Wealth International, Limited

Finance Digest for Week of February 6, 2006

Note:  This week’s Offshore News Digest may be found here.


The absence of a bull market means that we are in a bear market. Many people do not believe that we are in a secular bear market because they do not see the potential for double-digit percentage declines, especially over a multi-year period. And classical bears (including yours truly) have done too much to feed the notion that a bear market is characterized by such moves. These do occur during a secular bear market, but they are actually a special case, rather than the norm. Instead, we are now in a bear market using a more pedestrian, but useful definition: the absence of a bull market.

In the last secular bull market from 1982 to 1999 (comparing year-end closing numbers), the S&P went up every year – except 1990, which was punctuated by the Desert Shield build-up preceding the Persian Gulf War. (The actual onset of war triggered a “relief rally” early in 1991.) Absent this exogenous, non-economic, factor, there probably would have been zero down years during that stretch. The Dow did almost as well during this span, retreating only in 1984, as well as 1990. In the longer but less robust secular bull market from 1942-1965, the Dow fell in only six years, only one in four. (I am using the Dow for historical reasons, because the S&P did not exist in its present form until 1957.) And of those down years, three were marked by major political crises: the Berlin Airlift (1948), the end of the Korean War (1953), and the Cuban Missile Crisis (1962), leaving only a handful of declines caused by economics.

On the other hand, in the most recent secular bear market, from 1966 to 1981, the Dow was down year-to-year in seven years (1966, 1969, 1973, 1974, 1977, 1978, and 1981), or less than half. That is right: the market rose in the majority of years during that period, making it possible for bulls to earn good money on rallies in Presidential election and pre-election years. But the declines were larger than the advances, and at the end of 1981, the Dow had only returned to 1964 levels in nominal terms, actually losing the 1965 gain. (Forget for a minute about what stocks did in real terms during those inflation-ravaged years.)

Have we been in a bear market recently? Yes. In the past six years, we had three down years, 2000-2002, and three up years, 2003-2005, a bear-market-like 50-50 split, returning us to 2000 levels on the Dow and 2001 levels on the S&P, which also characterizes a bear market. Will we soon be in a new bull market going forward? My best guess is that two of the next three years from 2006-2008 will be up, and one will be down (with 2006 being the down year because of the Fed transition and mid-term election year dynamics), with the one decline roughly canceling out the two gains, so that the markets will be little, if at all higher at the end of 2008, than at the end of 2005.

Some argue that the market is “not expensive”, with the market P/E ratio approaching (but still slightly higher than) the long-term average of about 15. That is actually a bear market observation. An average, by definition, is a number that actual results “bob around” – they are higher than the “average” one year and lower another. So we might go from a 17 P/E to a 13 P/E, to a 15 P/E and back to a 17 P/E over the next few years. This would drive the back-and-forth action that characterizes a bear market i.e., the absence of a bull market. In a bull market the P/E ratio starts at rock bottom levels (8-10), not average. Then you have 5 to 10 years of consecutive (or near-consecutive) rises to the average P/E ratio, regressing towards the mean. After that, the process feeds on itself, and the P/E ratios (and market averages) continue to rise above the mean. Finally, valuations get too stretched, and you have a bursting of the bubble (as in 2000), that creates a bear market.

If history is any guide, we will not get our next bull market until we have experienced two or more back-to-back years of 20%-plus declines that takes the market P/E down to 10 or less. This could happen in 2006-2007, or 2016-2017, or anytime in between. Since it has not happened yet, I do not see a bull market (as defined above) on the horizon.

Link here.


Much is made of the so-called symbiotic relationship between the U.S. and China. It has been an especially good story over the past five years. With the U.S. consumer driving the demand side of the global economy and the Chinese producer increasingly driving the supply side, the two economies appear to fit together like a glove. China’s apparent willingness to play a disproportionate role in funding America’s gaping current-account deficit only adds to this conviction. My advice: Don’t get used to it. Like two ships passing in the night, both China and the U.S. are headed in very different directions.

At the macro level, disparities between consumption and saving underscore one of the most important differences in the structure of the U.S. and Chinese economies. U.S. consumption has been holding at a record of around 71% of GDP since early 2002, while the gross national saving rate fell to only about 13.5% in 2005. By contrast, based on China’s newly revised national income statistics, the consumption share of GDP appears to have slipped to a record low of slightly less than 50% in 2005, whereas the overall Chinese saving rate rose above 45% last year. In both cases, these are unsustainable extremes. America needs to consume less and save more, whereas China needs to do precisely the opposite – save less and consume more. Easier said than done, of course. But a shift in the consumption-saving tradeoff is an increasingly urgent priority for both economies.

How to achieve these outcomes is a different matter altogether. In the U.S., it will take nothing short of a groundswell of support for a national saving policy. And that will not work unless the goal is attacked on two fronts – a reduction of public sector dissaving (i.e., outsize federal budget deficits) and the enactment of some form of a consumption tax. In that latter regard, I continue to favor a national sales tax, with appropriate exemptions for low and lower-middle income families. Only by such an action, can America’s fiscal authorities alter the relative price between current and future consumption and thereby boost domestic saving. Sadly, there is little reason to be optimistic that Washington is about to embrace a pro-saving policy agenda. The budget deficit is going the other way, and the lack of support for tax reform effectively quashes any immediate hopes for major saving incentives.

In China, it will take unprecedented policy initiatives to spark a shift in the mix of its powerful growth dynamic – away from exports and investment and increasingly toward support from internal private consumption. The consumption piece of this equation could well prove to be one of modern China’s most vexing challenges. Its central planning heritage affords a natural advantage in the realm of resource mobilization by recycling a massive reservoir of saving into fixed investment and an export production platform. By contrast, a vibrant consumer culture – long the DNA of market-based capitalism – is not something well understood inside of China. In my view, China needs pro-consumption policy initiatives on two broad fronts – the first being the establishment of a safety net (i.e., pensions, social security, worker retraining, and unemployment insurance) to deal with the job and income insecurity arising from ongoing reforms of state-owned enterprises. Secondly, China needs to focus on new sources of job creation in order to expand the purchasing power of its enormous population. Whatever the option, rest assured that the Chinese leadership is very focused on shifting its growth mix toward private consumption.

China is well ahead of the U.S. in tackling its saving-consumption imbalance. My experience tells me never to underestimate the determination of the Chinese leadership to push ahead on a major policy initiative. For that reason, alone, China’s pro-consumption efforts can hardly be taken lightly. At the same time, there is little reason to be optimistic that Washington is about to embrace a pro-saving policy agenda. Yesterday’s passage of yet another $70 billion in tax cuts by the U.S. Senate only underscores the seeming intractable character of America’s structural budget deficit problem. An increased share of Chinese consumption could well have the important impact of dampening China’s rapid accumulation of official foreign exchange reserves. Any successes on the Chinese consumption front undoubtedly spell more imports and a smaller trade surplus – thereby leaving less saving to recycle back into dollar-denominated assets. Needless to say, that would only complicate America’s current-account financing burden – putting the dollar and even long-term real interest rates under greater pressure than might have otherwise been the case.

Failure has not been an option for determined Chinese reformers. And I do not think it will be this time, either. This determination stands in sharp contrast with Washington’s inattentiveness to saving initiatives. That could spell trouble for the U.S. As these two ships pass in the night, America may feel China’s wake most acutely in the form of a painful and long overdue current account adjustment. So much for the pipe dream of a newly symbiotic world.

Link here.


The global labor market was always destined to be the battleground of globalization. Signs of this conflict are everywhere. The Great American labor market is but a shadow of its former self, as lagging job creation and generally stagnant real wages have broken decisively with historical norms. The same pressures are bearing down on high-wage workers throughout the developed world. At work is an increasingly powerful IT-enabled global labor arbitrage that reslices the global pie. For the industrial world, the pendulum of economic returns has swung from labor to capital, whereas for the developing world, the benefits have accrued mainly to labor. The rules of macro engagement are being challenged as never before.

In the big industrialized economies of the developed world, the squeeze on labor could well be the singular macro development of our lifetime. In the structurally-impaired economies of Europe and Japan, labor-market rigidities are on a clear collision course with globalization. The result has been a protracted period of historically high unemployment (Europe) or chronic under-employment (Japan). Even in the U.S., with supposedly the world’s most flexible labor market, workers are feeling unprecedented pressures. The net result of these trends has been a significant compression of the share of output remunerated to labor in the developed world.

But there is an important twist to this development. It is one thing for labor’s reward to be squeezed in the structurally-impaired, low-productivity growth economies of Europe and Japan. It is another thing altogether for these same pressures to bear down on the productivity-enhancing contributions of American workers. This runs against the grain of one of the basic axioms of classic macro – that workers are ultimately paid in accordance with their marginal product. Yet that has not been the case in the U.S. for quite some time. The flip-side of the pressures on labor in the developed world is accelerating growth of labor input in the developing world. China and India – collectively accounting for 40% of the world’s population – are obviously the most important cases in point. The global labor arbitrage not only exploits current cost differentials but it also captures potential productivity gains in the developing world.

