydrocarbon supplies. Both camps present compelling ideas, but neither camp presents an idea that would prevent oil prices from soaring much higher than they are currently. In the end, does it not really come down to the Laws of Physics? Such is the central argument of James Kunstler’s provocative book, The Long Emergency: Surviving the Converging Catastrophes of the 21st Century.
The following passage presents the essence of Kunstler’s viewpoint: “The invention of the steam engine (a magical product of human ingenuity) provoked the invention of other new machines, and then of factories with machines, which prompted the need for better indoor lighting, which stimulated the use of petroleum, which produced brighter light than candles (and was much easier to get than sperm whales), which provoked the development of the oil industry, whose oil was found to work even better in the engines than coal did, which led to the massive exploitation of a one-time endowment of concentrated stored solar energy, which we have directed through pipes of various kinds into an immense flow of entropy, which has resulted in fantastic environmental degradation and human habitat overshoot beyond carrying capacity.”
Let me pause here to say I want to be somewhat skeptical of Kunstler’s claim there is such a thing as a physical limit to the number of human beings the earth can support. People have been saying this ever since Thomas Malthus. And they have been wrong. But it is important to note that Kunstler is saying that the entire world cannot live at the same “energy density” as we in the West currently enjoy. He is not suggesting we will run out of oil next year, merely that we will run out of “cheap” oil very soon. Scientific breakthroughs, for example, have already enabled us to extract “syncrude” from Alberta’s tar sands. Future breakthroughs might enable us to extract oil from Colorado’s oil shale in an economically and environmentally viable manner. Clearly, the road to innovation will be paved with high and rising energy prices. Unfortunately, according to Kunstler, global fossil fuel consumption is already bumping up against the earth’s physical limitations.
I am not so sure that I agree with Kunstler’s grim prognosis for humanity, but I do find the central elements of his argument pretty compelling, almost irresistible. In a closed system, nothing can prevent entropy. So given that the Earth is essentially a closed system, physically speaking, what is the way out of Kunstler’s dilemma? Well, maybe there is no way out. But if there is one, it is the variability of human thought. Is it not possible that we might find better ways to use the hydrocarbons that remain? Or devise more practical ways of using renewable energy resources? Even so, continuing to innovate does not preclude the possibility of $100 oil … or much more. In fact, the two go hand in hand. It seems a pretty safe bet that we will innovate ONLY if/as/when hydrocarbon fuels become unbearably expensive.
How high could crude oil go? Bill Browder of Hermitage Capital Management comes up with a nice specific number, $262. Browder and his team outlined six scenarios where oil could spike. Browder’s name sounded familiar to me. And then I remembered. Back in 2001, when I recommended Gazprom to my subscribers, Browder was about the only Western analysts who understood the importance of Russian natural gas to Europe’s economy. And Browder was years ahead of everyone in realizing that energy would be viewed by governments as a strategic asset, and used as a policy weapon. Other people are catching onto the theme now. Did you notice Saudi Kind Abdullah paid a visit to China this week, with all his critical oil and defense ministers in tow? Sounds like a strategic partnership in the making.
Writing on the growing importance of national energy companies as instruments of national grand strategy, Pam Boschee of Offshore magazine states, “It is possible that [national oil companies] may gain the upper hand as geopolitical forces become increasingly critical. The influence of combining political, economic, security, defense – and petroleum – may indeed create a volatile concoction.” Indeed, which is one more reason why the bull market in crude oil will last until we figure out a way to live without the stuff. The Laws of Physics would not have it any other way.Link here (scroll down to piece by Dan Denning).
POPULARITY OF ETF’S CONTINUES TO SOAR
The popularity of exchange traded funds continued to soar in 2005, with global assets under management climbing almost 35% to $417 billion. Investors increasingly saw ETFs as a way to gain exposure to international benchmarks, according to Morgan Stanley. At the end of 2005, there were 453 ETFs with assets of $416.8 billion, compared with 336 ETFs and assets of $310bb a year earlier. Assets grew at a much faster pace than the 7.6% rise in the MSCI World benchmark in dollar terms.
