Wealth International, Limited

Finance Digest for Week of February 13, 2006

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


This should be another good year in the stock market. Maybe it will be a great one. Yes, I have been too optimistic since 2003. Last year I predicted the Morgan Stanley Capital International World Index would be up 20%. It was up only half that, at 9.5%. Still, relative to bonds or cash, equities have been the place to be. Stocks could end 2006 like 2005, up a little, or like 1995, when they went up a lot – 37%. In 2002, for the first time in a quarter-century, the market’s earnings yield (inverse of the P/E ratio, where the earnings in question are projected for the current year) exceeded the yield on 10-year Treasury bonds. This cheapness indicator has held true ever since, and it is true today for most of the world’s big stock markets. The S&P 500 should earn at least $75 in 2006, which is what it earned in 2005 (both numbers are before nonrecurring items). That $75 is 6% of the recent price on the index, near 1250. The 6% is 1.5 percentage points better than the yield on the 10-year bond.

What would it take to bring the relationship between bond yields and earnings yields back to normal – that is, where the latter is lower? Any of three things would do it: Stocks rise at least 36%, bond rates rise at least 1.6 percentage points, or earnings fall 27%. Or some combination of the three. Since I do not think earnings will fall or long-term rates will rise much, I find an explosion in stock prices very plausible. The other possibility: We do not return to traditional relative valuations. Maybe investors remain historically dour and skeptical. Then earnings yields would remain well above bond yields. Stocks would rise only a little, as they did in 2004 and 2005.

Foreign valuation spreads are more extreme, and so the likelihood of an upward surge overseas is greater. In Britain, France, Germany and Japan earnings yields exceed bond yields by between 3.25 points (Japan) and 4.35 points (France). Forecasters, on average, foresee the U.S. 10-year rate climbing to 5.1% by year-end from the current 4.5%. I do not think that will happen. But even if these experts are right, that is still not enough to close the earnings yield gap. Forecasters have wrongheadedly expected long rates to rise markedly for three years. They miss the fact that U.S. long rates are set in a global market. Foreign long rates keep falling, in response to an abundance of savings and a shortage of thriving economies in which to invest. As long as foreign long-term rates remain benign, the U.S. bond market will not crash. Still, stocks offer more potential in this benign interest rate environment.

Link here.


How nice life would be if all bad ideas went out of style, like the divine right of kings, medicinal bloodletting and leisure suits. Unfortunately, a muddled notion called the efficient market hypothesis refuses to go away. This absurd thesis holds that nobody can beat the market, stocks always are correctly priced according to what is publicly known about them and any mispricings are chimeras. Such blind faith in the market’s omniscient rationality led to investor losses of $1 trillion in the 1987 crash and $7 trillion in the 2000-02 postbubble slump. It ignores the commonsense effects of fads and manias. Every year or so I take another look to see if this silliness is on the way out. But then I find that, like Dracula emerging from his tomb, efficient market dogma keeps returning to do harm. Many investment advisers still believe in it. Their clients should beware. Lately the most common failings of efficient market practitioners have been:

(1) Overdiversifying. Sure, it is wise to spread your holdings into several investment classes. But efficient market acolytes believe you should have a slice of every investment available, from iffy junk bonds to Kazakhstan stocks. Today a torrent of dollars is washing through European, Japanese and other foreign bourses, attracted by a few years of glittering performance. Do not let a short period of superior investment returns abroad fool you. Most recently the well-followed EAFE Index (Morgan Stanley’s 21-nation basket for equities in Europe, Australasia and the Far East) has sharply outrun the S&P 500 – by 9.8 percentage points annually for the past three years. During longer periods, however, the story is very different. Over the last 15 years the S&P outdistanced the EAFE, 11.5% to 7.3% annually.

(2) Not bottom-feeding. Baron Rothschild once advised that the best time to invest is when “blood is running in the streets.” That is when prices are the lowest for good stocks. But efficient market devotees believe that one should not try to take advantage of any crises. After all, they claim markets are always correctly priced. So the best plan, they say, is to wait until things settle down. Of course, prices are typically higher then. In the real world, though, emotion trumps rationality, resulting in large opportunities for those who can keep a cool head and can properly assess risks and rewards.

(3) Using beta as a benchmark. This keeps turning up. Beta measures how much a stock rises or falls with the broad market. It is not a gauge of volatility. To efficient market folk, high-beta stocks are riskier than low-beta issues but have better long-term results. Baloney. Eugene Fama, a prominent efficient market theorist, trashed the beta myth in a 1992 paper with fellow academic Kenneth French. They showed that in a tabulation of stocks no correlation exists between high beta and good returns.

A better approach is to buy fine stocks like Chevron (59, CVX), Tyco (25, TYC), and UST (39, UST).

Link here.


Last year was another great one for emerging markets. The MSCI Emerging Markets Index delivered a 34.8% return in U.S. dollars. Colombia, Egypt and Saudi Arabia all registered triple-digit-percentage gains, and only the Chinese and Venezuelan equity indexes ended the year in negative territory. The emerging market bonds also turned in a stellar performance, with the JPMorgan EMBI+ posting an 11.8% total return. These eye-popping returns drew, naturally, rivers of cash into emerging market stock and bond funds. Of course, low bond yields and lousy stock returns in the U.S. helped stimulate a global appetite for risk that has driven up the demand for emerging market assets. But beware. Emerging market booms are usually followed by busts. That is why you can often expect to take a white-knuckle ride and at the same time not realize outsize long-term returns.

That said, U.S. investors should, as part of a long-term strategy, have some foreign exposure. Having some of your portfolio overseas generates diversification benefits because foreign markets are less than perfectly correlated with the U.S. market. Accordingly, an allocation of, say, 10% of your portfolio to foreign markets will reduce the portfolio’s risk while increasing its likely returns. But where should you go to obtain your overseas exposure? Many investors embrace a top-down, go-for-growth strategy. They believe that countries with expected rapid growth are the best places to be. This strategy appeals to common sense.

However, even a casual inspection of the data should give one second thoughts about the strategy. The highest growth rates were generated in China and Venezuela, but their equity markets were the only ones in the emerging market universe to register losses last year. Fortunately, painstaking research out of the London Business School sheds a great deal of light on the go-for-growth investment strategy. They compiled data for 53 stock markets, and, for 17 of these markets, the data span a 105-year period. They found no statistically significant link between previous GDP growth and investor returns. If anything, their findings suggest that owning shares from low-growth countries would have been a better long-term strategy than owning those from high-growth countries.

Over the last decade China’s average annual GDP growth was 9.2% (again, in real terms). Astonishing. No other country comes close. For investors, however, China’s stock market has recently dished up the worst possible combination: high volatility and negative returns. Since its June 2001 peak, the Shanghai composite index has fallen by 44%. Forget GDP growth. What count in emerging markets, as in other markets, are the dividend yield and the expected growth in dividends. The current yield on the Shanghai exchange (A shares) is only 1.1%, and dividend growth prospects are not good.

In countries where minority shareholders have good legal protection and strong rights, they do just what we would expect: They extract dividend payments. In China the tiny dividend yields reflect the weak standing that minority shareholders have in the legal scheme. It is all too easy for insiders to loot Chinese companies, leaving scraps for dividends. Unfortunately, in the near future there will be even less to loot – let alone pay out in dividends – because overcapacity is rearing its ugly head and profit margins are being squeezed. Add to this the fact that Beijing controls two-thirds of the shares of China’s 1,400 listed companies. Notwithstanding the government’s attempts to jack the markets up, clear-headed, long-term investors see Beijing’s ownership of shares as a supply overhang and an impediment to a well-functioning market.

Link here.


Many seniors have yet to sign up for Medicare drug coverage because they are confused by the array of plans – each with its own premiums, copays, deductibles and lists of covered drugs and participating drugstores. But others are making a calculated choice to opt out – and buy from foreign pharmacies instead. These seniors are not bothered by the idea of relying on prescriptions filled by foreign pharmacists. Indeed, some say they prefer the ease of shopping by mail over going to the drugstore. And they have accepted the risk of paying a penalty if they change their minds and sign up for the Medicare program after the May 15 deadline.

Half of the $1.5 billion worth of drugs shipped by foreign vendors into the U.S. each year comes from Canada. Although it is illegal to import drugs from abroad, the FDA, by policy, overlooks purchases for personal use. But the FDA takes a dim view of customers buying drugs from foreign vendors, warning that they run the risk of getting the wrong medications, poor-quality substitutes or even counterfeits. Although some seniors may decide they do not need Medicare drug coverage, experts say Medicare needs them, or at least their premiums. If too many relatively healthy seniors opt out of the government plan, the Kaiser Family Foundation warned in an October study, the program could be in trouble.