Shifting trends on return to capital are the mirror image of the impacts on labor. Reflecting the compression of labor costs, profit shares of output are up sharply in most segments of the developed world. U.S. profit shares hit a record share of national income in 2005, and there have been sharp earnings gains accruing to a newly restructured Corporate Japan in the past 3-4 years. However, while Chinese workers are on the leading edge of reaping the benefits of globalization, the owners of Chinese capital are not. At least, that is the message that can be taken from the extraordinary disconnect between booming GDP growth and domestic Chinese stock markets, which have declined by about 50% over the past five years.

The implications of the global labor arbitrage can hardly be minimized. I would break the impacts down into three areas – economics, financial markets, and politics. In terms of economics, labor wins in the developing world but loses in the developed world – at least for the foreseeable future. That puts unrelenting pressure on income generation in the rich economies – raising serious questions about the sustainability of consumer-led growth dynamics. For financial markets, the biggest risk would be that of a shortfall in global growth – an outcome that would be bearish for equities and bullish for bonds. The political implications of the global labor arbitrage could well be the most vexing of all. The immediate risks are heightened trade frictions, with an outside chance of protectionism. Once jobless, now wageless, the current economic recovery is not going well for beleaguered middle-class workers in the U.S. Nor is this a partisan issue.

To his credit, U.S. President George W. Bush has taken the high road – arguing in his recent State of the Union address that America must resist the dark forces of protectionism and, instead, treat globalization as a competitive challenge. This puts the onus on educational reform, the training of more engineers and scientists, research and development incentives, and innovation. The problem with these proposals is that they offer no instant gratification for a body politic that is used to the quick fix. But that takes us to the biggest challenge of all posed by the global labor arbitrage – it has only just begun.

Link here.


Investors tell me that Japan is on fire. And on the surface, it certainly seems white hot – a stock market that is up some 50% since the spring of 2005 and an economy that our Japan team believes surged by at least a 7% annual rate in the final quarter of calendar year 2005. If that Chinese-style growth outcome comes to pass, Japan would instantly qualify as the fastest growing economy in the industrial world – an extraordinary reawakening for Asia’s long-slumbering giant. The global implications of this development cannot be minimized: Can the world’s second-largest economy lead the way in the rebalancing of a still unbalanced global economy?

In answering that question, it helps to know where Japan has come from. Significantly, the recovery in the Japanese economy has not materialized out of thin air. After more than a dozen years of 1% real GDP growth, the economy first moved into a 2-3% growth channel beginning in 2003, and then accelerated to a 3.9% average annual pace in the first three quarters of calendar 2005. If our Japan team’s Q4 ‘05 estimate is even close to the mark, the steady increase in momentum now seems to have moved into rarified territory. According to Takehiro Sato, our resident Japan watcher, the gains in the period just ended showed a Japanese economy firing on all cylinders – external as well as internal demand, with the latter driven by especially impressive gains in private consumption, residential construction, and business capital spending. For my money, the most important element in this equation is Sato-san’s estimate that Japanese consumption growth may have exceeded 5% in the period just ended, pushing the year-over-year growth rate in real consumer demand to 3.6%. It would be one thing if Japan’s reacceleration were driven largely by external demand or autonomous investment. But when the consumer finally steps up, it is a different matter altogether insofar as multiplier effects to other sectors of the economy are concerned.

A sustained pickup in Japanese consumption could also be a very welcome development for the global economy. The key here is the import side of the Japanese growth equation – the transmission of domestic growth to any country’s trading partners – and whether Japan’s revival of internal demand is sourced mainly at home or partly through foreign production. Rising import penetration holds out the hope that a revival in Japanese internal demand spells heightened export impetus to the rest of the world – moving Japan to center stage as potentially a new engine of global growth. However, the U.S. share of total Japanese imports has fallen from close to 25% in 1999 to only about 13% today. The reason – a stunning surge of Chinese imports. Consequently, to the extent that Japan is able to sustain its recovery in domestic demand – and in the import content of that demand – most of the incremental benefit would undoubtedly flow to China and Asia’s increasingly China-centric supply chain.

This has the potential to be a very important development on the road to global rebalancing. On the surface, Japan’s gathering recovery is good news for an unbalanced world. And it comes just in the nick of time. Yet, ironically, Japan’s long-awaited economic recovery may do little to temper the world’s largest and most serious imbalance – America’s gaping current account deficit. This underscores what has long been the single most worrisome aspect of America’s current account imbalance – that there is little hope for a fix from the export side of the equation. With U.S. imports currently running nearly 60% greater than exports, an export-led fix for the U.S. current account problem was always a stretch. The loss of market share in Japan by American exporters makes that even more of a stretch. That underscores the obvious – that import compression is the only realistic hope for a meaningful U.S. current account adjustment. And, of course, the obvious way for that to happen would be through a sharp reduction in the excesses of asset-dependent U.S. consumption – the one economic development that the rest of the world dreads the most.

Japan’s turnaround is nothing short of stunning. As the momentum of its economic recovery builds, the world economy will benefit from a long-overdue restarting of another growth engine. But do not count on Japan to fix the world’s imbalances. That is a task that remains very much in the court of the most unbalanced economy of all – the U.S.

Link here.


These are quiet times in the global economy, just the sort of lull that worries Raghu Rajan, one of the University of Chicago’s leading stars. On loan to the International Monetary Fund, where he became the youngest-ever chief economist and the first from a developing country, the 42-year-old native of India sees risks on the rise in housing markets, hedge funds, pensions – all across the seemingly tame landscape of world finance. Difficult to track and often disguised, the steady accumulation of risks has increased the odds of what Rajan cautiously terms “a greater [albeit still small] probability of a catastrophic meltdown.”

A sharp decline in home prices, for instance, could cripple the job market, trigger loan defaults, hurt anyone invested in mortgage securities and eventually undermine every moving part of the interconnected financial system. “When you’ve let down your defenses, things can come and smack you,” Rajan said. Rajan is no Dr. Doom. His sophisticated ideas have won him the respect of the world’s financial experts. Yet he is convinced that years of easy credit and the rapid expansion of financial markets have left little cushion if things go wrong. “We haven’t had a real storm in the financial markets since 1987,” he said. “The cost of this thing could be tremendous if it turned out the wrong way.”

What to do? Surprisingly for a dedicated advocate of free markets in the University of Chicago tradition, Rajan believes more government regulation is needed. After decades of deregulation and laissez-faire policies, “We are in danger of the pendulum swinging too far,” he said. “The times have changed.” The same applies to the University of Chicago, which has warmly embraced what might have sounded like heretical sentiments not long ago.

In the 2003 book that Rajan and close University of Chicago colleague co-authored, Saving Capitalism from the Capitalists, the pair described how economic elites use their power to restrict competition, limit access to capital and promote their vested interests over those less fortunate – undermining the potential of free markets to spread wealth and opportunity. His recognition of the difficulty of bringing about free markets led Rajan to the IMF. Rajan has continued his research, and in August at a Fed-sponsored symposium spoke about how today’s seemingly quiet times could end with a bang.

The popularity of derivatives such as swaps, for instance, has enabled big banks and other regulated institutions to offload their risks. Spreading the exposure among more players might be a plus, since it reduces the concentration held by any given institution. But as it is dispersed, that exposure becomes harder to follow. The players involved become more mutually dependent. Money managers take on more risk than they should. “Even though there are far more participants who are able to absorb risk today, the financial risks that are being created by the system are indeed greater,” Rajan told the Fed group.

So given soaring U.S. debt levels, rising interest rates and the economy’s reliance on a housing sector that is slowing, what should happen next? Greater transparency and disclosure could help, but it is not enough, Rajan said. He urges stricter lending requirements to target excesses such as interest-only mortgages. Continuing to do nothing “has its own costs,” he warned. “You have to be vigilant and it’s harder in this environment. Don’t wait for the pieces to fall and pick them up afterwards.”

Link here.


Verizon, Ford, and ExxonMobil, pay attention. It looks as though pensions and other retiree benefits are about to graduate from the footnotes to the balance sheet. And companies that have previously been able to hide underfunded retirement programs may have to count them as liabilities – often multi-billion-dollar liabilities. In November, the Financial Accounting Standards Board voted to move toward a proposal that would require companies to report the difference between the net present value of their pension- and other retirement-benefit obligations and the amount the company has set aside to meet those obligations. And although a final decision is a year or more away, the numbers will not be pretty.

Standard & Poor’s, in fact, estimates a retirement-obligations shortfall of some $442 billion in the S&P 500 alone. Indeed, it is difficult to overstate the potential impact of the FASB plan, which is expected to be only the first phase in a larger effort to overhaul the accounting treatment of pensions and benefits. “We believe this FASB project will have a significant impact on stock evaluations, income statements, and balance sheets, and will become the major issue in financial accounting over the next five years,” S&P wrote in its December report. The news was welcome to many in the accounting business who have been concerned that current rules allow companies to hide retiree obligations in the footnotes.

But it will not be without pain for many companies faced with adding a large negative number to their balance sheets, such as telecom giant Verizon Communications Inc. S&P reported in December that Verizon has underfunded the nonpension portion of its postretirement benefits by an estimated $22.5 billion. The company is clearly trying to get a handle on retirement benefits and health-care costs, announcing that same month that it will freeze the pension benefits of all managers who currently receive them.

If any of these companies think the markets will treat these obligations as a one-time problem, they had better think again, says S&P equity market analyst Howard Silverblatt. “Moving this onto the balance sheet is going to wake people up,” he says. “The bottom line is that shareholder equity [in the S&P 500] is going to be decreased by about 9 percent.”