An ETF typically tracks an index and can be bought or sold like a share on the stock exchange. It owns a fixed portfolio of all the stocks in the index it tracks. Most ETFs are equity funds, but they can cover other asset classes such as bonds and commodities. Some 119 ETFs were launched globally last year, more than double the 53 launched in 2004. The U.S. led the way, with 52 launches, but Europe was right behind with 51, with 16 in other parts of the world. Two ETFs were delisted in Japan.
Deborah Fuhr, executive director of investment strategies at Morgan Stanley, said, “As the job of most portfolio managers has become broader and deeper, covering all the developed and emerging markets as well as looking at sectors and countries, we have found that many are admitting they do not have the time nor the resources to try to add value in all markets and are embracing the use of ETFs to gain international market exposure.” She said, in the U.S., ETFs providing exposure to international equity benchmarks saw their assets grow 97%, while those focused on the U.S. grew 18%. This year 64 ETFs are already planned: 43 in the U.S., 11 in Europe and 10 in the rest of the world, while four Canadian ETFs are set to be delisted. Barclays Global Investors and State Street Global Advisors are the biggest ETF providers, with the former having a 46.9% market share and the latter 22%.Link here.
NASD STEPS UP HEDGE FUND PROBE, SEEKS CUSTOMER DATA
The NASD is expanding a probe of the world’s biggest brokerage firms for possible improper sales of hedge funds to individual investors, three people with direct knowledge of the matter said. The industry regulator sent letters to firms including Merrill Lynch, Citigroup and UBS AG seeking details on customers who bought “retail hedge fund products” for $50,000 or less, said the people, who declined to be identified because the probe is not yet public. The NASD, based in Washington, is asking how the brokers who sold the funds gauged clients’ ability to withstand potential losses.
“You worry about small investors getting involved through the back door in investments that aren’t suitable for them because they’re too risky or the fees are too high,” said David Becker, a former chief counsel at the U.S. S.E.C. “NASD requires brokers to have a reasonable basis for recommending an investment, as a counterforce to the overwhelming economic incentives for salesmen to sell.” Hedge fund assets swelled more than 6-fold to $1.1 trillion during the past decade, as the average fund rose at an annual rate of 11%, beating the 7.5% advance of the S&P 500 Index. Until about five years ago, hedge funds were limited to investors with more than $1 million. Now, people can invest in the loosely regulated funds with as little as $25,000. The NASD started examining hedge fund sales practices in June, asking as many as 10 firms how they promoted products to individuals. The regulator has not accused any firm of wrongdoing.
The number of hedge funds has doubled to almost 8,700 since 2001 and frauds such as last year’s $450 million collapse of Bayou Management LLC have prompted regulators to step up oversight. The SEC cited the proliferation of funds of funds as a “development of significant concern” when it decided in 2004 to force hedge funds to register with the agency. The deadline for registration was February 1 and almost 800 hedge fund advisers filed with the SEC. Funds of funds, which account for almost $400 billion of the hedge fund industry’s assets, levy added fees. Many charge 1% of assets under management and keep 10% of any profits on investments in addition to fees charged by the underlying hedge funds. That can increase the total fee load borne by investors to 3% of assets and 30% of profits, since many hedge funds charge 2% and 20%.Link here.
SEC PROPOSES EXECUTIVE-LOAN DISCLOSURE
Within its proposed new rules on disclosure of executive compensation, the SEC has included a requirement that may address an issue which could have played a role in WorldCom’s bankruptcy. The requirement would require a footnote disclosure of the number of shares pledged as collateral by executive officers, directors, and director nominees who receive a loan from the company. Specifically, the proposal refers to shares that “may be subject to material risk or contingencies that do not apply to other shares beneficially owned by these persons.”