Link here.


For outgoing corporate chieftains, the lovely parting gifts remain as lovely as ever. Wallace Malone Jr., for example, is retiring as vice chairman of Wachovia Corp. with a nest egg of at least $135 million. He will likely get tens of millions more in reimbursements for income taxes, the idea being that no executive should have to endure the trauma of writing that kind of check to IRS. Malone’s benefits consist of a dizzying array of payments from five separate deferred compensation plans and three different retirement plans. The package also includes five “annual termination payments” of $6.7 million and an annual allowance of $200,000 for five years for office space and administrative support.

And no tale of corporate excess seems complete these days without a story from the Magic Kingdom and Michael Eisner, the former chief of Walt Disney who once championed a $140 million golden parachute for Michael Ovitz, a friend who lasted just 14 months as his deputy. Eisner departed prematurely last year with a parachute of nearly $24 million, not including a $300,000 annuity for life.

The purpose here is not to recite all these large numbers simply for dramatic effect. One might dream of an executive who would be chastened enough by the public spotlight to forgo some severance, but most are apt to respond to criticism like the former CEO of Gillette, albeit not so publicly: James Kilts used a September speech to denounce attacks on his $165 million windfall from the sale of Gillette to Procter & Gamble. The real issue is whether the outcry against excessive pay and severance has resonated with the boards who control the corporate cash register.

The money going to Eisner and Malone is the legacy of an era before the collapse of the bull market five years ago. Both were long-serving executives whose contracts were renewed in the mid-1990s, at a time when many boards seemed to feel no need to sweat the details of the packages they were approving. So do the executive contracts awarded more recently show more restraint? The evidence is mildly encouraging at best, with some contracts offering two full years of salary and bonus rather than three.

Link here.


While corporate earnings are in the midst of a record-breaking streak of double-digit growth, the historic profits reported by the energy industry thanks to the soaring price of oil are a big reason why. Last year, for instance, earnings reported by companies in the S&P 500 continued their double-digit streak of growth gaining 13.2%, S&P says. ExxonMobil alone posted the largest annual profit in U.S. corporate history of $36.1 billion. But take out the contribution from energy companies, and that growth shrivels by a third to a less-impressive single-digit number of 8.9%.

Link here.


Most believe that the dollar holds the key to global rebalancing. Academics are especially adamant on this point, with many maintaining that it will take at least a 20-30% drop in the greenback to “fix” the U.S. external imbalance. Yet that remedy does not square with the raison d’être of America’s trade deficit. The problem is concentrated on the import side of the equation, driven largely by the excesses of asset-dependent consumption. That means higher real interest rates are likely to be far more important than a weaker dollar in resolving America’s external imbalances.

The latest U.S. trade report says it all. With goods imports fully 89% larger than goods exports, even if exports grow at twice the rate of imports, the deficit on goods will remain essentially unchanged. In other words, just from an arithmetic point of view, it will be exceedingly difficult for the U.S. to export its way out of its trade deficit. The export solution also suffers from an even more glaring deficiency – the hollowing of Smokestack America. With manufacturing capacity and jobs moving steadily offshore over the past 20-plus years, the U.S. simply lacks the wherewithal to spark an export-led turnaround in foreign trade. In all too many cases, the loss of U.S. manufacturing prowess has been a permanent, or structural, erosion.

I am certain there is a level of the dollar that might reverse this process. But I think it is well in excess of 20-30%. My guess is that in order to make a meaningful difference to America’s trade dynamics on both the export and import sides of the equation, the U.S. currency would have to be sustained at an exchange rate on the order of 30-50% below present levels on a broad trade-weighted basis. Needless to say, the odds are quite low that either the U.S. or other global authorities would accept such a dollar-collapse scenario as a palliative for America’s trade deficit. Thus, I think it is safe to conclude that a weaker dollar is not the answer for the U.S. external imbalance.

And that takes us to the essence of the problem – America’s massive import overhang. Import fluctuations in any economy are, of course, a derivative of the cyclical ups and downs of domestic demand. But there is also an important secular overlay that is traceable to the same structural pressures noted above. On both counts, the U.S. qualifies as “importer extraordinaire”. The shift in the global competitive playing field leaves an increasingly hollow U.S. economy with little choice but to rely more and more on foreign production to source internal demand. And the extraordinary burst of domestic consumer demand in recent years – with personal consumption expenditures holding at a record 71% of GDP since early 2002 – pushes the internal-demand underpinnings of U.S. imports into an entirely different realm.

In terms of fixing America’s external imbalance, for reasons also noted above, I am not optimistic that the answer can be found in the structural, or competitive, angle. Instead, my sense is that the answer lies mainly in the cyclical piece of the equation – specifically, in the asset-driven excesses of U.S. consumption. With consumption growth running well ahead of labor income growth over the entire four years of the current economic expansion, there can be no mistaking the importance of property-driven wealth effects in closing the gap. Estimates conducted by none other than Alan Greenspan put the equity extraction from residential property in excess of $600 billion in 2005 alone. In short, look no further than the asset-dependent consumption binge as a major cyclical culprit behind America’s import overhang.

This takes us to the most controversial piece of the debate – the so-called real interest conundrum. In my view, led by the world’s major central banks at the short end of the curve, and augmented by the conundrum at the longer end of the curve, the super-liquidity cycle has played the decisive role in taking asset markets to excess over the past decade. First with equities, then bonds, and now property, American consumers, in particular, have come to take excessive rates of asset appreciation as an entitlement. As I see it, the Federal Reserve played a critical role in fostering this outcome – first by condoning the equity bubble in the late 1990s and then by setting up the now infamous serial-bubble syndrome by slashing its nominal policy rate to the rock-bottom 1% level once the equity bubble burst.

The Fed, of course, has attempted to normalize real interest rates over the past 18 months, but its 350 basis points of tightening at the short end of the curve has had next to no impact at the long end. Policy-related buying of dollar-denominated assets by Asian central banks has been an important, but by no means exclusive explanation of this conundrum. For me, the bottom line is clear: If the U.S. wants to come to grips with this imbalance, or if the world wants to address this increasingly worrisome source of instability, the answer can probably be found more in the real interest rate than in the dollar.

Lacking in domestic saving – America’s net national saving rate fell into negative territory for the first time in modern history in late 2005 – the U.S. has turned heavily to foreign saving in order to fill the void. And it has had to run massive current account and trade deficits to attract the foreign capital. The imported saving comes at a real cost – overly-indebted and asset-stretched American consumers, on the one hand, and a collection of U.S. creditors that are under-consuming at home and massively overweight dollars in their rapidly growing stashes of official foreign exchange reserves. I do not buy the idea that these tensions are manifestations of a glorious new era for a dollar-centric world economy. I worry, instead, that as the liquidity cycle turns, asset-driven global imbalances are reaching the breaking point.

Link here.


You did not hear it? You have company. Wall Street missed it, too. And who can blame them? After all, they are engrossed in important issues like if they should be buying Google shares after its recent decline or perhaps adding to their gold collection. After two years of being on bubble watch, the media, save for the Wall Street Journal, has lost interest in the housing bubble. They too are distracted with Iran, Iraq and Washington shenanigans occupying their thoughts. This week we received notification that the great, mega, massive Greenspan housing bubble has finally arrived at its graveyard. However, there is still time for a eulogy and a last viewing and the chance to listen out for the chant of last rites.

It is fitting that the end of the housing bubble is aligned symmetrically to Greenspan’s retirement from his position chairman of the Fed. His 18 year tenure was marked by the astonishing increase of debt in American society and an addiction to speculative gains in asset prices, catalyzed by declining interest rates. Leading the housing bubble busting “pin-prick parade” this week was Toll Brother, the nation’s largest builder of luxury homes and just reported a 29% decline in new orders. Standard Pacific, another homebuilder operating in the prime bubble territories of California, Arizona and Florida also recently reported a 20% decline in new orders. Ryland, a California builder reporting on its 2005 year-end results reported a drop of almost 5% in January.

But wait, if the WSJ’s “Finding A House gets easier” article is correct, this string of recent disappointments is the good news. The really bad news is inventories. In one bubble territory after another, homes are piling up as speculators cut their losses and run. According to the Journal, Washington D.C. leads the pile up with inventories increasing by 149.2% compared to last year. Los Angeles County and Manhattan saw respective increases of 88.0% and 86.9%. Nationwide inventories too have increased by 25% over last year. Evidence that listings are increasing while sales are declining is illustrated by the 5.1 months supply of existing homes on the market, vs. the 3.8 months supply observed in January 2005. As the recent decline in home builder’s orders are computed into these statistics, that number is headed straight up.