Link here.


When Google stock plummeted last week, investors in the Legg Mason Value Trust, lost $130 million in value in a single day. But Google could do no damage to investors who had heeded the advice of the analyst who used to study Google for Legg Mason Equity Research. Scott W. Devitt, who now works for Stifel, Nicolaus & Co. in Manassas, Virginia issued a “sell” recommendation on Google two weeks earlier – soon after the stock peaked at $471.63 a share. Clients who took his advice dodged the bullet that blasted a hole in Google stock when the Internet search company failed to deliver the outsize profit investors had expected.

Devitt and the entire Legg Mason retail research department were traded away by Legg Mason last year when the Baltimore company got out of the retail brokerage business, selling its branches to Citicorp and its research division to St. Louis-based Stifel. Devitt expressed skepticism in his reports about Google’s stock even before he left Legg Mason. Since then he has repeatedly escalated his warnings, citing both the astronomical price of Google shares and potential flaws in the company’s business model.

Devitt’s doubts about Google put him at odds with the man he calls his “idol” at Legg Mason – the legendary William H. Miller III, manager of the Legg Mason Value Trust, the only mutual fund that has outperformed the S&P 500 stock index for 15 years running. Miller was one of the first to get on the Google bandwagon, grabbing the stock when Google went public in August 2004 at $85 a share. Many investors thought Google was overpriced at $85, but Miller considered it undervalued and loaded up with 4.2 million shares. That bold bet made more then $1.2 billion for Legg Mason Value Trust investors – and that is after the recent retreat that knocked $90 a share off Google’s stock, which closed last Friday at $381.56.

It would be great to sit Devitt and Miller down to debate the value of Google shares. But Miller is letting his track record do the talking, and you get the impression from Devitt that he is hesitant to argue with such a highly regarded former colleague. He added that picking a stock that will quadruple in 18 months, as Google did, is a lot tougher than telling investors when it is time to get out. But give the guy credit. Devitt told people to sell Google when almost everyone on Wall Street was telling people to buy it. In fact, almost everyone on Wall Street is still telling people to buy Google. As of Friday, the stock was rated “buy” by 30 analysts and “sell” by just two, Devitt and Scott Kessler of Standard & Poor’s Equity Research Services.

After Google shares plunged, the same analysts who had touted it before touted it again, insisting that the decline was not a reality check but really good news: The stock we told you to buy at $450 a share is an even better buy at less than $400, they said. “It is a very promotional sector,” Devitt said with deadpan understatement. “Some of my colleagues were being very promotional in raising expectations” – “promotional” is a polite way of saying that Wall Street analysts are pumping up the Internet bubble all over again, leading investors into the same trap that cost them billions of dollars the last time overpriced, over-hyped Internet stocks blew up. Google, Amazon.com and Yahoo all have burned investors in the past few weeks.

Google’s IPO of stock was a much-hyped and eagerly awaited event. Still, no one expected Google stock to soar as high as it did. And once it looked like a hit, analysts started predicting that it could go as high as $300 a share. When Google hit $300, they raised their targets to $400. After $400, one analyst predicted that Google would go to $2,000 a share. Analysts are not supposed to pull stock price targets out of thin air, so each higher price had to be rationalized by a higher estimate of sales and profits. Wall Street analysts know all too well how to play this game. They invented it in 1999 and 2000 when the tech-stock bubble was inflating, pushing the Nasdaq Stock Market composite index past 5000.

With the Nasdaq now around 2300, nobody is saying the tech bubble is going to inflate to 5000 again, but plenty of analysts are willing to pump up individual stocks like it’s 1999. Even by the standards of that time, Google is mind-bogglingly expensive. At its peak, the price of the stock was 75 times company profit. Now it is trading at a mere 68 times earnings. In comparison, the S&P 500 stocks sell for 18 times earnings and the Dow Jones industrial average companies go for 21 times earnings. Since Google reported its earnings, analysts have finally started taking a harder look at the company’s numbers. Google blamed the disappointing profit on income taxes, saying it wound up paying a higher tax rate than expected.

Devitt rejected that explanation immediately, saying that even without paying more taxes, Google would not have hit its profit target. By Friday, the Wall Street Journal was talking up the same theory, calculating that taxes accounted for only half the disappointment, and quoting Devitt. Wall Street also is likely to start listening to some of Devitt’s other concerns. He thinks Google advertising is infected with “click fraud”, a term that covers a variety of ways that advertisers, their competitors and others can game the system and manipulate the number of “hits” that online advertising attracts. He thinks Google’s advertising rates are headed for a fall because advertizers are not getting the results they want. Devitt sees none of these issues accounted for in Google stock at its current price.

Yet Devitt said he agrees with his idol Bill Miller on the fundamental premise that Google is a great company with a great future. It is just not – at this time and at $381.56 a share – a stock worth owning.

Link here.


18 years is too long. Our Activist chairman Greenspan attained boundless power, and the greater the uncertainties that unfolded over this long boom the more intense the system’s desire to create a mythical commander with masterly control at the helm of the Federal Reserve. I am a reluctant proponent of the necessity for discretionary monetary policy, although I repudiate discretion placed interminably in the clinched hands of a single policymaker – especially in this age of unbridled global finance and leveraged speculation. There is too much at stake and too much for society to lose from a period of runaway monetary instability. Undoubtedly, there have been profound financial, economic and social developments during Greenspan’s term, and this unelected official held extraordinary sway in orchestrating how things developed.

Greenspan championed financial liberation and a bastardized market and securities-based credit system dependent upon myriad government assurances, guarantees, supports and bailouts. Under his watch, GSE holdings and guarantees exploded to surpass $4 Trillion. Over the same period, a small cadre of enormous financial institutions amassed unprecedented power and influence (market, financial, political, and otherwise). With Greenspan’s blessing, global derivatives markets ballooned to unfathomable dimensions with unknowable risks. The “repo” market has mushroomed to the several trillion.

Greenspan’s discretion has availed incredible wealth upon the leveraged speculating community and their wealthy clients. Throughout the system, the aggressive borrower and speculator have done exceptionally well, at the expense of the prudent saver. Predictably, speculating has flourished and saving has foundered. And in the ultimate escapade of “trickle-down” economic management, the working class has been forced to lever up in real estate and gamble their retirements in the markets in a futile effort to not fall further behind. I consider the Greenspan Fed’s activist incitement of household mortgage credit excesses for the purposes of post-technology Bubble reflation a despicable act. As always, Major credit bubbles are incredible mechanisms of wealth redistribution, in the process snaring the stalwart middle class in the slippery slope of Bubble Economy Wealth Illusion. The scope of injustices is masked until the bust.

Under his stewardship, the U.S. economy radically deindustrialized. This dovetailed too smoothly with an enterprising asset-based credit system that was keen to (over)finance real estate and securities markets. Unparalleled credit expansion assured a flourishing services-based economy and booming asset markets, in the process engendering profound structural distortions upon the real economy. Booming Asian investment and trade (“globalization”) assured a supply deluge of low-cost manufactured goods. Not unlike the U.S. in the Roaring Twenties and Japan during their ‘80s Bubble, disinflation in goods prices detracted from the paramount issue of highly destabilizing credit and asset bubbles. Greenspan could not have been oblivious to these dynamics. Yet he impetuously adopted an ideology that a secular surge in productivity gave the Fed greater leeway to accommodate loose financial conditions. A disciplined and less activist central banker would have approached these monumental changes with circumspection and caution.

I believe that Alan Greenspan fully appreciates the relationship between U.S. financial excesses, asset inflation, over-consumption, mal-investment and our now untenable current account deficits. Alan Greenspan was known to say in private during the ‘60s that the Great Depression was the consequence of the Federal Reserve repeatedly placing “coins in the fuse box” during the 1920s. Greenspan clearly understands credit, credit booms and credit busts, yet he too assiduously avoids discussion of these key issues. But the secret of his “success” was that he was – for 18 years and 5 months – able to keep new credit flowing, the financial sector expanding, the “structured finance” mechanism enlarging, and speculators increasing the size of speculations. Chairman Greenspan was able and more than willing to repeatedly administer “coins to the fuse box”. His acclaimed “risk management” approach to monetary management was centered upon the framework of avoiding potential debt collapse – that is, perpetuating the Bubble – at all costs. He clearly will never articulate the true nature of his modus operandi or analytical framework.

While his tenure as Fed chief has finally run its course, The Greenspan Era is very much still in play. Mr. Greenspan relished in extraordinary flexibility throughout his term, while professor Bernanke will surely be hamstrung by a backdrop much less accommodative in many respects domestic and international, economic and financial. The backdrop that Greenspan has bequeathed to his successor could not contrast more markedly from that which he operated within during much of his term. Under Greenspan’s watch, the true Federal deficit (including future obligations) became untenable; the GSE’s became a major risk to system stability; healthcare cost inflation skyrocketed; and pension obligations ballooned. The surging cost of higher education forced millions to take on heavy debt loads. Historic real estate Bubbles in California, the East Coast, and elsewhere forced tens of millions more into wagering their financial futures on their residences. The Greenspan Fed subsidized an historic boom in large suburban home construction and gas-guzzling SUV manufacturing. Our nation’s dependency on Middle East oil crossed the point of no return. With respect to our energy and manufactured goods requirements, we sacrificed any hope of self-sufficiency. At the same time, New Paradigm Perceptions had it that we could afford guns and butter and heaps of pork. Of course, such a profligate environment cultivates fraud, corruption and malfeasance, the vast majority to be unearthed during the downside of the Greenspan Credit Cycle.