“These circumstances have the potential to influence management’s performance and decisions,” continues the requirement, which is tucked nearly one-third of the way into the 370-page SEC proposal. “As a result, we believe that the existence of these securities pledges could be material to shareholders.”
The Wall Street Journal observed that this proposal could generate a slew of complaints from executives who are subject to this disclosure. One compensation expert told the paper that he thinks executives will no longer make these kinds of pledges if the requirement is finalized in its current form. “Most CEOs don’t want to disclose pledging of their stock on a personal investment because it’s an invasion of privacy, and it may make them look bad,” Mark Reilly, a partner at 3C, Compensation Consulting Consortium in Chicago, told the Journal. “A lot of executives and their advisers are going to have heartburn [about revealing so much personal information].”Link here.
GLOBAL IMBALANCES WATCH
“There are signs the current global imbalances will turn out to be prolonged and it is fallacious to believe that Asian central banks will forever fund rising U.S. deficits,” Bank of England Deputy Governor Rachel Lomax said. … In a speech at a Royal Institute of International Affairs conference, Lomax joined the chorus of central bankers raising serious concerns about the threat to stability posed by the imbalances. The U.S. current account deficit has risen to over 6% of GDP, and Lomax warned that it could not be taken for granted that Asian central bank would continue to finance it. Lomax said the U.S. was not “immune to the basic arithmetic of debt sustainability – sooner or later persistent deficits will lead to levels of external indebtedness that represent a significant economic burden even on the U.S.; but it is more than usually hard to predict how long this might take,” she said.”
From Ms. Lomax’s speech: “Financial globalization has relaxed the constraints on countries in financing their savings investment balances, thus allowing larger imbalances to be sustained for longer. This is in principle welcome in so far as it permits more efficient adjustment over time, and smoothes the impact of economic shocks on real activity and consumption. But it also poses major new challenges for creditors and debtors, both public and private sector.”
My comment: I do not believe that “financial globalization” per se is the real issue or the problem (scapegoat, perhaps). Rather, I will pin blame directly on the character of the current global financial apparatus that fosters unconstrained credit growth and speculative excess – which I refer to as “Global Wildcat Finance”. Any and every credit system – domestic or international – that operates with unlimited capacity to create and easily disseminate liquidity will, during periods of optimism, supply too much of it. Importantly, this dynamic will work surreptitiously to distort and eventually abrogate market processes – as we continue to observe. The capacity for the unfettered global financial system to create unlimited finance is at the root of today’s dangerous prevailing dynamic: a veritable breakdown in the market mechanism for creating and pricing global finance. No longer does the interaction of the supply and demand for finance determine market yields, while the surfeit of global liquidity has widely distorted asset prices, risk premiums and the allocation of credit and finance. An unsound system has nurtured a precarious yet trumpeted backdrop, where surging demand for borrowings (by the U.S.) is easily accommodated (“relaxed constraints”) at predictably low interest rates.
I take quite strong exception with any view holding that the current dysfunctional arrangement “permits more efficient adjustment over time,” or that it “smoothes the impact of economic shocks.” The reality of the situation is that this current market failure is prolonging U.S. excesses and only delaying what will surely be a monumental adjustment process. It is a maxim of Macro Credit Bubble Theory that the risks associated with prolonging financial and economic bubbles grow exponentially over time and generally culminate with a “blow-off” period of manic excess. Timid policymakers have watched the global cycling and recycling of dollar liquidity in awe – deer in the headlights. Having loitered long enough to recognize that there will be no self-adjustment or correction, policymakers now face the dilemma that to impose the necessary policy restraint to commence the adjustment process comes at a cost much higher than they are willing to bear. So they are stuck hopelessly eyeballing the situation, while paying more strident, but basically useless, lip service. Meantime, highly speculative markets relish in what has evolved into an historic policy vacuum.