The Journal has more worrisome news for recent homebuyers. Toll Brothers CEO, Robert Toll, says that speculators are canceling their contracts and exiting the market while prospective buyers sensing a slowdown are no longer eager to commit to homes with a long delivery lag. Further, the article says that “as orders slow, builders are engaged in heavy discounting and promotional activity, particularly among homes for the second-time, move-up and luxury buyer.” These observations are signals that the boom is done. It is only a matter of time before the long-predicted panic ensues. But there is no fear … yet. John Weicher, Director of The Hudson Institute’s Center for Housing and Financial Markets, attributes recent weakness to a innocent misunderstanding by sellers, i.e., they think their homes are worth more than the market is willing to pay for them. He cites the 30-year history of the OFHEO price index. “In those 120 quarters house prices have dropped only eight times and never for more than one quarter.”

Statistics are meaningless without context. During the 30-year period cited, as Weicher himself admits was a period of “erratically accelerating inflation that … drove everyone into tangible assets in self protection.” In other words, another boom that ended badly. Further, mortgage rates hit an all time low during the current cycle, reaching a nadir of 5.23% in June 2003. Low rates have been the transformational factor for home prices over this period. It is delusional to believe that these values will be sustained as interest rates rise. Weicher ends his commentary writing that “this time, it is real.” We know how to translate this to standard bubble talk: “This time, it’s different.”

But that is the way it is with bubbles. Investors and speculators spurn the opportunities to get out while the getting is still good. Do not forget too that Uncle Al is no longer around to provide liquidity to save the bubbleheads. For the rest of us, left holding the bag from Greenspan’s halcyon days of being savior to the markets, its dark days ahead. The Greenspan housing bubble will be different than the aftermath of the Greenspan stock bubble. Back then, he had the luxury to reduce rates to 1% and consider rates of less than zero to stave off an asset bust and accompanying deflation. With $11 trillion in personal debt and $8.2 trillion in national government debt, we can thank Greenspan’s liquidity manipulations for leaving us at the precipice of a financial disaster.

Today, Ben “printing press” Bernanke is at the helm of the Federal Reserve. Bernanke is a student of the Great Depression. He believes the Federal Reserve did not inject enough liquidity into the economy during that period and caused the deflation that nearly destroyed the political and social fabric of the country. He is determined to ensure that this mistake will not be repeated. Destiny though has dealt Bernanke a cruel hand. His quota of liquidity-supplying heroism was avariciously consumed by Greenspan. Instead, he will preside over the biggest housing and asset bust in recent history.

Links here and here.

Bush sees safe landing for housing. (And to think we were worried!)

The high-flying housing market should make a safe landing by gradually losing altitude, the White House suggested. Housing has been an important source of power for the economy as home sales hit record highs for five years running. Low mortgage rates were a factor behind brisk activity. “A gradual slowing of homebuilding appears more likely than a sharp drop because the elevated level of house prices will sustain homebuilding as a profitable enterprise for some time,” President George W. Bush’s annual economic report to Congress says. The direction of the housing market is closely watched. Most private analysts also expect gradual moderation. If the housing market were to collapse, it would pose grave dangers to the country's overall economic health.

Link here.

The Democrats: Trapped in a Bubble

When the housing boom is over, the politics will begin. That is my feeling as I watch the politicians jostling for position these days ahead of the 2006 Congressional elections and the 2008 Presidential ones. Democrats have been searching for the right way to politically exploit the country’s undeniable economic problems, including weak wage growth for most Americans and fears of globalization. Democratic politicians fail to understand that their economic attacks on the Bush Administration cannot really take hold until the housing market goes south. Rising home prices are an engine of prosperity for the typical American family. Until that engine goes in reverse – which may be starting to happen – doom-and-gloom politics will not really resonate.

To understand why the housing boom makes such a difference, let me introduce you to the typical American worker, one in the middle of the educational and occupational distributions. First, the typical American is less educated than you think, with some higher education but no college degree, not even a two-year one. He or she is between 35 and 44 years old, holding a job such as a reservation ticket agent, a parking enforcement worker, a dental assistant, or the guy who installs a new windshield in your car. These are all jobs with average wages at or near the median of the pay distribution. These folks have hardly seen any increase in real wages since President George W. Bush took office. That is the sort of damage that makes many Democrats think that they should be doing better in the polls. But wait! The typical American, living in the typical American household, also owns his or her own home. For that typical American, the most important thing that has happened over the past five years is not the decline in wages, but the fall in interest rates, combined with the dramatic rise in home prices.

So, after refinancing, the typical American is seeing a pretax gain from the lower interest payments that more than compensates for the decline in wages. And we have not yet factored in the increase in the inflation-adjusted value of their home, which has risen by about 33% over the past five years, or about $50,000 in inflation-adjusted dollars (assuming a $150,000 value for the home in 2000). No wonder the typical American, while grousing over slow pay gains, is not ready to turn totally pessimistic. That is why the Democrats are having a tough time making headway on the economic issues. And that is why their response to the housing bust – if and when it comes – will be politically crucial.

Link here.

Municipal housing bonds face IRS audit.

At least $200 million of municipal bonds sold by Louisiana, California and other states for a Freddie Mac program to help renters buy houses is being audited by the IRS for possible tax-exempt financing abuses. Freddie Mac, the second-largest source of money for U.S. home loans, helped state authorities set up programs that sold bonds to buy homes that were later leased to future buyers. Freddie Mac later bought the mortgages.

Charles Anderson, the manager of the IRS’s tax-exempt bond office, said the agency is looking at the bonds because the lease-purchase program may constitute private loans to individuals, which would be an illegal use of so-called private activity bonds. Under U.S. tax law, issuers in the municipal-bond market must use tax-exempt debt for public purposes. “It’s a technical matter,” Anderson said. Repayment of mortgages used to back the bonds also may generate profits that are illegal under tax law, he said.

Link here.

Farewell, condo cash-outs.

When developers in Arlington, Virginia, threw a party 18 months ago to showcase plans for Clarendon 1021, a condominium development that had not yet been built, 3,600 prospective buyers stood in line just for the chance to book reservations to bid on the apartments. Now, less than a year after the building opened, speculators in this and other buildings are putting dozens of units on the market at the same time, causing asking prices and profits to slip. Of 23 investors who sold since Clarendon 1021 opened last summer, the three most recent sellers actually lost money, after paying all fees, and average profits in the building have declined since August, said Frank Borges LLosa, owner of FranklyRealty.com.

The Great Condo Gold Rush is fading from memory and the Great Sell-Off has begun. “Money Down! Motivated Seller, Want More? Just Ask!” screamed an investor’s online advertisement last week for a one-bedroom apartment in Clarendon 1021 that had never been lived in. “I hate it when people say prices can never go down,” said Mr. LLosa, a resident of the building. “The speculators make the profits more volatile.”

Over the last few years, real estate speculators looking to make a quick gain also snapped up preconstruction condos in Chicago, Miami and San Diego. With prices rising by more than 20% a year, short-term buyers figured that by the time the condos were ready to occupy, they could sell them without ever moving in, clearing thousands of dollars in profits. But as more speculators look to cash out in recently hot condo markets around the country, some economists say they could put even more downward pressure on prices in those buildings where for-sale listings are swelling. In Miami, at the Jade Residences at Brickell Bay, more than 20% of the building’s 352 units are on the market. In San Diego, about a third of the 96 units in the Alicante, a condominium that opened last fall, are listed for sale and sellers are already starting to cut asking prices. In Donald Trump’s luxury condos at 120 Riverside Boulevard in Manhattan, owners of more than one-fifth of the building’s 250 units are currently marketing their apartments. With so much inventory, said Ilan Bracha, a broker with Prudential Douglas Elliman in New York, “the buyers are coming in, checking the best views and then they negotiate. This is the reality.”

While investors made up only 9.5% of residential mortgages nationally in the 10 months through October, the numbers are much higher in places like San Diego, where investors represented 13.5% of residential mortgages, and Miami, where they were 16%. Hans Nordby, research strategist at Property and Portfolio Research in Boston, said those numbers underreport the real level of speculation in those markets because many buyers disguise their intentions when they get their mortgages. As those speculators flood the market, he said, they will put pressure on other sellers to cut prices, too.

Still, a sell-off in speculative condos is unlikely to start a widespread housing crash, because condos were more overbuilt than single-family homes during the recent boom, said Joseph Gyourko, professor of real estate and finance at the Wharton School of the University of Pennsylvania. But weakness in the condo market, he said, “is a consistent indicator that the great boom has really ended.”