Moreover, liquidity to sustain our enormous debt markets became dependent upon foreign central banks and global speculators. Liquidity created in the process of leveraged asset market speculation evolved into a prevailing source of liquidity for the financial markets and Bubble Economy. Under the chairman’s watch, a highly corrosive strain of “Financial Arbitrage Capitalism” took command of the creation and (mis)allocation of both financial and real resources throughout our economy (and, more recently, globally). Under Greenspan’s stewardship of the world’s reserve currency and dominant credit system, global imbalances went to unparalleled and unmanageable extremes. Nonetheless, the crowd today showers Alan Greenspan with praise and glorifies his accomplishments. To be sure, any chief central banker universally lionized at the end of his term most certainly ran a very loose ship.

I do not believe Credit cycles should or can be prolonged indefinitely, so I naturally scoff at notions of Greenspan’s greatness. To nurture a system of unrestrained Credit and speculation is to jeopardize the market pricing mechanism. To abrogate the business cycle is to undermine a capitalistic system. There is the expectation today that most Americans are accumulating sufficient wealth to retire comfortably, although the U.S. system in aggregate is borrowing and consuming too much to have the economic wealth creating capacity to live up to inflated expectations. Now that the U.S. Credit Bubble has gone global, there are expectations in China that their recent tremendous gains in wealth can be extrapolated, while rising expectations in India and elsewhere envision their economies following similar growth paths as to that of the Chinese. The oil producing and commodity-based economies now have expectations of great future prosperity. Never have so many had their expectations rise to lofty levels – the type of elevated expectations that leads to disappointment and disillusionment. For now, we have global competitors for limited energy and commodity resources liquefied like never before.

I have in the past referred to Alan Greenspan as the Great Inflationist – a modern day John Law. The essence of The Greenspan Era is one of unprecedented “money” inflation, credit inflation, asset inflation, financial wealth inflation, expectations inflation and obfuscation. The essence of the ongoing Greenspan Era is one of an historic credit bubble. His legacy should be based upon future circumstances and developments with respect to this bubble and not how things appeared the afternoon he paraded out the door.

Link here (scroll down to last section in article).


On October 12, 2002, a beautiful, 28-year old French woman named Audrey Mestre attempted a record-setting “no limits” free dive to a depth of 561 feet. She succeeded in diving to 561 feet, but not in resurfacing alive. Today, many investors are diving headlong into high-risk stocks and bonds … and we would not be surprised if these “no limits” investment plunges also end badly. When bipedal, oxygen-breathing mammals descend 500-feet below the surface of the sea on a single breath of air, bad things can happen. And bad things can also happen when greedy or naïve mammals descend into the murky depths of high-risk securities.

We would readily admit that “buying risk” has paid off nicely for the past couple of years. In fact, we have suggested buying the stocks and bonds of countries like Russia and Brazil. We have not abandoned our long-term faith in these two economies. But, in general, we think the time is fast-approaching to “sell risk”, rather than to buy it.

Since the dawn of the new millennium, risky assets like emerging markets stocks and bonds, U.S. junk bonds and U.S. small caps have greatly outdistanced their less-risky counterparts. Over the past three years, for example, the S&P 500 has gained a respectable 50%. But over the same time-frame, the Russell 2000 Index of small-cap stocks has doubled, and the Morgan Stanley Index of emerging market stocks has tripled. Risk-taking has also excelled in the global bond markets. Debt securities from traditionally high-risk borrowers like Russia and Brazil have racked up enviable returns, while U.S. Treasurys have produced almost no return at all. As these various risky assets have dazzled and amazed, the perception of risk in the capital markets has dwindled to almost nothing. You could say, therefore, that fear is in a bear market.

“You can almost see it in the marketplace,” observes James Grant, editor of Grant’s Interest Rate Observer. “Stock- market volatility, as measured by the VIX Index, is at 10- year lows. Credit spreads – investment-grade, speculative-grade, emerging market, etc. – are hugely compressed. Observing the levels, one would almost suppose that the nation was at peace, the yield curve was positively sloped, the H5N1 strain of bird flu had been eradicated and the chairmanship of the Federal Reserve Board was not changing hands…” One might also suppose that Iran had decided to build tractors, instead of reactors … or that the suicide-bombing terrorist groups of the Middle East had taken up new hobbies, like quilting and stamp-collecting.

But the modern-day world does not feature such blissful and serene conditions, as evidenced by the array of anti-terrorist squads and NYPD K-9 units that continuously patrol the streets of Wall and Broad, just outside your editor’s office window. Curiously, Grant notes, “theses echoes of September 11 do not penetrate the financial district office towers. Inside, computer screens trace out the lows in stock-market volatility and bargain-basement prices in credit default swaps.” In other words, most professional market participants are fearless – or complacent – or fearless and complacent, which amounts to a kind of recklessness.

Not only do they fear no evil within the financial markets, but they eagerly sell insurance against it. For example, many hedge funds have embraced the business of “writing insurance” against credit defaults – a practice known as selling credit-default swaps. Glossing over details, the essential thing to understand is that these swaps illustrate the price of insurance in the bond market, and therefore, the level of fear or complacency that investors are exhibiting. At the moment, swap prices are very, very low, which means that fear is also very, very low … and complacency is very, very high. (That is rarely a good thing). Default swaps on Russian government debt, for example, have tumbled to record-low levels. Ten years of insurance against a Russian credit default costs a mere 84 basis points. For perspective, as recently as 2001, Russian credit-default swaps cost ten times as much.

The U.S. stock market displays a similarly striking absence of fear. The VIX Index of implied option volatility languishes near all-time lows. Because the VIX is based on real-time option prices, it reflects investors’ consensus view of future expected stock market volatility. “During periods of financial stress, which are often accompanied by steep market declines,” the CBOE Website explains, “option prices – and VIX – tend to rise. The greater the fear, the higher the VIX level. As investor fear subsides, option prices tend to decline, which in turn causes VIX to decline.

Eighteen months ago, buying risk seemed like a decent idea. But the balance between risk and reward has shifted dramatically away from the buyers of risky assets to the sellers of them. Most risky assets are simply offering too small a return in exchange for the hazards they impose. So while there may be no urgency to sell high-risk assets, we would not argue with the idea. “Professional investors could protect themselves by buying a portfolio of credit default swaps or an index on stock-price volatility,” Grant advises. “Amateurs could lay in Treasury bills.”

Aggressive amateurs could seek to profit from the return to rising risk awareness – and the commensurate rise in risk premiums – by investing in a fund like Access Flex Bear High Yield Fund. This innovative mutual fund, according to its Website, “seeks to provide inverse (opposite) exposure to the overall high yield market. That means that unlike traditional high yield mutual funds, Access Flex Bear High Yield Fund generally should increase in value when the high yield market falls – and generally should decrease in value when the high yield market rallies.” Interestingly, ProFund’s Access Flex Bear High Yield (AFBIX) buys credit-default swaps to gain positive returns as junk-bond indexes plunge. Maybe that is a plunge worth taking … from the short side.

Link here (scroll down to piece by Eric J. Fry).


the rise of China and other emerging economies has triggered a boom in commodity prices that could last another 15 years or more, one industry veteran predicted. Demand for commodities – oil, metals, agricultural products and others – is now running well ahead of supply, suggesting that the “bull market” has a long way to run, said international commodities guru James Rogers. China is “all over” Africa, Latin America and other regions searching for energy as well as hard and soft commodities, he noted during a three-day investment symposium held by Hong Kong-based investment bank CLSA. “The best way to invest in China is to invest in commodities; in other words, to buy the things that the Chinese have to buy,” he suggested.

Even as he spoke, copper prices charged to a new all-time high. Also hitting new peaks were aluminium and copper futures in Shanghai as Chinese investors caught up with global price moves while they were on holiday. Zinc and other metals also sped to fresh highs while rubber futures rebounded and oil prices and naphtha were driven higher. Previous commodity price booms have tended to last anything between 16 and 23 years, noted Mr. Rogers, mainly because it takes that long to bring new production capacity on stream once shortages arise and prices turn up, he said. Global supply of many commodities is going down while demand is climbing. Malaysia, and even Indonesia, have become oil importers, and Britain will also import oil within the next decade.

The price of gold is likely to go a lot higher even though it is already at its highest level in more than 20 years, the commodities markets veteran suggested. Gold is still 40% below its all-time high of $875 an ounce registered in the late 1980s. Silver is still 80% below its all-time peak. Nickel, zinc and copper are among other metals that are likely to see higher prices in future, he suggested. The global boom in commodities is not limited to metals. Agricultural commodities such as sugar, coffee, soy beans, orange juice and many others are also booming. “If you want to be in a bull market, it is in raw materials, natural resources and commodities,” said Mr. Rogers. Countries such as Australia, New Zealand, Canada, Brazil, Argentina and others are among the chief beneficiaries, he said.

In contrast to commodities, global bonds could continue to go down for more than a decade while stocks are likely to be profitable only to those who know how to trade in and out, said Mr. Rogers. Among currencies, he is bearish on the U.S. dollar. It is losing its status as a reserve currency and that will have reverberations that go on for a long time, he noted.