Ms. Lomax hits on a very key (and timely!) point with respect to the extraordinary Global Wildcat Finance backdrop commanded by the interplay between expansionist central banks and the enterprising global leveraged speculating community. I believe very strongly that the hedge funds, “proprietary trading desks”, and others’ “willingness to hold dollar assets depends to” a great “extent on their expectations of what these Asian central banks will be doing.” It has evolved into the ultimate combination of market intervention, moral hazard, and trend-following leveraged speculation. And this gets right to the heart of the danger inherent in the confluence of activist central banking, marketplace distortions, and speculator liquidity as a key source of system liquidity. This powerful dynamic is as alluring as it is self-serving and reinforcing, yet it is progressively destabilizing and inevitably unmanageable. No one dares to remove the punchbowl.
There is today growing concern that the indomitable “foreign bid” for Treasuries and agencies may be on the wane. To be sure, if confidence in the foreign backstop abates much at all, prospective U.S. interest rates become a whole lot more uncertain. And, as I have explained in the past, it is my view that the entire global currency derivatives/hedging marketplace has been and will continue to be dependent on the willingness of chiefly Asian central banks to act aggressively as dollar buyers of last resort. This unprecedented liquidity backstop has not only (magically) kept the dollar bear market orderly, it has as well abrogated the traditional cycle of faltering currencies begetting sinking bond prices. And while I do not at this point see foreign central banks retreating much from U.S. securities markets, I would not be all too surprised if they dabble a bit with attempts to wean the marketplace from recent heavy dependency.
It is a (yet unrecognized) legacy of the Greenspan era for the Fed to exploit the global leveraged speculating community and foreign central banks liquidity expedients. The ease with which this policy mechanism incites predictable credit expansion and liquidity creation responses has simply been too powerful not to abuse. Although many have argued that this extraordinary financing arrangement can finance U.S. current account deficits for years to come, it is better analyzed as a huge regrettable accident in the making. Sure, the deficit is being financed as easily today as ever. Yet the negative consequences of the resulting global liquidity glut have become conspicuous.
How could we have drifted such a long distance from the traditional role of central banks as prudent regulators of sound money and credit? We know that we cannot trust politicians to restrain booms or to even recognize underlying financial distortions and excess. It should be a Credit Bubble maxim that politicians never meet a bubble they do not adore. Central bankers must be willing and able to analyze the soundness of credit systems and recognize and thwart excess; it is our only hope, especially in the wild world of contemporary finance. Today, the stability of the system depends significantly on a consensus group of independent, astute and principled central bankers (i.e., New Zealand’s Dr. Alan Bollard). They picked an especially inopportune time to shirk traditional responsibilities.
Since 1987, we have witnessed recurring bubbles, each bubble and inevitable “mopping up” policy response only more commanding than the last. For years the nagging issue has been how this all ends: What is the “end game”? Well, we remain very much in the dark. Of course, the unwieldy global liquidity glut does today, as Mr. Geithner noted, “complicate the task” of monetary policy. Of course gradually rising U.S. yields and interest-rate differentials induce speculative inflows and, failing to disrupt credit and speculative bubbles, sustain loose financial conditions. Of course the U.S. bubble has gone global and the most acute inflationary manifestations have developed in the oil and commodity markets – the things that the holders of the inflating dollar balances are keenest to acquire. Of course, the massive pool of global speculative finance grows larger and more dominant with each passing year of enormous U.S. current account deficits, and that the entire world is one’s speculator community oyster.
But at what point do Asian central bankers finally recognize that they are trapped in a dangerous game of false prosperity? When does the euphoria associated with stockpiling unprecedented financial wealth transform into trepidation that they are accumulating receivables that will never be honored for the welfare and enrichment of their citizens – that they are being “Ponzied”? Or perhaps we are moving in the direction of an initially less dramatic case of unnerved central bankers recognizing that the recycling of U.S. current account deficits is fomenting progressive inflationary pressures throughout the energy and commodities markets, not to mention bubbling financial markets the world over. They must these days be coming to the realizations that the global financial system is in serious disarray and that the Bernanke Fed is simply not going to be up to the task. For now, I will take an increasingly vocal “chorus of central bankers raising serious concerns about the threat to stability posed by the imbalances” as a meaningful development.Link here.