Link here.


I too frequently use the terminology “blow-off” when discussing this extraordinary credit bubble environment. An email from a reader has provoked an attempt on my part to place a little meat on the “blow-off” analysis bone. To be sure, “blow-offs” are a prominent aspect of my macro credit and credit bubble analytical frameworks, as well as a key feature of today’s market and economic backdrop.

It is tempting to simply exclaim, “We know it when we see it!” And, yes, “blow-offs” are rather obvious in hindsight. One can explore market history and easily identify the manic behavior of stock market speculators such as what transpired in the U.S. during 1928/29, Japan in 1988/89, and global technology stocks in 1999/early-2000. To note a few in other markets, there was the spectacular precious metals run in 1979/80, the U.S. bond market in 1992/93, South East Asian financial markets in 1995/96, and 2004-to-present in U.S. housing markets. A shallow analysis of market “blow-offs” would have us focus on end-of-cycle bouts of marketplace irrationality, where the full-throttle pursuit of perceived easy speculative gains comes at the expense of disregarding mounting risks. Market psychology is certainly a critical facet, but there is much more to these fascinating processes than simply “The Crowd” going nuts.

I have repeatedly declared that we are in the midst of historic “blow-off” dynamics throughout U.S. and global credit systems, and that these forces are behind myriad asset market and economic bubbles. Well, first of all, it is critically important to appreciate that a major systemic “blow-off” period, virtually by (my) definition, is a manifestation of deep-seated monetary disorder fostered by a confluence of factors. It is my view that financial historians have focused mostly on the (engrossing) irrationality and the “madness of crowd” aspects at the expense of more fruitful (but hopelessly plodding) analysis of underlying financing mechanisms.

When a “blow-off” is in full bloom, The Crowd will never look in the mirror and appreciate that things are getting out of hand. At the same time, the curmudgeons will always be easily dismissed when fortunes are being made and finance is deluging those most aggressively profiting from “blow-off” inflationary manifestations. “Blow-off” analysis is unconventional and has no hope of becoming mainstream. Let’s face it, there is no constituency for analyzing, identifying or dealing with “blow-offs”, while the (increasingly) powerful interests will go to great lengths to rationalize and sustain them. Nonetheless, a focus on credit creation mechanisms, the nature of system-wide liquidity generation and speculative dynamics provide a sound framework for analyzing and appreciating an atypical and risky environment destined to bamboozle the vast majority. Always, somewhere in the bowels of the credit mechanism there are atypical developments fostering an extraordinary over-issuance of finance (“credit inflation”). But where, and what are its fragilities?

Fundamentally, “blow-offs” arise inherently as a consequence of an extended period of overly abundant – and generally inexpensive – finance (“easy money”). There must be both wholesale risk embracement throughout the marketplace and a bountiful supply of finance made available through various Financial Sphere avenues. Only after years of economic expansion and asset price inflation does the financial sector infrastructure evolve to the point of having the required capacity for a substantial step-up in issuance. For example, it took years of moderate expansion before the GSE’s had garnered the infrastructure and market confidence necessary for the commencement of the spectacular agency debt issuance boom in the late ‘90s. Each year of fortune entices a firmer push of the risk envelope, nurturing progressively looser credit availability and higher-yielding risky loans for securitization.

One cannot overstate the significance that the passage of time plays in nurturing credit system “blow-offs”. Major “blow-offs” occur only after years of rising securities and real estate prices and, importantly, recoveries from various asset market stumbles, scares and serious set-backs. Each recovery works to embolden and empower, and multiple layerings of both are prerequisites for once-in-a-lifetime complacency. Those with the bullish determination to “buy the dips” are aptly and repeatedly rewarded, garnering ever greater control over marketplace assets and influence. The most bullish and aggressive risk-takers generally rise to the top levels of investment management, corporate management, lending, investment banking and finance generally (not to mention law, accounting, consulting and policymaking). I believe the widespread perception that policymakers are prepared to bolster the boom – and will definitely not tolerate a bust – is an integral factor associated with major (throw caution to the wind) credit system “blow-offs”. And, as we have all witnessed, the more encompassing the effects of asset inflation and speculation, the more cowering policymakers become with respect to reining in excesses. Administering cautious “restraint” (a.k.a. Greenspan “baby-steps”) may indeed appear a reasonable approach. After all, such a policy prescription might in more normal circumstances actually orchestrate the coveted “soft-landing”. Not, however, during credit system “blow-offs”.

It is a central tenet of credit bubble and, more specifically, “blow-off” analysis that risk rises exponentially during the late, terminal stage of excess. At some point, credit creation reaches a crescendo where a major bubble attains size and scope to create system over-liquidity sufficient to spur the wholesale formation and expansion of myriad individual credit and asset bubbles (Mises’s “crackup boom”?). Just such a circumstance was realized with the U.S. mortgage finance bubble. Resulting massive U.S. current account deficits have now become the major impetus for economic and asset bubbles internationally, as well for as the major inflations throughout global energy and commodities complexes. At this precarious stage of excess, players across the broad array of inflating asset markets perceive unlimited liquidity. And as long as asset markets rise, additional liquidity will be forthcoming (asset bubbles create their own liquidity). But there is no getting around the reality that to sustain the “blow-off” phase demands enormous and unrelenting new finance. The nature of the “blow-offs” ever greater appetite for additional finance leaves it inherently unstable annd highly vulnerable.

It was curious this week to observe the tight interplay between various markets. One can be pardoned for sensing that a rally in the yen was the catalyst for selling in a broad range of markets including energy, precious metals, commodity currencies, bonds, and global equities. There is certainly good reason to suspect that the “yen carry trade” (borrowing in yen and/or shorting low-yielding yen-denominated securities and using the proceeds to finance holdings in inflating markets) has ballooned to massive proportions and has, in the process, become a seminal source of “blow-off” finance.

To what extent the “yen carry” has been financing the leveraged speculating community, hence the U.S. securities markets, commodities, emerging markets and global M&A, I am in the dark. But the size of The Trade is undoubtedly enormous, while the Japanese recovery is demonstrating impressive momentum. There will be pressure on the Bank of Japan to (belatedly) normalize interest-rates, both increasing the global cost of funds and narrowing interest-rate and asset-return differentials. The BOJ today appears in little hurry to raise rates, but I nonetheless would not be surprised to see the seasoned speculators a bit anxious for the exits. If so, we have a first crack in the façade and a potential “blow-off” antagonist.

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


This week’s most valuable investment insight will not issue from the mouth of Ben Bernanke, the brand new Chairman of the Federal Reserve, bu from the pages of a bland report from the U.S. Department of Treasury, which will release TIC data on Wednesday. TIC stands for the Treasury International Capital system. It is a monthly and quarterly survey that tells us who owns what. The data within the survey reveal the dollar value of foreign assets that we Americans own. The data also reveal the dollar value of American assets that foreigners own. Recently, the rest of the world has begun accumulating more of “us” than we own of “them”. (Luckily, American investors have been earning more on their assets overseas than foreign investors have been earning on their assets in America. This delightful circumstance has prevented all sorts of nasty economic consequences).

Why does it matter who owns what? Well, you could say that a nation that runs a $700-billion current account deficit is a long-term liability, especially if that nation is continually selling assets, instead of acquiring them. As our national balance worsens, so does our credit-worthiness, which might be of interest to anyone who owns a U.S. Treasury bond … or a U.S. dollar. The TIC data provide a timely glimpse into the condition of our national balance sheet or, more precisely, the transference of wealth from America to the rest of the world. A disturbing story in the Wall Street Journal, entitled “Global Emergence of the Emerging Markets”, detailed one aspect of this accelerating wealth transfer: “Companies from emerging markets, armed with piles of cash from rising commodity prices and abundant financing, are snapping up targets in Europe and the U.S., a trend that could shift the global economic balance of power in some industries.”

The story went on to explain how one Indian telecom company, Videsh Sanchar Nigam (NYSE: VSL), bought up the fiber-optic assets of Tyco International, as that hobbled conglomerate went through a restructuring, undoing all the “synergies” of the prior 10 years that were supposed to have been both profitable and good for the economy. Videsh bough the “massive fiber-optic network, a state-of-the-art, 37,200-mile long fiber loop laid along ocean floors and into dozens of cities world-wide.” The network cost more than $3 billion to build, but was bought by VSNL for $130 million in 2004. Think about that for a second. Tyco shareholders and bondholders spent $3 billion and got next to nothing. VSNL spent $130 million and steps into a world where broadband content and services are just now starting to take off. All that fiber is starting to light up.