Link here.


In his State of the Union speech, President Bush said, “America is addicted to oil,” and set a goal of replacing 75% of the nation’s Mideast oil imports by 2025 with ethanol and other energy sources. Who is he kidding? Saudi’s Ghawar field is close to being in irreversible decline. The Saudis are only managing to maintain current oil production volumes by virtue of a massive seawater injection program that pumps more than seven million barrels of salt water per day into its oil fields. This pumping helps to maintain production pressures in the oil reservoirs, but is also the source of formation damage due to the presence of oxygen and bacteria in the seawater. By 2025, Saudi will still export oil, but far less oil than now and each tanker will be of such value as to require its own armed escort.

Iran is not quite at its production peak, but within 20 years, even the most optimistic estimates forecast that Iran will cease to be a net oil exporter. (This may also have something to do with Iran’s desire to develop a nuclear program.) And Iraq? By 2025, Iraq may be an oil exporter, not to mention an eastern province of Iran. But considering the looming and inevitable decline in daily world oil production, who will be able to afford whatever gets exported? (Hint, do you speak Chinese?) The point is, on the other side of Peak Oil, the U.S. will be fortunate to receive any oil at all from the Mideast, let alone the Bush goal of only 25% of current (or forecasted) imports. The planners, who are connecting the dots of the past, and mechanistically extrapolating out into the future with no allowance for Peak Oil, are living in a fantasyland. They are planning, if anything, for the failure of the American economy and the attendant decline of American civilization.

Still, our Mr. President raised the subject. To recall an old phrase: “What does the President know, and when did he know it?” If G.W. Bush is onboard with Peak Oil, he failed to bring up the subject with specificity in his State of the Union speech and give the concept the publicity and credibility that such a speech would merit. Then again, maybe the president saw the movie A Few Good Men. Maybe he is imitating Jack Nicholson’s character, a colonel in the Marines, who said, “You want the truth? You can’t handle the truth.” Maybe, to Mr. Bush’s way of thinking, he is just doing the best that he can.

There are people who plan for the long term. There are Japanese companies with 100-year business plans. Can anyone predict what the world will be like in 100 years? No. But these companies, reputedly, intend to be around when the next century rolls over. Strategic planning, operational planning, tactical planning … they all have their place in this world. It is not that things will follow exactly the plan. It is that you have at least planned something and thought things through. You need to think in terms of “what if this?” and “what if that?” And then you act, starting tomorrow morning, knowing full well that the next day, some freaking damn thing will occur to screw you all up. But at least you have a plan for this as well. And whoever has the better plan, the U.S., China, Russia, the EU, or the Bolivians … they are going to be left standing at the end of the day.

Yes, we have been hearing this “We will have to reduce our dependence on foreign oil” B.S. for 30 years. And for 30 years, it was easier to let the daily oil markets dictate that the nation did not have to get serious. What were we going to do, put a $4.00-per-gallon tax on gasoline and kill the driving-based economy? Sorry, guys. Democracy gave you Hamas in Palestine, and Ahmadinejad in Iran, right? Well it also has given cheap gas in the U.S. for the past century. It was fun while it lasted. Now, Mother Nature is at the door, telling you that it is payback time. Uh-oh.

So, we had our $8.00-per-barrel oil in the 1980s, and our $10.00-per-barrel oil as recently as 1999. We sprawled all over the land, from sea to shining sea, paving over the amber waves of grain, running condos up the sides of purple mountains, and laying out housing tracts where the deer and the antelope used to play. We choke the land with Interstates from the Redwood Forests to the Gulf Stream Waters. This land was made for you and me, huh? And we plugged a hell of a lot of stripper wells along the way, too. So long to those marginal barrels, at three or five units per day, times 100,000 wells. Now we see and hear G.W. Bush, who is pals with Matt Simmons and Richard Rainwater (ahem …), saying we are going to reduce out oil imports from the Mideast by 75% in the next 20 years. We never heard Herr Clinton say that, did you? Considering the reality of Peak Oil, G.W. Bush’s statement is a freaking no-brainer. Wisdom may come late, but it seldom never arrives.

Then again, maybe Bush is talking alternative energy for the right reasons, but sometimes a president just cannot tell people what is going on. Why did the U.S. decide, almost overnight, to implement the Safeguard Antiballistic Missile System in late 1968 and early 1969? Do you think that President Johnson or President Nixon could have come out and said, “Hey, we almost got nuked on March 8, 1968, by some Red Star Rogue (hey, catchy title …), so we need an ABM system.” Sorry, there are some factual secrets that you just have to keep. This applies to motive as well. Why alternative energy? Why now? Hmmm. The gears are turning, slowly maybe. But they are turning. I can hear the medulla oblongata, grinding away in the Oval Office. “I cannot really say ‘Peak Oil’. … The lumpenproles in Florida cannot even push a stick through a piece of paper on election day. Do I want to lay the Peak Oil gig on them? … I will say as much as I can get away with, and not get myself assassinated by the … well, I am not supposed to even think about those people.”

Something is going on. Something big.

Link here (scroll down to piece by Byron King).

Ethanol, a boon to farms, will not cure oil addiction.

Ethanol, touted in President George W. Bush’s State of the Union speech as a partial cure for America’s oil addiction, is the product of another pernicious habit: subsidizing farmers. From the beginning, use of ethanol has been sold as a way to lessen the U.S. dependence on foreign oil, which as Bush said in the January 31 speech, is “often imported from unstable parts of the world.” In reality, it is a way to boost corn farmers’ income, along with that of the industries that supply farmers with machinery, fertilizer and other goods and services.

Even with today’s high oil prices, ethanol is too costly to produce to compete with gasoline. To make it viable, the federal government provides a subsidy of 51 cents a gallon when it is mixed with gasoline and sold as motor fuel. In addition, it takes a lot of energy to grow and transport the corn, the main ingredient of ethanol, and to turn it into a liquid fuel. The latest studies indicate the process consumes about 80% as much energy as it produces, though that figure depends on a variety of assumptions such as corn yields and the location of ethanol plants relative to the corn fields. On the other hand, a lot of the energy consumed is in the form of electricity generated from coal, of which the U.S. has plenty. Another large chunk is from natural gas, which increasingly is in tight supply.

One big problem with ethanol is that it is more corrosive than gasoline. Gasoline stations need special equipment and tanks, and only a handful of cars and trucks made in the U.S. today can burn fuel that is more than 10% ethanol. To make sure foreign farmers and producers cannot get in on the gravy train, there is a “temporary” tariff of 54 cents a gallon on imported ethanol on top of an overall tariff of 2.5% of its value. Brazil, with a large industry making ethanol from sugar cane, is the main target of the tariff.

If energy security was the overriding consideration in having ethanol available in the U.S., a quick step would be to reduce that temporary tariff. Brazil hardly rates as an unstable part of the world compared with the Middle East. Unfortunately, that is not what ethanol is really all about.

Link here.

Ethanol, Sugar and a 200% Surge

Sugar has tripled in value during the past two years. Prices have doubled in the past five months. They jumped 20% in just three sessions in mid-January. In short, sugar has been rallying. Just in time to explain the move, the February 9 Wall Street Journal includes an in-depth look at this soft market that seeks to explain “Why Sugar Costs More And More”. At the top of their list: Ethanol. This vegetable-derived fuel is apparently the bee’s knees now that the fuss over traditional energy costs is pandemic. Perhaps to illustrate the broadening awareness about ethanol, the article cites the President’s recent State of the Union address, which called on industry to investigate the fuel as a more widespread alternative to crude oil products.

As the argument goes, this ties into higher sugar prices because more ethanol means higher demand for sugar. Brazil already uses more of its huge sugarcane crop for fuel than food, and other countries are heading in that direction. That gets you about halfway through the article. Then comes the real reporting, which calls into question just how influential this ethanol buzz really is for sugar prices. After all, you can use any kind of starch to make it, including agricultural waste and tapioca root. The Journal reporter also observes that even in “countries with large sugar industries” it is “unclear whether sugar will necessarily be the most important source for ethanol.” To make a long story shorter, there is a lot of hype about ethanol, but not a lot of evidence to back it up. Indeed, the article’s only disputable fact that I can find about why sugar prices have risen has nothing to do with alternative fuels, “dry weather in Brazil and Thailand” or “last year’s hurricanes.”

Yet ironically, on the same day that the Journal finally devoted a thorough news story to sugar’s surge, prices for the soft saw their biggest single-session decline in months. The practical question is obvious: Is this an opportunity to catch a bounce – or the first big step in a major reversal? Futures Junctures Service offers an answer that is firmly rooted in objective price data – the 200% surge we have witnessed is the result of a 28-year price pattern. And now the new Daily Futures Junctures reassesses the situation in sugar in light of the steep February 9 decline. The technical signals are startling, and the Elliott pattern appears to be at a critical juncture.

Link here.


Report from Cheuvreux summary points:

• We are raising our mid-cycle gold price estimate to $900/oz from $750/oz and see the possibility of a spike to $2,000, or higher. Covert selling (via central bank lending) has artificially depressed the price for a decade.

• Central banks have 10–15k tonnes of gold less than their officially reported reserves of 31k. This gold has been lent to bullion banks and their counterparties and has already been sold for jewelery, etc. Non-gold producers account for most and may be unable to cover shorts without causing a spike in the gold price.