HISTORY POINTS TO HIGHER RATES
The New Year started with a bang, as the global equity markets charged ahead. Investors worldwide seem to be celebrating the Fed’s announcement, which stated that its policy outlook “was becoming considerably less certain,” that the number of additional rate hikes to control inflation “probably would not be large,” and the future rate decisions “would depend on the incoming data.” That statement was perceived as a rather soft message, and investors now believe that the interest-rate hikes are about to end.
In my opinion, the markets overreacted to this news, as I feel that the Fed funds rate is going to rise significantly in the future. Perhaps the Fed will pause momentarily after the Fed funds rate is pulled up somewhat more, but the overall trend for interest-rates is now up. Looking back at history, it is interesting to note that the Fed funds rate went up from 1955 to 1981. Thereafter, the cost of money (interest-rate) declined for the next 23 years. I believe this cycle reversed when the Fed funds rate bottomed at 1% and think that we are now in the early stages of a major uptrend, which will probably last for years.
Over the past year, the U.S. money supply has grown by 7.3%. In other words, inflation is running above 7% – still significantly higher than the current Fed funds rate of 4.25%! Quite simply, even today, the Fed is literally giving money away. In my view, the Fed has no choice but to continue raising its rate, otherwise the massive ongoing inflation will surface through even higher commodity prices and the public will smell a rat. If the Fed does not continue to hike, the price of gold and oil could go up to the point where people lose faith in the modern-day monetary system – not what the Fed wants! When commodity prices went crazy in the 1970’s, the Fed increased its interest-rate to almost 20% in 1981. If they had not increased the Fed funds rate dramatically, the American currency would have collapsed as people continued to exchange their dollars for tangibles.
Today, the majority of analysts feel that the Fed will not raise rates any further because if it does, the U.S. stock and property markets will get badly hurt. However, these analysts seem to forget that during the 1970’s, the U.S. economy was in a mess, Britain had to be bailed out by the IMF and America’s stock market was in shambles. Yet, the Fed continued with its rate-hiking program without caring too much about asset-values! Why? Remember, the Fed can tolerate a recession or a bear-market, but it cannot survive if people realize that the U.S. dollar is basically a junk currency.
If my assessment is correct and interest-rates continue to rise, the equity and real estate markets will come under pressure. I expect some more upside in the equity markets over the coming weeks. However, I am of the opinion that once a top is formed, the global stock markets may embark on a very overdue and lengthy correction. Therefore, investors are advised to book their profits and fresh buying should only be done after a major shakeout.Link here (scroll down to piece by Puru Saxena).
THE COMMODITY SUPER CYCLE – HOW LONG CAN IT LAST?
Are we in the 9th inning of the “Commodity Super Cycle” that has lifted the Reuters Jefferies Commodity (CRB) price index 91% higher from four years ago to its highest level in 26 years (see chart)? The Reuters Jefferies CRB index of 19 commodities reached a high of 349.56 on Jan 30th and is comprised of futures in live cattle, cotton, soybeans, sugar, frozen concentrated orange juice, wheat, cocoa, corn, gold, aluminum, nickel, unleaded gasoline, crude oil, natural gas, heating oil, coffee, silver, copper and lean hogs.
Barclays Capital said on January 5 that commodity investments might parlay another $40 billion this year up to $110 billion as pension funds and other money managers diversify from stocks and bonds. Big-money investment funds have boosted their stake in commodity indexed markets to around $70 billion in 2005, up from $45 billion by the end of 2004 and only around $15 billion at the end of 2003. Pension funds, as well as small, retail investors are looking to commodities as a crucial part of diversification of any investment portfolio. Although schizophrenic commodity day traders could decide to turn massive paper profits into hard cash at a moment’s notice, causing a 5% shakeout, the longer-term odds still favor a continuation of the “Commodity Super Cycle”, into extra innings.