So this it what happens when America consumes more than it produces. It pays borrowed dollar bills to the countries who manufacture things. These countries then use those dollars to buy what is left of our good businesses, or what is left of the good assets of businesses that have been run into the ground. It is a massive wealth transfer, what I have called “The Money Migration”. That is why deficits matter … not just this week … not just to the holders of U.S. Treasury bonds … but to all of us who earn dollar bills. That is also why I think the current account deficit should carry a new name – reflecting the self-inflicted destruction of America’s economic competitiveness. Perhaps we should call it the “Economic Suicide Index”. Or we could just give the entire country a “Darwin Award” for collectively engaging in the kind of self-destructive behavior that will self-select us out of the gene pool of future economic success-stories.

Successful economies abide by one vital rule: Produce more than you consume. To engage in the opposite activity is to transfer wealth and to invite impoverishment. We are well on our way.

Link here (scroll down to piece by Dan Denning).

Dollars Out, Dollars Out

The TIC data confirmed my grim expectation: foreign demand for dollar assets continues to wane. Net foreign purchases of long-term U.S. securities fell 38% from November to December. But that is not the most alarming number. Poke around in the data and you will see that private foreign investors purchased 75% fewer government bonds and notes in December compared to November. In dollar terms, it was a decline of $38 billion, from $50.8 billion in private purchases in November to just $12.7 in December.

Can we blame them? Why on earth would a private foreign investor take on a 30-year bond from Uncle Sam, when the interest rates on T-Bills is higher? Let’s see … short-term liability with a higher yield on the one hand … or owning the long-term liability of a government mired in war and bankrupting itself? Even I am smart enough to figure out that trade. Is it any coincidence that the Treasury sold off $37 billion in 3- and 6-month bills last week, nearly the exact size of the decline in private purchases of long-term debt in December? Well, yes, given the size of the bond market, it probably is a coincidence. But a fortuitous one, just the same.

Will all this result in a dollar adjustment soon? Well, the strong housing starts data (the strongest in 33 years!) and Bernanke’s upbeat forecast of U.S. GDP growth might support the dollar for awhile. Even so, I would say, “Follow the money.” The foreign money is making for exits. Maybe we should follow close behind.

Link here (scroll down to piece by Dan Denning).


The next time you think your job is impossible, think of Haruhiko Kuroda. The soft-spoken 61-year-old runs the Asian Development Bank, which may not seem like a huge deal to investors. After all, it is not the IMF or even the World Bank. Based in the Philippines, the ADB is known for making loans to countries like Cambodia, Mongolia and Papua New Guinea. Less known is the ADB’s key role in accelerating development and reducing poverty in China and India. When you consider that investors and executives are pinning their hopes for prosperity on those two nations, the ADB’s importance comes into sharper focus.

There is an even bigger task Kuroda is taking on, one with great significance to investors: bringing Asia’s booming, yet disparate, economies together. It is not that the Oxford-trained economist and former Japanese Ministry of Finance official is a glory hound. Rather, Kuroda is one of the few policy makers who understand the importance of greater cooperation in Asia and are in a position to do something about it. “Countries working together can do much more than they can alone,” Kuroda said in Tokyo last week. “They can create more growth, solve more problems, attract more investment, jobs and opportunities and consolidate the significant gains of recent decades.”

Gains, indeed. Asia is already home to many of the world’s most vibrant and potential-drenched economies. In 2005, Asian stocks rose 22% in U.S. dollar terms, according to the Morgan Stanley Capital International Asia-Pacific Index. Rallies were far bigger in local currency terms. Good stuff all around. That is, until you think about the magnitude of Kuroda’s task of integrating East Asia’s 13 economies and that of India. For one thing, Asia’s three biggest economies – Japan, China and Korea – are barely on speaking terms amid unresolved disputes over World War II. For another, Asian nations are far more disparate than the 12 euro-area members. When I asked him about all this, Kuroda put a positive spin on things. “It won’t be easy, of course,” he said. “But increasing economic integration could affect politics.”

The gulf between the 10 members of the Association of Southeast Asian Nations raises other problems. Within the group you have democracies, communist regimes, authoritarian governments and military leaders. You have wealthy Singapore (per capita income of $23,636) grappling to find common economic ground with poor Laos (per capita income of $372). Linking Asia’s currency, bond and stock markets is easier said than done. One immediate goal is creating an Asian entity resembling the Group of Seven industrialized nations. After all, what has the G-7 done for Asia lately? And does the G-7 really matter anymore? You will be excused for not realizing the group – along with Russian policy makers – met in Moscow on February 11, an event that barely registered with markets. The reason: The G-7 holds zero sway over economies that are doing the most to influence financial trends.

Link here.


I am breathing a sigh of relief at the selloff in energy and gold stocks. In the last few weeks, enthusiasm for the two sectors had risen to such a level that I could not find anybody with anything bad to say about these stocks. Everyone wanted to buy. And frankly, that had me worried. I feel much better now that volatile small-cap oil-and-gas producer Ultra Petroleum (UPL:Amex) fell 14% from January 31 to February 10. And with heavy-oil refiner and sector favorite Valero Energy (VLO:NYSE) down nearly 19%. And with Canadian oil sands play Canadian Natural Resources (CNQ:NYSE) down nearly 12%. And now that gold stocks Newmont Mining (NEM:NYSE), Glamis Gold (GLG:NYSE) and Goldcorp (GG:NYSE) have all dropped about 11% in the same 2-week period.

No, I am not some kind of investing masochist. I personally own shares of Glamis Gold and Goldcorp, and I do not like the pain of an 11% loss any more than the next investor does. But the simple truth is that stocks go up when doubting investors are converted into buyers. If everyone is a believer, there is not a reservoir of potential buyers ready to increase demand for shares. You make more money investing in the trend when at least a sizable minority of investors doubts the trend – or worries that it is about to come to an end – and resists buying into the trend even while other investors are making money.

As long as the fundamental trend is intact – and I believe it is in the energy and gold sectors – I am happy to see signs of skepticism. And I get positively giddy when I see a story like Commodity Bubble’s Burst Is Good for Stocks. Bring me your worriers, your doubters, your shorts with a need to cover. In today’s column, I am going to take a look at the trend ahead for gold stocks.

Link here.


Anyone who sees Syriana, the new George Clooney movie about political hugger-mugger in a Middle East oil kingdom, will not come away with an enhanced understanding of the global oil predicament. They will see a dark, brooding, and impressively restrained story with one brief car chase, few explosions, and barely a bullet flying. They will sense several layers of intense paranoia that seem to suggest almost no one in authority here in America can be trusted about anything. They will see a foreign culture depicted as (to crib a phrase from Winston Churchill) a riddle, wrapped in an enigma, wrapped in a hairball. In the movie’s most terrifying scene, they will see George Clooney’s character, Bob, a washed-up CIA agent, receive an extremely severe manicure, so to speak, from an al Qaeda-type sadist.

But they will not get any clear ideas about the implications of our sick dependency on Middle Eastern oil for life in U.S. In fact, one of the unfortunate results of this otherwise not-stupid movie, is that it will cater to exactly the kind of paranoid fantasies that will be least helpful for Americans facing a bewildering future and needing desperately to take measured collective action to preserve living standards. Sure, there is plenty of greed and bad faith out there in the big leagues of geopolitics and corporate life. But the global energy predicament is foremost a geological problem.

Despite the claims of those who believe that the Earth has a creamy nougat center of oil, the supply of this critical resource is actually finite, and we are at very dicey moment in our brief history with it. There is good reason to believe that the world is now passing over the tippy-top of its all-time maximum peak oil production and starting down the gruesome slope of irreversible depletion. Meanwhile, discovery of new oil has been practically nil in the 21st century, and you cannot produce oil that has not been discovered. The shorthand for this conundrum is Peak Oil, a subject lately growing in the public’s awareness.

The great problem, therefore, is not that we are immediately running out of oil, because at peak there will still be a lot left. The problem is that the first half was the lightest, sweetest crude in the easiest-to-reach places, including Texas. It was cheap to get and refine. The remaining half is mostly harder-to-refine heavy, sour crude, or tar sands, or oil shales (which are not even composed of oil, by the way, but of an uncooked organic precursor called kerogen), and these things can now only be gotten in forbidding arctic terrains, Amazonian jungles, deep under the sea, or in unfriendly countries. The remaining oil is distributed inequitably around the world. More than two-thirds belongs to the nations of the Middle East. It does not come cheap, either in monetary terms or in geopolitical costs.