• There is a supply deficit in the gold market of around 1,300 tonnes p.a. before any central bank selling and perhaps 700 tonnes p.a. after “official” sales, but before covert selling. This compares with world gold mine output of only 2,500 tonnes p.a. Some central banks, notably Russia, are starting to buy gold.

• Gold acts as an early warning of potential crisis such as rising inflationary/deflationary pressures and general confidence in paper currency, especially the USD. A strongly rising gold price could have severe consequences for U.S. monetary policy and the USD. History suggests that gold always wins against an inflating paper currency (i.e. one subject to excessive supply growth).

• Gold and gold mining stocks are poised for an unprecedented rise in prices and profile. Investors in UK/European equities need to assess the implications for their portfolios. Global/hedge funds may be better placed to respond. Anglo American is the only large cap gold/precious metals play domiciled in Europe.

Link here.

Would Hayek hoard gold?

Individuals, companies, and financial institutions default on an ongoing basis as part of the rejuvenation mechanism that is both capitalism’s hallmark and its comparative advantage – a process Joseph Shumpeter called constructive destruction. Of course, F.A. von Hayek, who graduated from the University of Vienna a decade later than Shumpeter, would not be frightened by piecemeal defaults, and he certainly would not cite this risk as a basis for owning gold. The prospect of systemic default as the culmination of unprecedented financial speculation and leveraging, in contrast, would leave him with no practical alternative. Today the world finds solace in the promise of omnipotent state intervention. In a teaching career spanning three-quarters of a century, Hayek sought to warn others of the value of this promise. Most will wish they had listened.

Hayek is perhaps best known for debunking the socialist explanation of the price mechanism. He observed that a spontaneous order arises from the interaction of a decentralized, heterogeneous group of self-seeking agents whose knowledge limitations force them to be price-takers, the crucial feature that makes the price system work. In his words, the “fatal conceit” of the socialists was their belief that this order could be designed by a planner attempting to set prices correctly, without realizing that a price system evolved spontaneously as a result of lack of knowledge. The same limited knowledge that impedes the economic agent’s predictive power must necessarily constrain the planner’s as well.

The universally held view of the U.S. as a free market, or purely capitalist, economy is most ironic in light of how the single most important price, the value affecting all economic transactions, is fixed by central planners: the price of money. The price fixing of a good whose production, in turn, is monopolized by a government-sanctioned cartel is clearly not what Hayek had in mind with his concept of spontaneous order. This state of affairs, however, is old news. The Federal Reserve System was created in 1913, and under chairmen such as William McChesney Martin and Paul Volker it appeared to keep the level of state intervention to a reasonable minimum, at least compared to the price fixing schemes of Moscow’s Gosplan. Since the removal of the comparison benchmark, though, the U.S. version of central planning and state intervention has known no bounds.

During the tenure of Alan Greenspan, the Federal Reserve fostered a degree of moral hazard that has effectively abrogated the price mechanism in US financial markets. No longer is intervention limited to the manipulation of short-term interest rates through changes to the Federal Funds rate, as had previously been the case, but now includes the influencing of long-term rates directly through bond purchases by other central banks, systemic contorting of the statistics that serve as key market signals, emergency liquidity injections to deal with financial crises, and even direct intervention in the gold market through leasing and covert selling. Faith in the omnipotent power of monetary policy is total.

The assumption that central bankers will always intervene to protect market participants from sizable losses has had a predictable outcome: complete disregard for risk. The psychological imperative for the blow-off stage of history’s most intense period of financial speculation and leveraging has thereby been put in place, and the markets have obliged with gusto. The upshot is an exponential increase in debt and a swift deterioration in the sustainability of debt structures. In essence, we have paid for our blanket insurance of individual losses with the risk of systemic collapse.

With the risk of systemic default, gold’s greatest drawback becomes its greatest advantage: it cannot default. It is the only financial asset that one can own that does not appear simultaneously on someone else’s balance sheet as a liability. In contrast to paper financial assets such as bonds, stock certificates, and Federal Reserve notes, there is no one whose bankruptcy would cause the value of gold to fall to zero. In contrast to industrial commodities, there is no one whose bankruptcy would diminish its primary source of demand, which is as a monetary instrument. Gold is commonly derided as a dead asset, providing neither dividends nor a stream of interest income. Its ability to stand in the face of default, even systemic default, however, makes it immortal as debt-backed financial claims threaten to succumb to the fatal conceit of central bankers.

Link here.


The long bond’s rebirth may be a delight for Wall Street but it is the bane of deficit hawks, who see it as a sign that huge budget gaps are here for the long haul. The 30-year bond was abandoned in 2001, when a newly elected Republican administration was still working under the assumption that U.S. budget surpluses were the new norm. Back then, the decision to withdraw the bond was based largely on debt-management priorities aimed at minimizing the government’s debt-servicing costs. Yet five years later, the budget outlook has been flipped on its head, with deficits largely accepted as a fixture of the country’s economic landscape.

So it is natural, analysts said, that the government would have to backpedal and reintroduce the long-term debt maturity, particularly given strong interest from pension funds and insurance companies. “The U.S. Treasury’s 2001 hubris led from false premise – the federal budget is in perma-surplus and the entire national debt will soon be repaid – to a false deduction – do not pay more for existing borrowing by using longer-dated bonds,” said Charles Dumas, chief economist at Lombard Street Research.

President George W. Bush last week renewed his call for the Republican-led Congress to make his tax cuts permanent even as he projected a surge in the federal deficit to $423 billion this year, up more than $100 billion from fiscal 2005. “This budget number is way out there; it was quite a shock,” said Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi.

Link here.


Young adults seen facing huge credit-card balances as incomes stagnate.

Zoe Paul has made drastic changes to her former lifestyle. As a Web designer in San Francisco during the heady dot-com era, she started her mornings at Starbucks, bought her coworkers drinks during happy hour, and ate out nearly every night. Now 30, Paul works without benefits for a small ad agency in the Bay Area and worries daily about being laid off. To help pay off $10,000 in credit card debt, she routinely empties coins into a jar by her bed. When furnishing her living room, a trip to a furniture store was not an option; instead, she bought a tweed sofa bed from a thrift shop for $67. She packs lunch every day. Cable is gone, so is Internet access. The most painful trim: Abandoning her daily Starbucks run. “That’s a thing of the past. Now it’s a treat,” she said.

Serves her right, you think? Many 20- and 30-somethings raised on MTV and InStyle magazine have tried to mimic the glamorous lives of the rich and famous through the use of credit cards. But as the 21st century has ushered in skyrocketing housing prices, stagnant income levels and 5- or 6-figure student loans to pay off – a seismic shift has occurred: A growing number of young adults are reassessing their lifestyles and mimicking the frugal habits of their Depression-era grandparents. They clip coupons, organize grocery-shopping trips to Sam’s Club instead of darting to Whole Foods and now consider a $4 cappuccino as an infrequent luxury. “Life just seems more expensive these days,” said Paul. “When I was growing up, I didn’t know a lot about handling money or being frugal. Now I’m learning.”

With the median home price rising by 26% in the past five years – while young adults’ income has gone up less than 10% – people in their 20’s are playing an endless game of catch-up. Buying a home is not even in the cards since prices in many urban areas where young people go to start their careers have more than doubled. “It used to be that spending more than 30% of your income on housing costs was a major cost burden, but many young people are spending 40, even 50%,” said Bruce Nissen, director of research at Florida International University’s Center for Labor Research and Studies. “Housing price and rents both have tripled, way faster than income.”

A college degree is mandatory for most entry-level professional jobs, but most of today’s job growth is in low-paying, low-skill industries like retail and food preparation. That translates into a very bad time for 20-somethings to be entering the labor force, said Nissen. “The job market is expanding but 80% of these new jobs don’t require a college degree. So your choices are working at either Burger King or Wal-Mart where, obviously, the pay is not good.” And with deep cuts to education and tax breaks aimed mainly at older, wealthier Americans, government no longer has young adults’ back. Many economic forecasters believe that those under age 35 will be the first generation not to equal or surpass their parents’ standard of living. That is a disturbing reality for a group that should be in its prime, looking toward marriage and their first home. Instead, they struggle to pay hefty student loans and credit card debt.

Link here.


I keep reading inflation and deflation analyses that say, “The Fed can print until there is no tomorrow, so deflation will never happen.” Ok. So the Fed prints until the dollar’s value drops to zero. Who says that means there will still be demand/transacting from the consumer? If the value of a currency drops to zero, then it hyperinflates but that does nothing for real economic demand. The U.S. consumer is 70% of the U.S. economy, and if he is hurt financially he cannot buy anything. Hyperinflation hurts the consumer drastically and real economic demand collapses.

Basically here is the issue: When the economy is wounded badly, the ability of consumers to provide real economic demand disappears. It does not matter if the cause/effect is deflationary or hyperinflationary, in either case real economic demand collapses. The idea that hyperinflation will stimulate real economic demand enough to outrun a drop in real economic demand is a false concept. Sure, before a currency loses all its value, inflating that can create some modicum of real economic demand because people are willing to borrow against the future and buy physical and financial things.