Central bankers point the finger of blame for soaring commodity prices on China’s juggernaut economy, competing with rampant demand for basic resources from big importers like India, Japan, Germany, South Korea, and the U.S. China bought about 22% of the global output of base metals in 2005, compared with 5% in the 1980’s, and has doubled its crude oil imports from five years ago. Central bankers stare at the explosive CRB rally from the sidelines with a sense of indifference or stone faced silence, though sharply higher commodity prices are telegraphing higher producer price inflation. Furthermore, China is under daily pressure from the Bush administration to revalue its yuan higher against the dollar, which in turn, would give Beijing even greater purchasing power abroad. But perhaps, the simplest answer to explain the long term bullish outlook for global commodities boils down to one simple equation. According to the latest population count by the UN, the world had 6.5 billion inhabitants in 2005, 380 million more than in 2000, or a gain of 76 million persons annually. By 2050, the world is expected to house 9.1 billion persons, assuming declining fertility rates. In other words, a world of finite raw materials, along with an increasing population base, translates into higher prices.
How did the Reuter’s CRB index reach record levels in the first place? Well consider the Chinese and Indian economies, which also account for one third of the world’s population, and the super easy money policies pursued by the big-3 central banks, the Bank of Japan, the European Central Bank, and the Federal Reserve. Both ingredients, when mixed together, make an explosive cocktail that has lifted commodity indexes into the stratosphere. And a trend in motion, will stay in motion, until some major outside force, knocks it off its course. So not withstanding inevitable profit-taking sessions, what major outside force is out there that could derail the CRB’s upward trajectory?
Global commodity prices bottomed out in late 2001 (see chart), soon after the Bank of Japan lowered its overnight loan rate to zero percent, and adopted quantitative easing. The central bank prints about 1.2 trillion yen ($10 billion) per month to purchase Japanese government bonds, inflating the amount of yen circulating around global money markets. More Japanese yen yielding zero percent, chasing fewer natural resources in turn, leads to sharply higher global commodity prices. The Japanese ruling elite are devaluing their way to prosperity, by flooding the Tokyo money markets with 32 trillion to 35 trillion yen above the liquidity requirements of local banks. With borrowing costs at zero percent or less, Japanese and foreign hedge fund traders have found the cheapest source of capital to leverage speculative positions in global commodities. And the Japanese ministry of Finance is not expected to grant permission to the Bank of Japan to begin mopping up some of the excess yen until the second half of 2006, at the very earliest. Kozo Yamamoto, the ruling LDP party chairman on monetary policy matters expressed outrage at the prospects of a BOJ policy change, saying quantitative easing must stay in place to eradicate deflation for good and to keep bond yields low to help the government trim debt servicing costs.
The European Central Bank cannot ignore the Euro zone’s loose monetary conditions and increased risks to price stability, said ECB chief economist Otmar Issing on December 19th. “Money growth has been high for quite some time and credit growth has continuously increased, supporting our assessment of the risks to price stability. Liquidity in the Euro area is more than ample. A central bank with the mandate to maintain price stability cannot ignore these signals,” Issing added. Yet for 2½ years, the ECB ignored a 50% surge in commodity prices, since lowering its repo rate to 2.00% in May 2003. The Euro M3 money supply growth rate was 7.6% higher in November from a year earlier, above the central bank’s original mandate of 4.5% growth. Thus, the ECB’s quarter-point rate hike to 2.25% in December was too little, too late, to get in the way of the “Commodity Super Cycle”, with the Reuters CRB rising another 10% in its aftermath.