Syriana is about some of those geopolitical costs. The movie was loosely based on Robert Baer’s gripping 2004 account, Sleeping With the Devil, of his career as a CIA agent operating in Saudi Arabia, and much of the book is devoted to the stupendous corruption, greed, and incompetence of the al Saud royal family – as well as the behind-the-scenes string-pulling by the Anglo-American interests scheming relentlessly to do what is necessary to keep the oil flowing – into American gas tanks, that is. And that is the more precise context of the problem we face over Peak Oil: we have poured our postwar national wealth into an easy motoring suburban sprawl living arrangement that cannot possibly operate without continued reliable supplies of cheap oil. Perhaps even worse, our economy has insidiously shifted from manufacturing to sprawl-building (otherwise known as the housing bubble). Having made such massive misinvestments in the infrastructure for a way of life with no future, we are trapped in a deadly psychology of previous investment which prevents us from even thinking we can do things differently.

This was all neatly encapsulated by the remark widely attributed to Vice-president Dick Cheney that “The American way of life is non-negotiable.” Whatever you think of the remark, it is probably an accurate representation of how most Americans feel – that we are entitled to 3500 square foot houses, all the cheap gasoline we can burn, and supernaturally easy credit because we hold the torch of freedom as an example to the world. Thus, we are dismayed when other people in the world scoff at our torch-bearing while they blow up our soldiers, because they know – as the characters in Syriana know deep down somewhere – that it is all basically about our desperate addiction to their oil. It would be unfortunate if our dismay turned into unbridled wrath, because that kind of political rage is just as likely to turn inward.

There is a whole set of intelligent responses to Americawts oil predicament that we ought to be talking about now. These range from restoring the nationwts passenger rail system, to supporting local agriculture in earnest, to rebuilding local networks of retail trade and economic interdependency for the time ahead when the Big Boxes die of oil starvation, to setting legal limits on new suburban sprawl. These are the kind of things that will help us through the Long Emergency of the post-cheap-oil world we are entering. The temptations of paranoia will only make things worse.

Link here (scroll down to piece by Jim Kunstler).
Gentlemen, Start Your Engines – link.


Over the last two decades, departing Fed Chairman Alan Greenspan has affected many people in many ways. Few people understand the impact he has had on their lives – how he has helped transform a culture. After 18 years as the world’s most powerful central banker, he has changed the way people think about money, credit, and most importantly, he has changed the way people view debt. Debt, a pariah to generations following the Great Depression, has been embraced by recent generations. Recent generations, that is, who are now far enough removed from the tragedy of the 1930s that history’s lessons of excess credit and debt have been forgotten. Debt, always a tempting seductress, has been raised to new levels of respectability under the tutelage of Mr. Greenspan. Many, emboldened by rising asset prices, have completely lost what had been for centuries a largely uninterrupted natural aversion to borrowing money. Benjamin Franklin and Adam Smith abhorred debt.

Today, borrowing against equity in real estate occurs at rates never seen before. Mortgage equity withdrawal was unheard of generations ago – a second mortgage was the last recourse for a family in trouble. Today it is routine. Septuagenarians shake their heads as they see young people living lifestyles which do not square with what they know of their incomes and expenses. Debt it seems has not taught any hard lessons lately – debt has become too friendly, too tame, and too forgiving. Nowhere is the cultural change more apparent than on television – a constant din of pitchmen offering new and innovative ways of extending credit to ordinary people. In a truly disturbing symbol of how times have changed, the once mighty General Motors now hawks home equity loans and EZ cash-out refinancing through its Ditech.com subsidiary – the only GM group that has been consistently profitable in recent years.

A once dynamic and innovative economy has become increasingly dependent on borrowing money to fund consumer spending. This spending, in turn, produces economic growth and most accept this condition as just another reality – another fact of life. With a zero savings rate, Americans borrow and spend paying little heed to the mounting debt or the implications for the future. As long as asset prices rise faster than debt, household balance sheets do not seem to matter, and bills never really come due. Someday, maybe soon, the accumulating debt will matter.

The magnitude of the new debt over the last two decades is evident when looking at household liabilities over this period. Household debt gently rose during the 1990s until the bursting of the stock market bubble necessitated massive monetary stimulus from the Fed. The stimulus came in the form of multi-generational lows in interest rates which, when combined with a largely unregulated mortgage lending industry, ignited a housing boom the likes of which the world has never seen. There is now over $8 trillion in mortgage debt in all. In the last three years alone, nearly $3 trillion of new mortgage credit has been extended – first mortgages, second mortgages, home equity loans, and lines of credit.

Some dismiss concerns of too much debt by pointing to the bottom line. Debt, they say, is not a problem because household balance sheets are the best they have ever been. Today, household net worth does look impressive – against a meager $12 trillion in debt stands a hefty $64 trillion in assets. A closer look at net worth, however, shows that while liabilities have marched steadily upward, assets can go up or down. A closer look at how different types of assets have behaved during the first half of the decade shows a neat handoff between equities and real estate. Stocks had run their course, interest rates were slashed to 40-year lows, and housing markets across the land began to boom. One rapidly rising asset class having exhausted itself, another asset class began to rise rapidly, easing the pain that, historically, would have been expected. A crisis had been averted. Ordinary people are now wealthier than ever before, and the effects of more credit and debt have confirmed what many had come to conclude over the years – debt is good. The cultural transformation is now complete.

But as Alan Greenspan prepares to exit the stage, leaving behind mountains of debt, where does that leave us? With all this new debt and prosperity comes a potential problem. What happens if real estate assets suffer the same fate as equities did a few years ago? Or, what if real estate values simply go flat for an extended period of time? Since debt lingers long after assets lose their glow, how might the bottom line look then? How might the culture change as a result? Warren Buffet famously said some time ago, “Give me a trillion dollars and I’ll show you a good time too!” With almost $9 trillion of new household debt created during his years at the Federal Reserve, and having changed the way the entire Anglo-Saxon world views debt, is this all that Alan Greenspan ever really wanted? To show everyone a good time?

Link here.


A trivia question: Which city has the highest number of billionaires in the world? New York? London? Dubai? Hong Kong? Nope. According to Forbes, in 2004 Moscow became the city with the most billionaires: 33, “passing New York City by two.” Who would have thought that barely a decade after the defeat of communism and break-up of the Soviet Union, and after the devastating 1998 foreign bonds default, Russia could establish itself as billionaire heaven? Today Russia’s capital is one of the world’s centers for luxury goods consumption, top-notch nightclubs and restaurants. It sports real estate values approaching those in Western capitals and, according to Mercer Human Resource Consulting, overall prices in Moscow are so high that it is “the most expensive city in Europe” and second most expensive city in the world after Tokyo. If it were not for the dreadful Russian winters, it would actually be a nice place to live. If you can afford it, that is.

The reason for Russia’s newly found prosperity are its vast natural resources. Badly mismanaged during the Soviet days, commodity exports have since became the country’s economic staple. As a result, the Russian economy has been growing strongly, adding 6.4% in 2005 – way above analysts’ and even government’s expectations.

Russia’s image as the world’s major power got another boost recently when the country was elected the leader of the prestigious G8 alliance for 2006. And while other G8 members probably took that vote somewhat tongue in cheek – after all, Russia’s low per capita income, high corruption, poor medical care and other “third world” problems are hardly fitting for a G8 member, let alone its leader – Russia is the world’s second-largest oil producer and the largest exporter of natural gas (and let us not forget all those Soviet-era nukes). So the West sees no harm in playing along a bit.

Russian stocks, still relative newcomers to the world markets, have also been getting a lot of attention lately. The Russian RTS stock index advanced strongly in 2005, breaking above the psychologically important 1,000 level for the first time. Our readers knew to expect this strength in the RTS. We have been bullish on Russia for months; last July, for example, we published this forecast and chart: “Expect gains [in the RTS] towards 785-809 while price remains above 664.”

Link here.


Natural gas prices have fallen 54% in four months. Just since Feb. 1, they have fallen 27%. And they have fallen lower in each of the past eight sessions. On Wednesday (2/15) the dip established a new 7-month low, as prices fell below $7/million BTU. In short, the recent trend is clear. What is far less clear, at least from a fundamental standpoint, is the maturity of that trend. Revisit mainstream news reports from two weeks ago, and you will see plenty of speculation that warm weather was to blame for the decline. Likewise, cold weather was supposed to buoy the bulls – if Jack Frost ever showed up.