But once the rate of hyperinflation reaches a certain level, the real drop in the purchasing power of that money falls behind the acceptable transacting curve, and real purchasing power of all the currency out there drops no matter how fast the monetary authorities try to keep ahead. The currency at this point is mortally wounded. At this juncture, the economy collapses from a lack of real purchasing power and demand, and a vicious cycle of falling real wages and real demand leads to an economic collapse (demand contraction). That leads to either a hyperinflationary depression or a deflationary depression. I have written several times that the ultimate outcome of hyperinflation and deflation is the same, an economic depression. I can provide two good examples, no three, to show this point that ultimately inflation cannot stop a deflation.

(1) Germany in the 1920’s: hyperinflationary depression. Real purchasing power collapses, result is hyperinflationary depression and a new currency. Now, when people talk about the Fed being able to avoid deflation by dropping money by helicopters, if necessary, they miss the crucial issue that, at some point, the Fed would not be able to stay ahead of the accelerating fall of the currency. Ultimately, they would not be able to maintain real total purchasing power of the currency, people would stop taking dollars, and commerce and demand would stop altogether.

(2) The U.S. in the 1930’s: deflationary depression. After the collapse of the real estate and stock and finance bubbles of the Roaring 20’s, the financial losses were so great and widespread that there was not enough money and earning power left in the economy to sustain normal commerce. The value of the dollar was all right, but people lost their money and jobs. Here, it is not necessary to explain why a deflation occurred. Economic demand fell off a cliff and prices fell.

(3) Japan in the 1990’s. After the collapse of the Japanese real estate and stock bubbles, Japan entered a period of about 10 years of mild deflation. People stopped all unnecessary purchases, consumer demand fell precipitously. The government lowered interest rates to literally zero. They spent a fortune with government fiscal stimulation, leaving Japan with a national debt of 160% of their GDP. The stimulation did not work, and ultimately, Japan started to pull out by reviving through exports. The point is that, by direct government spending and monetary flooding with ultra low interest rates, Japan did not pull out economically until normal economic forces did the lifting.

This last is an example where, once the consumers pulled back significantly, they were reluctant to borrow more money, which negated the effects of monetary loosening. Also, the government deficit spending never did resolve the deflationary forces. Obviously, a government cannot replace a consumer in the economy. In the case of the U.S., if the consumer is 70% of the economy and pulls back a mere 10%, for the government to replace that spending power, it would have to deficit spend about $1 trillion in a single year! And that is just for that component, never mind the usual government expenses. That cannot and will not happen for long. We would see hyperinflation with in a year probably. Then, the total aggregate value of the U.S. dollar would collapse, and the U.S. economy would stop transacting because there is not enough real acceptable currency to make things go round. Result? Hyper inflationary depression followed by massive deflation in the end and a new U.S. currency.

Conclusion: Hyperinflationary solutions to deflation do not succeed in keeping the aggregate value of a currency up enough to keep demand alive. Ultimately, when hyperinflation overruns any simulative effects to the economy, the net aggregate value of all the money in circulation collapses, and commerce stops. Hence, deflation in the end.

Link here.


In my opinion, the majority of economists, strategists and financial media – the full “punditocracy” – are exactly wrong on inflation. Indeed, I am hard pressed to think of another item of such grave economic consequence that most of the Street has so backwards. The problem is, they are looking for inflation in all the wrong places. The inflation (ex-inflation) crowd has managed to ignore robust price increases across a variety of goods and services. Yet somehow they seem to have found inflation in the one part of the economy where there is almost none: wages. One only had to see the market reaction to last week’s data on non-farm payrolls, hourly wages and unemployment rate to realize how much the Street has gotten its panties in a bunch.

The Federal Reserve is acutely sensitive to wage pressure – much more so than to the commodity price increases we have seen over the past five years. If the Fed falls prey to the erroneous interpretation of wages and jobs, we could see a tightening cycle that goes far beyond what many on Wall Street currently expect. And that would bode extremely poorly for market prospects, both this year and next.

Recall the 2001-02 period. The economy was essentially a flat line. Tax cuts had not helped, spending down the surplus was of no avail, nor was the war in Afghanistan all that stimulative. The Fed had seen the Japanese debacle and was in no mood for a decade or more of zero growth. With Bernanke providing the intellectual rationale, it made a concerted effort to “reflate” the economy by cranking up money supply and radically dropping rates to half-century lows. The prime risk of artificially reflating any economy is inflation. And that is precisely what has followed this Fed orchestrated “reflation”. With the exception of wages, prices for just about everything else have risen, as detailed here and reflected in the Reuters/Jefferies CRB Index. Except, of course, wages. They are flat to slightly higher over the past five years. In real (i.e., inflation-adjusted) terms, they are actually negative.

Part of the reason the majority is wrong about inflation owes to the fixation on core CPI. Removing a volatile component from a single month is sensible when an event gives cause. However, one has to wonder just what is going on the brains of those who insist on ignoring the situation when the volatility is in but one direction. With the the CRB index trending upward for 51 consecutive months, the ongoing reporting of inflation ex-inflation is nothing short of idiocy. I suspect the other source of error is laziness. Many people read the headlines but do not delve into the (boring) details beneath. So let us review the recent data trilogy and see if we can determine whether wage inflation is real or imagined. Do the most recent data give it cause to act pre-emptively?

Hardly. January hourly wages rose 7 cents per hour – a 3.3% increase. As you can see from the constant-dollar CES chart below, wages dove in late 2005 after the hurricanes hit. They have since snapped back to pre-hurricane levels. But they are hardly trending upwards. The most recent wage increase is very likely the result of the mix of new construction jobs – especially in the Gulf region. That is hardly emblematic of surging wage pressure. Looking at wage improvements since 1965, we are coming off the lowest annual improvement levels in half a century. In fact, the recent wage gains are weaker than even the lows in 1986-87 period. In the 1970s, wages rose at a 6% to 8% annual level. Coming from below 2% annual gains, and still far below 4%, is hardly cause for concern.

The Fed’s reflation has succeeded all too well. The prices of homes, food, energy and all manner of commodities have been moving higher for several years now. Wall Street has mostly ignored this kind of inflation. Income, on the other hand, has been fairly stagnant. I am hard pressed to recall any union negotiating victory in recent years. Globalization and outsourcing have kept wage pressures extremely low. I expect the economy to slow in 2006, and to possibly enter a recession in 2007. If the Fed erroneously misreads the most recent data as proof of a too-strong economy and a tight labor market, it risks turning a bad, but manageable, situation into a disaster.

Link here.


A+ students are self-disciplined, long-term planners. So are A+ investors. When a couple of researchers from the University of Pennsylvania conducted a recent 2-year study of 8th graders, they expected to find a very close connection between high IQs and good grades. Not so! Instead, these two researchers, Angela Duckworth and Martin Seligman, identified a very different key to success: self-discipline. The most successful students possessed a superior ability to defer gratification. In fact, the study identified a whopping 0.67 correlation between self-discipline and final GPA, compared to only a 0.32 correlation for IQ. The most self-disciplined 8th graders beat their “more impulsive peers on every academic performance variable.”

Two decades before Duckworth and Seligman’s study, another researcher had reached a similar conclusion. He found that a 4-year-olds’ ability to delay gratification (to wait a few minutes for two cookies, for example, instead of taking one cookie right away) was predictive of academic achievement a decade later. Sound familiar? Most of us struggle with the urge to grab one cookie immediately, rather than hold out for two later on. We do not want to wait. We want results we can see today.

Not surprisingly, the world’s “A+ investors” take the exact opposite approach. For example, the celebrated mutual fund manager, Bill Miller, tends to trade rarely and hold positions for a very long time. His Legg Mason Value Trust has beaten the S&P 500 each and every one of the last 15 years. But really, how important is such a record? Is it really a worthy goal to try to beat the market EVERY year? Barton Biggs says, “No” … and the facts seem to back him up. Biggs, as the longtime investment strategist of Morgan Stanley, encountered many brilliant investors during his 30 years with the firm. The best of the best, Biggs relates, produced inconsistent returns – sometimes trailing behind the S&P 500 for long periods of time.

The table below presents a list of fund mangers that have produced better investment returns than Bill Miller over the last 15 years, even though they did not beat the market every year. Instead, we would find that their meaty returns were not consistent. In Biggs’s new book, Hedgehogging, he examines the track-records of the “superinvestors” that Warren Buffett’s mentions in his famous essay “The Superinvestors of Graham-and-Doddsville”. Biggs notes that these superinvestors produced returns that lagged the S&P 500 about 30-40% of the time. John Templeton, another legend – but not included in Buffett’s essay – lagged the big index about 40% of the time. “None in the group always beat the S&P 500,” Biggs relates, “probably because no one thought that was the primary objective.” Even more interesting, some of the greats had relatively long periods of time – 3-4 consecutive years – where they lagged behind the S&P 500. “Almost invariably, sustained bursts of spectacular returns either preceded and/or followed those bad periods,” says the former Morgan Stanley guru.

An extreme example was Pacific Partners, which went through four straight years of lagging the market, and five out of six. Yet, it had several years where it bagged returns of 120%, 114% and 128% – so that overall, it beat the market over 19 years by a wide margin, 23.6% per year, versus only 7% for the market itself. Many investors would not have stuck with Pacific Partners for the four long years of lagging returns. (They would have wanted their cookie … NOW!) But imagine what a mistake it would have been to bail out of Pacific. “Two or three straight years (much less four) of performance worse than the S&P 500 today would result in most investment managers getting fired,” Biggs remarks. “People have short memories.”