For the past three years, the ECB pursued a policy of “asset targeting”, inflating its Euro M3 money supply to lift European stock markets into higher ground, and through the “wealth effect” lift the spirits of the frightened European consumer. The ECB is running into a barrage of resistance from top European finance officials to higher Euro interest rates, fearful of any action that could undermine the European stock markets. The ECB has much greater political independence than the BOJ. One has to question how the Japanese wholesale price index is only 1.9% higher from a year ago, or roughly 3.3% less than the German PPI, when the yen was 6% weaker than the Euro against the dollar last year. But in an age where ruling parties distort data to serve their own interests, it is hardly surprising that Japan’s financial warlords present price indices and inflation data in a manner best suited to their immediate needs. There is simply is no limit to how far the Japanese government will go to keep its borrowing costs down and to protect the interest of its exporters.
Because most commodities are traded in US dollars, the Federal Reserve has a special role to play in the fight against commodity inflation. The Fed must protect the value of the US dollar in the foreign exchange market, with higher interest rates if necessary, to keep the Commodity Super Cycle in check. Yet the Greenspan Fed waited for the Reuters Commodity price index to rise by 45% above its 2001 low, before taking its first baby step to lift the fed funds rate by a quarter-point to 1.25% 9 (see chart). The Greenspan Fed produced a sizeable counter trend rally for the US dollar in 2005, pushing the greenback from 102-yen to as high as 121.50-yen, and knocking the Euro from as high as $1.3450 to a low of $1.1650. However, the Fed efforts to control commodity inflation were completely undermined by the super easy money policies of the Bank of Japan and the European Central Bank. A weaker dollar could give commodity prices extra support.
Fortunately for commodity bulls, new Fed chief Ben Bernanke does not believe there is a link between a higher CRB index and higher producer price inflation. Bernanke has also rejected opinions that the recent rise in oil prices is largely a symptom of super easy central bank monetary policies. “The consensus that emerges from this literature is that the relationship between commodity price movements and monetary policy is tenuous and unreliable at best. Moreover, recent experience doesn’t support the notion that monetary policy had a substantial effect on the oil price rise,” he said. Most likely, Bernanke would continue to ignore a surge in commodity prices, but keep a close eye on U.S. home prices. Any sign of a significant downturn in home prices, could quickly prompt the new Fed chief to lower the fed funds rate.
Weighing all the bearish and bullish arguments, it appears likely that the “Commodity Super Cycle” is bound to go deeper into extra innings and reach new frontiers in un-chartered territory.Link here.
TAKING THE BULL-ION BY THE HORNS
On January 31, a 1000-pound bull named “Little Birdy” shocked spectators at a Mexico City bull fight after leaping over the stadium wall and landing in the audience. That is what they get for naming him after a bird. All jokes aside, though, the incident sounds exactly like the January 31 action in the gold market as bullish sentiment for the yellow metal scaled the fence of common sense, reaching heights that NASA satellites have not been able to touch.
As for what caused the breakout – gold’s 13% rally in 2006 to levels not seen in 25 years. And according to the mainstream “experts”, this BULLion’s not stopping anytime soon, with the likes of Forbes advising traders to take a stab at the armored car market – a sector sure to profit from the increase in transportation of gold bricks that is sure to come. But that is nothing compared to other recent bullish prognostications. We just have one problem with every single one of these suggestions – a matter the February 1 Short Term Update clears straight up.
First, our chart of gold versus the Daily Sentiment Index over the past year shows what direction prices moved the last time bullishness reached today’s extreme – a clear picture of how “foolish” traders would be to “fight” the uptrend while “sentiment is so strong”. Next, saying that gold prices are “firmly” supported by the wildly inconsistent, ever-changing list of fundamentals above is like saying a suspension bridge is a secure place to build a house.Elliott Wave International February 2 lead article.
BRAVO, COMMERCE DEPARTMENT, FOR A SENSIBLE GDP REPORT!
ast Friday, Wall Street suffered instashock, when the US Commerce Department reported that fourth-quarter real GDP only had expanded at a 1.1% annual rate. Colleague, John Williams, and I were shocked, too, but for considerably different reasons! John and I spend much of our respective analytical time criticizing the accuracy – occasionally, even the outright honesty – of the government’s economic numbers. Understated inflation and overstated employment growth are a couple areas that are among our favorite targets. But overstated economic growth gets a good deal of attention, as well. After all, the automatic consequence of consistently understating inflation is to consistently overstate the economy’s real growth.