Funny thing is, smack in the middle of that 8-session decline, Jack Frost did show up: A powerful nor’easter storm blasted the Eastern Seaboard with freezing weather. The 2-foot-thick blanket of snow in New York’s Central Park set a new record, and airports from Virginia to New England shut down. As a result, nearly every analyst you will find quoted in today’s natural gas news has come to the same conclusion: “Cold weather during the remainder of the heating season will not affect stored supplies,” nor, as the reasoning goes, the price of natural gas. So the trend in gas that was supposed to get snapped by last weekend’s weather not only goes on, from reading the mainstream account it now seems fundamentally unstoppable – it is immune to cold and feeding on huge domestic stockpiles!

The fact is that every market trend eventually ends, and each matures according to discernible Elliott wave patterns in price. So despite confusing claims that suggest the contrary, the latest price decline in natural gas offers clear insight into the maturity of its trend. More importantly, that move has set up an excellent opportunity. Senior Analyst Jeffrey Kennedy’s wave-labeled charts show the pattern in natural gas prices, how much deeper the decline will dig and how big a bounce to expect next time prices do reverse.

Link here.

Convinced, after the trend.

Question: When is Wall Street more likely to say prices have nowhere to go but down? (1) Before a certain commodity loses half its value in an eight-week stretch, or, (2) After a certain commodity loses half its value in an eight-week stretch?

OK, time is up – and by the way, the answer is the same whether the question is about “most investors” or “Wall Street”. It is “After”. Regardless of the commodity (or financial market), the majority of participants do not become convinced of where the trend will go until prices have already gotten there – and the bigger the size and speed of the move, the more convinced they will be that more of the same is just ahead.

Link here.


Nobody loves a good deception more than investors … unless it is voters. The Dow shot up more than a hundred points yesterday. And would you believe it? Consumer spending also shot up last month! Retail sales just posted their biggest increase since May of 2004. As a consequence, China is bringing in so much U.S. cash that they are running out of space to store it. Merchants cart it over to the bank, where it is exchanged for local currency. So much new money has been created to keep up with the inflow of dollars that M2 – a measure of money supply – is rising at nearly 20% per year in China. No wonder the place is booming.

Oh, what a tangled web we weave. The U.S. Fed practices to deceive consumers with cheap money and then, consumers deceive their own retailers. These retailers then deceive their suppliers, who deceive their bankers, who deceive their borrowers. The borrowers build factories and office towers all over China. Whew! It makes your head spin and your skin crawl. How do we untangle this web? We begin by wondering where consumers get the money to spend. After all, the Fed is now on a tightening cycle, threatening to raise short-term rates to 4.75% just to assert Ben Bernanke’s bona fides. And the house price bubble that was responsible for so much consumer spending since 2003 seems to be leaking. And those houses that are already in homeowners’ hands are getting more expensive to own. The teaser rates under which they were purchased are expiring. Maybe the January figure is a fluke. Or, maybe consumers are just pressing the pedal to the metal, as they say. You are dead at 60 MPH anyway, so why not go 80? Wheeee!

Here in Britain, inflation is disappointing central bankers. As in America, they wanted to deceive the public at a fixed and controlled rate – a minimum of 2% per year. But in the latest 12 months, only 1.9% of the pound’s purchasing power fell off. Last month, prices actually fell (the pound grew larger). What does this mean? It means the economy is slowing down. Quick, start up the printing presses! Get Bernanke on the phone. Ask him what to do. Gently remind him about those “unconventional methods” he favors – destroying a currency to incite a boom. Remind him that if he can weaken the value of the currency, people will be only too eager to get rid of it. Spending will sizzle again. The consumer economy will flourish. At least, that is the simple-minded reasoning that undergirds his oeuvre. It never seems to have occurred to him that people might catch on and dump their dollars before he gets a chance to cheapen them. But in the Bernanke Weltanschauung, he and his central bankers pals are fleet afoot and sharp abrain; they will always stay one step ahead of the people they are trying to fleece.

Historically, no national bank, by purely conventional means, has ever failed to ruin its money, but not necessarily when or how it was planned. Bernanke’s obsession, say the experts, is neither with protecting the dollar nor with destroying it, but merely with controlling the rate of disintegration. There, we think the central banker is asking for too much. He is like a killer who asks him victim to stand still so he can stab him slowly. Imagine his surprise if the victim stabs first.

Link here.


“Rogers, Wien See U.S. Commodity Producers' Shares as Overvalued,” a Bloomberg News headline declared. “Jim Rogers and Byron Wien are still bullish on commodities after their biggest weekly decline in 15 years,” the news story explained, “Yet they view the shares of U.S. raw- material producers as overvalued.” Your editor would not rush to disagree with either Rogers or Wien, but he would add one important qualification: Some commodity shares are more overvalued (or less undervalued) than others. That is because the supply/demand factors influencing the price of crude oil, for example, are not identical to those influencing the price of soybeans.

Jim Rogers, the hugely successful former hedge fund manager, is a full-time fan of physical commodities, but only a part-time fan of resource stocks. In fact, he created his own commodity index in the late 1990s (along with a fund that mirrors the index). So when he says, “Don’t buy the stocks. Buy the stuff itself,” he is both offering honest investment insight AND “talking his book.” But that does not mean we should not heed his advice. Rogers correctly notes that “costs are going through the roof” for many commodity producers, thereby reducing the profits they would be earning from the soaring prices of their products.

As we also anticipated, steel makers, copper minors, gold miners, fertilizer producers, chemical companies and many other types of commodity-based companies are all suffering from a toxic combination of high energy prices and mounting labor costs. Therefore, profit growth at many resource companies is, in fact, grinding to a halt. Based on Wall Street’s consensus forecast, the profits at basic materials companies in the S&P 500 will fall 8% in the first quarter of 2006, compared to a 9% increase for the rest of the S&P 500 companies. Phelps Dodge, DuPont and Alcoa number among the many resource companies that have reported disappointing earnings due to rising costs.

The cost side of the profit and loss statement, however, is not what worries us most. It is the revenue side. The prospect of falling commodity prices poses a much more serious threat to profitability than the prospect of rising production costs, especially if the most buoyant commodity markets, like crude oil and platinum, deserve their recent savage declines. If, as many seasoned commodity traders believe, “artificial demand” has been boosting the prices of many commodities, then the current washout in the commodity sector may signal something more serious than a mere “correction”. “Billions of dollars of long-only index-fund money is pouring into these markets,” observed commodity-trader Richard Morrow, “And that’s throwing the traditional fundamental influences all out of whack. These markets are just too small to handle an influx of money this large … I can tell you this; if the money-flow into these markets stops, there’s going to be some great opportunities on the short side.”

Immediately after Morrow’s Delphic warning, the commodity markets tanked. Likewise, the stocks of most commodity-producing companies. But maybe the high-flying resource stocks deserved their whuppin’. Certainly, they had enjoyed a spectacular run over the last few years – a run that may have become a bit too spectacular over the last few weeks. But before panicking in the face of these wicked declines, we should take a peak inside the commodity indices to see what is up and what is down. For example, the energy complex has been dropping sharply, while the grains have barely budged. This divergence may contain the kernel of an opportunity: sell what has been frothy to buy what is less frothy. The agricultural sector has been about as frothy as a week-old glass of champagne, suggesting itself as one possibility.

As the nearby chart illustrates, agricultural commodities have been conspicuous laggards throughout the resource bull market of the last few years. Perhaps their day will soon arrive. We based this conjecture on no greater wisdom or authority than the mere idea that markets tend to be mean-reverting. Thus, as the chart also suggests, energy prices are rolling over at the same time that agricultural prices are turning up. Hence a possible mean-reversion has already begun. The fact that the agricultural sector has been trailing far behind the energy sector does not automatically imply that the energy sector is a “sell” or that agricultural sector is a buy, but it does raise that possibility. So rather than “sell the stocks and buy the stuff,” as Rogers suggests, maybe it would be better to sell some of the stocks and some of the stuff, and buy OTHER stocks and OTHER stuff … like the stocks of agriculture-based companies.

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


To the surprise and wonder of many economists, the U.S. dollar continues to be rather strong in international money markets despite ever growing American trade deficits. Last year, these deficits amounted to more than $700 billion, or 6% of GNP, increasing the indebtedness of the U.S. to the rest of the world to nearly one-fourth of GNP. At this rate, American indebtedness is likely to reach one-half of GNP in just five years. Despite the soaring debt, the U.S. dollar rose some 14% relative to the euro and even more, relative to the Japanese yen. It lost a fraction toward the Chinese renminbi after the Chinese central bank raised its dollar rate by 0.4%. Yet, the dollar seems to be the rock on which most countries rest their currencies.

The financial world, apparently, is ignoring the trade deficits and the rapidly rising American indebtedness. Being accustomed to deficit financing, American officials seem to handle them with ease. Even long-term interest rates are remaining exceptionally low. But many politicians and media spokesmen like to complain about China, especially about its refusal to allow its currency to find a free market rate and thus allow the money market to function freely. They like to look abroad and find fault with foreign demeanor rather than reflect on their own conduct.