Biggs also notes the study done a few years ago by Dalbar, an investment research organization. Dalbar’s study showed that the average mutual fund earned a return of 13.8% per year (during the great bull market that ended in 2000). Yet the average investor earned only 7% per year. Why? Because the average investor was switching his money in and out at the worst times. He takes his money out when the market has a bad year and puts it back in when things are back up. A-plus investors, just like A-plus students, think long-term. They do not mind foregoing one cookie today, for the sake of eating two cookies tomorrow … or 10 cookies five years from now.

Link here (scroll down to piece by Chris Mayer).


Bob Prechter formulated his ideas about what helps traders become successful 20 years ago, and they are every bit as useful today. In this edition of Prechter’s Market Perspective, we present you not only with the six secrets of a successful trader but also with a chance to view for free our specialty service for intraday U.S. stock markets. What every trader needs to be successful:

1.) A method. Any time you enter or exit a market, it must be for a predetermined reason that will also apply in the future.

2.) Discipline to follow the method. Without discipline, you really have no method in the first place.

3.) Experience. The School of Hard Knocks is the only school that will teach you the emotional aspects of investing, and the tuition is expensive.

4.) Acceptance of responsibility. Do not blame the news, “insiders”, “floor traders”, or “THEM” for your losses. Accept responsibility, and you will retain control of your ultimate success to the extent that the market allows.

5.) Accommodation of losses. The perfect trading system does not exist, so your method must deal with taking losses.

6.) Acceptance of huge gains. When the big winner finally comes along, you need the self-esteem and confidence in your method to take all that it promises.

Link here.

“Listen To The Market”

If you have a misfortune of being a fundamental analyst forecasting British stocks these days, recent conflicting reports about the UK economy are not making your job easy. How in the world do you make sense of it all? In the excellent Market Wizards: Interviews with Top Traders, one famous investor summarized his success this way: “Listen to the market, it will tell you everything you need to know.” In other words, do not let economic data confuse you. Listen to market sentiment; study the long and short-term trends; look for any repeating patterns in the charts, etc.

If we relied on economic reports to make market forecasts, EWI would never have turned bullish on European stocks in the autumn of 2004. Back then, European economies were going from bad to worse, and few fundamental analysts were optimistic. But we “listened to the market”, and based mostly on Elliott wave structure and Fibonacci relationships, here is just one of the many bullish forecasts we published in late 2004. In the months that followed, European markets advanced as forecast.

Link here.


A real estate valuation website that could alter U.S. home-buying terrain launched on the Internet. Zillow.com was crammed with more traffic than it could handle shortly after the beta service went online this week providing estimated home prices, tax records and sales histories. More than 300,000 pages were viewed at the Seattle-based website between its Wednesday midnight launch and 7:00 a.m., causing intermittent shut-downs of the site, said chief financial officer Spencer Rascoff. The website made its debut backed by $32 million in venture capital funding and headed by chief executive Rich Barton, creator of online travel service Expedia. “Until now, finding out a current market value of any home – whether it’s yours or one you want to bid on -- has been quite difficult,” Barton said in a statement. “We believe you shouldn’t need a computer science degree or a real estate license to find out what a home is worth.”

Among the Zillow features are free “Zestimate” values of most U.S. homes, according to Barton. The website charts how specific home values have changed over time and compared to others in chosen neighborhoods. Satellite and aerial views of some homes were available, along with details about properties and tax rates. Zillow is aimed at generating profit from advertising and is not intended to put real estate agents out of work by letting home shoppers and sellers do their own research, according to Barton. Industry experts expected Zillow to pressure U.S. real estate agents to do more for their money. Agents for buyers and sellers typically split commissions equaling 6% of sales prices.

Link here.


In a discussion of how violence is rising around the world, I realize it may be bad manners to note that everyone seems to have, well, a short fuse. That said, the metaphor works. More than once, within a brief time an unremarkable incident has provoked a long and disproportionate spasm of violence. Race riots that began in Paris in October quickly spread across France and into several other EU countries, lasting several weeks. Less publicized (in the U.S.) were race riots in Sydney, Australia in December, with crowds numbering as many as 5,000, and attacks on houses of worship.

Most recently we have had wall-to-wall coverage of the cartoon riots, fueled by one instance in a tradition nearly as old as the printing press itself: A graphic image that politically lampoons a prominent somebody. In this case the prominent somebody happened to be the final prophet of Islam, a faith whose adherents apparently embrace (shall we say) dissimilar traditions regarding politics, print media, satire, and graphic images.

Oh, and I supposed I should note that state-sponsored encouragement of the p*ssed-off masses has not helped much, either, but I am not a big believer in trying to offer rational explanations of irrational behavior. If you think you can figure out why rioters in Damascus burned down the Chilean embassy, please do. Solve that one and maybe you can write a whole book about people who (1) Object to a depiction which implies their prophet is violent, and (2) Register their displeasure by gathering into a mob and burning down a bunch of stuff.

All the above – and a lot more – has something in common. That thing is psychology, manifested by anger, inexplicable violence, irrationality … the stuff of short fuses. Most importantly, this mass behavior follows a pattern, and patterns are understandable. Social mood is at work across and within cultures, and in activities that lots of people take part in – like the stock market, for example.

Link here.


I watch in amazement the bullish rhetoric that continues to come from the mouths of our political and financial establishments, while the cold hard facts are completely dismissed. Having had a pulse and a set of eyes in 2000 to 2002, which happily I still possess, I wonder how so many individuals could again deny the facts so plainly set before them solely for the comfort that bullish rhetoric brings. Then I remember I am dealing with rationalization, not rationality. The Journal of Behavioral Finance says it this way: “Rationalization does not mean ‘acting rationally’. It means attaching desirable motives to what we have done so that we seem to have acted rationally. In other words, people seek justifications for their behavior. And rationalization, which is largely about perception, often comes post hoc.”

So, it all boils down to investors’ perceptions. For investors to become willing to hire excellent storm managers, they must encounter something to change there thinking enough to come to the realization that a storm is setting in. Further, to overcome inertia and act, they must perceive that the approaching storm is not a summer rain shower, but a level five hurricane. After all, the umbrella of diversification may be enough to shelter them from the summer rain. But, this same umbrella is an ill-suited tool for a level five.

Chances are that you like hearing bad news about as much as I like the ostracism I receive from its conveyance. The fact is – hurricanes scare us. I get that. I am human. Yet, if we allow this fear to deter us from preparing for the storm, we will have done ourselves a great disservice. So, for your own benefit, I ask the reader to momentarily close the door on your emotions, and reason with me, with Spock-like logic, to see if we can ascertain our current position, and in so doing, properly prepare for what lays ahead. First, I would like to touch on an article that I wrote last summer titled, “An Asset Allocator’s Nightmare”. My point in that article was that the dramatic increases in various indices made it less likely, not more, that the indices would continue their upward progress.

But, since that time, as evidenced by the charts and stats below, these major markets have moved higher still. What exactly does this prove? Perhaps it proves that I am wrong, that we should go back and listen to the old familiar tunes … “if you miss just a few days out of the markets…” or “market timing is impossible”. Yet, if we race into these indices before we “miss out” on the next wave of winnings, in retrospect, we may look back on such a hasty decision with regret. More likely, it proves that manias can go on longer than expected and that history takes longer to unfold than you or I would like. Throughout history, those who have rationalized that some “new” occurrence is the reason why they should “hurry up and get in” on such rapid price increases, have not fared well at all. They eventually learn that historic and scientific evidence always wins out.

Storm clouds are on the horizon. For those who are hoping that the umbrella of diversification will protect them, consider the following comments that are outlined in the Seventh Edition of the Investments Planning Textbook used by the College for Financial Planning: “Diversification and the reduction in unsystematic risk require that asset’s returns not be highly positively correlated. When there is a highly positive correlation, there is no risk reduction. When the returns are perfectly negatively correlated, risk is erased. This indicates that combining assets whose returns fluctuate in exactly opposite directions has the effect on the portfolio of completely erasing risk.” (Emphasis mine.) The charts from “An Asset Allocator’s Nightmare” and the charts above make one thing perfectly clear. Today, the markets around the world have a high positive correlation – that is, they move (in step) together. Though the tools in the marketplace that are negatively correlated are few, they are there for those who are willing to listen, learn, and act.

So, why do we not act? In answering this question, let us again turn to The Journal of Behavioral Finance. The earlier mentioned article states: “The mathematician, [Blaise] Pascal wrote ‘ordinary people have the ability not to think about things they do not want to think about.’ In other words, intrinsic laziness often causes individuals to be inefficient, but proper pressure will reduce this kind of inefficiency and boost productivity.” So basically, it is human nature. From discussions I have had with numerous individuals, both personally and professionally since last August, this lesson bears repeating. When it comes to investing, we are hard-wired to fail.

The reality of our current environment requires us to realize that most investors, investment advisors, and investment managers are set up to sink their ship in the storm that is directly in front of us. I would encourage you to download our research paper, “Riders on the Storm: Short Selling in Contrary Winds”, in order to gain a better understanding of the systemic risks that are straining our markets, the history of short selling from 1610 to Refco, and the character traits excellent storm managers. Forget the couch potato strategy and the pretty pie charts of the ‘90s. This is a time to search of the very, very few managers who have already been following John Templeton’s maxim for years. “Never follow the crowd.”

Link here.
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