So when along came a GDP report that appeared to us to portray more accurately the economy’s actual condition, it was at least a mild shock. On the other hand, Wall Street’s shock was driven by a materially different reason and motivation. If you are out heavily promoting a “Goldilocks” environment, the last thing you need is a report showing the worst economic growth in three years. In fact, growth that actually came in negative, if you place analytical importance on real final sales. (We do!)
This launched Wall Street into a mode of maximum spin, and at warp speed, too! The defense mechanism immediately employed by the Street (and others) was to impugn the data’s accuracy and sensibility, in the process, assuring everyone the data would be revised to better readings in February, when Commerce publishes its next estimates. An overall upward revision very well may occur, but surely not to a level that will make the Street (and others) overly ebullient. After all, were Commerce to revise last week’s number up by 100% (terribly unlikely), the 2.2% real GDP growth that would result would still be well below the roughly 2.8% the consensus forecast was envisioning. We believe last Friday’s numbers, as rendered, were not as outlandish as some would have people believe. The balance of this missive will provide some of the reasoning.Link here.
Dr. Richebächer slammed his hand down on the table. Not many people got excited by Friday’s U.S. GDP growth figure. Dr. Richebächer was the exception. We met with him in Paris after our radio show. Even before the coffee came, he had enquired about the GDP number. We checked our usual sources. Then, when the news came to him he said, “I knew it. They cheat … they rig up the calculations and still they can’t come up with a decent number. The recovery has totally failed. This latest number is just more evidence.”
The recovery is as phony as the slump that came before it. During the recession, Americans refused to cut back. Now, they have nothing to recover from. But they have nothing to recover with, either. No savings, and no new income. Unlike previous recoveries, this one saw few new jobs added. And those that have been added, have brought little to consumers’ incomes. The typical household has less money to spend now than it did two years ago. “The whole thing is incredible,” said Dr. Richebächer. “I mean the ‘savings glut’, and nonsense like that. It’s the kind of thing you’d expect from a Third World country, but not from America. You know what amazes me most is that Americans have come to believe that consequences no longer exist. They think they can do whatever they want for as long as they want … and nothing will ever go wrong.”
This is probably the first generation of Americans to believe that savings do not matter. It is also the first generation to believe that America does not really need to make anything. It can buy what it needs from abroad. But where will it get the money? “That’s the thing,” Dr. Richebächer went on. “They think the bubble economy will never end, but bubbles always end. This one will end, too. And there will be consequences, and not very pleasant ones. This is not something the Fed can manage. And nowhere in America do you hear any serious discussion of the real problems involved. When I first started talking to American economists, it was back in the 1960s. We had problems back then. We thought we had problems, at least. But when I look back I realize that we had no problems that come anywhere close to the problems we face today. These problems, on an international scale, never existed before – at least not in this size. And no one talks about them.”
Somehow, the economics profession seems to have taken leave of its senses. We had just had an illustration earlier in the day. The two economists confronting us at Radio BFN were sure that “international cooperation” would surmount any difficulties. “The fact is, the world”s central banks coordinate much better today than they used to,” said one, gravely. “We can be sure that this international cooperation will continue and will help us overcome any rough patches we may hit.”
We could barely contain ourselves: “What has international cooperation got to do with it? The problem lies at the heart of the U.S. economy, where people spend more than they earn. Someday, perhaps soon, they will be forced to spend less. Then what? The monetary authorities can cooperate all they want. What are they going to do … reduce the price of gasoline? Cut U.S. taxes? Stop the war in Iraq? All they can do is the very thing that will do the most damage … they can conspire to give the American consumer what he needs least: more credit.”Link here.
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