Ever since the world discarded gold as the standard medium of exchange, the U.S. dollar has served in its stead. And just like gold or any other commodity, the dollar has been moving from places where its market value is low, to places where it is higher. And just as the gold-producing countries usually experienced “unfavorable” balance of payment – that is, the exports of gold exceeded the imports – so does the U.S. suffer “unfavorable balances”, or exports of dollars exceed their return. But while the quantity of gold mined and offered on the market was always rather small, the volume of Federal Reserve notes and deposits, as well as the fiduciary credits resting thereon usually is much larger. The Fed has generated numerous boom-and-bust cycles ever since it opened its doors in 1914. The booms are periods of easy money and abundant credit that lead to malinvestments, squandering, scarce factors of production, and encourage over-consumption. In the recessions that are bound to follow, the maladjustments are corrected and the factors of production are employed again for the best possible satisfaction of consumer needs and wants. But before the recession has run its course and properly corrected all maladjustments, the monetary authorities usually launch another cycle.

Where in the cycle are we today? Most symptoms seem to point to the phase when goods prices begin to rise. Yet, foreign central bankers and commercial bankers continue to trust the financial structure and invest some of their dollar surpluses in U.S. Treasury obligations. They simply ignore the massive level of dollar debt and the large maladjustment of the global economy. The final phase of the cycle – where a new central banker facing runaway inflation may have the courage to raise his discount rate to the market rate – is not yet in sight. However, we must face and get ready for the ordeal that is bound to come at home and abroad. The Fed may continue to raise its discount rate until it finally reaches the market rate, at which time the readjustments begin. But even if it should not dare to raise its rate to a level at which the demand for funds is covered solely by genuine savings, the readjustments may commence whenever the distortions come in sight. The coming readjustments may commence abroad. Some foreign creditors may tire of amassing ever more dollars and supporting the standards of living of a rich and powerful country. They may question the creditability of a debtor who makes no preparation for reducing his debt, but actually continues to enlarge it.

If the negotiations with Iran fail, and it edges ever closer to the possession of nuclear arms, there is serious speculation that either the U.S. or Israel may strike at the country’s nuclear bases. Such an assault undoubtedly would enrage the world of 1.3 billion Muslims in 206 countries, and topple the international debt structure that is resting on the U.S. dollar. There are times when precaution is wise and profitable. It keeps a watchful eye on present dangers and on things to come.

Link here (scroll down to piece by Hans Sennholz).


Picture it: You are a top-level security adviser to the president of the U.S. The issue at hand is whether or not to attack Iran, by military means or otherwise, in a last-ditch effort to prevent Tehran from obtaining nuclear weapons if UN channels fail (which they almost certainly will). Your fellow advisers are divided, leaving you to break the tie. If you decide to attack, brute force is not the only choice - there is also an indirect option. The first action you can take is attempting to cripple Tehran by cutting off its supply of refined petroleum products, i.e., gasoline. (Iran is a major crude oil exporter, but it does not have the necessary refinery capacity to meet internal demand for finished product.) If you choose to cut off Iran’s access to gasoline, this would in essence be a game of economic chicken: Either you cripple the regime and take away the mullahs’ popular support by forcing economic implosion or they hang on and cripple you first by cutting off crude oil exports – a matter of who cries uncle first. You are aware that if you attack Iran, the consequences could be dire no matter what happens. Along with the long-anticipated “super spike” that takes oil into triple digits, there would be the ramifications of an economic unraveling in Asia to contend with.

Another option, of course, is conventional warfare – hitting Iran hard with military force. Such a course of action raises the stakes even higher. But the nuclear workshops cannot be taken out through air strikes alone. The mullahs have had too much time to “harden” their targets, and the facilities are anyway too dispersed and too well hidden to uncover without boots on the ground. Stretched as thin as the U.S. already is, and considering the moth-eaten financial state of the Western powers in general, physical invasion hardly seems an option at all. Nor does this take into account the potential backlash of the Islamic world any military efforts would bring about. We have seen a frightening preview of Muslim anger in the fury of the Danish cartoon row. Giving the West such a preview may be the political raison d’etre for the orchestrated outbursts in the first place.

The name of the game Tehran plays, then, is “How Crazy Are We – and Do You Really Want to Find Out?” Strategists seem to be of two minds on the subject. The first camp argues we should take Mahmoud Ahmadinejad at his frightening word and assume he really is driven by madman visions of ushering in a 12th Imam. The second camp argues that Iran is still a rational actor at heart, spewing out the fire-and-brimstone stuff for show. If the first camp’s assessment is correct, invasion could be warranted no matter the short-term cost, because the stakes are just as high as they could possibly be. If the second camp’s assessment is correct, coolheaded pressure and a firm backbone in the face of bluster could be the best course of action.

Then there is the option of doing nothing, putting off the risks for another day, and virtually ensuring the proliferation of nuclear weapons across the Middle East. Iran has roughly 20 years worth of energy reserves left. The mullahs cannot sit idly by - at some point down the road, fiscal implosion awaits. Thus, nuclear capability could come in quite handy when it comes time for Iran to appropriate assets from one of its weaker neighbors. How would the first Gulf War have turned out against a nuclear-armed Saddam? The assumption that Israel could take care of the Tehran problem is similarly wishful thinking. An Iraeli strike is about as close to a no-win situation as one can get.

One of the remarkable elements of this grave situation is how effectively the broad market has managed to ignore it, even though energy issues address the very core of modern life. The truly ugly what-if scenarios are no longer found at the tail end of an accidental chain of events; they are increasingly tied to a deliberate series of provocations, which increases the probability of their occurrence significantly. It could be said that the price of gold and oil reflects this reality, but that does not explain the consistently low risk premiums and Pollyannaish attitudes elsewhere. In large part, we are still riding the global liquidity wave. The bluebird is on Mr. Market’s shoulder, with few, if any, worries in sight.

Consider another scenario: You are the incoming chairman of the Federal Reserve. Alan Greenspan has passed the baton (which is actually a stick of dynamite, as an Economist cover recently depicted). You know that there are serious risks before you: As consumer spending grinds to a halt under the pressures of broad wage stagnation and ballooning mortgage payments, you may end up forced to stimulate (by cutting short-term rates) to save America from its backbreaking load of accumulated debt. On the other hand, with gold at multidecade highs and your inflation-fighting credentials still unproven, you will not be able to indulge your stimulus desires so easily. You also have a hawkish board looking forward to a democratic policy-setting environment, rather than the stifling autocracy that kept it muzzled for so long.

These two scenarios – the Iran and the Fed chairman questions – share an unpleasant characteristic: They both put the decision maker between the devil and the deep blue sea. There are no shortcuts or pat answers. Unfortunately, Wall Street and Washington are geared to supply pat answers, and to behave as if such answers have merit. This is why we hear about frivolous theories like the existence of financial “dark matter” to explain away our growing burden of nonproductive debt. It is why we see BusinessWeek touting the virtues of the “we think, they sweat” argument, blithely overlooking the fact that intellectual property gains apply to specific industries, not entire economies. It is why we pretend that the Bretton Woods II arrangement can go on forever, and why we convince ourselves that it is our moral and God-given right to enjoy infinite credit lines.

All this comes back to market action by way of the Peter Principle. In his book Origins of the Crash, Roger Lowenstein sheds light on the concept: “By the latter part of the ‘80s, every investment bank – not just Drexel Burnham – was underwriting LBOs [leveraged buyouts], often with management participating. Many of the early buyouts succeeded, and there is no doubt that some achieved efficiencies and that Corporate America had been in need of a belt-tightening. But the details became steadily, then recklessly, more leveraged. Finance has its own Peter Principle, by which a successful model will be adapted to progressively riskier cases until it fails. Ultimately, borrowers such as Federated Department Stores … promised to pay far more in junk bond interest than they had in earnings. These later LBOs were – by simple arithmetic – doomed to fail.”

Different names, same game. Lowenstein was describing the buildup of market excesses that began in the 1980s, but the same basic logic applies to the situation today. Our entire economy, and arguably the market as a whole, has become a sort of massive LBO. The Peter Principle illustrates why a bad ending is virtually inevitable – we are determined to push our luck until it fails us. If our current debt load is not enough to do the job, we will accumulate more. If the most recent straw is not enough to break the camel’s back, then, by golly, we will get more straw. Expect rough waters and plan accordingly.

Link here (scroll down to piece by Justice Litle).


Debt-insurance contracts may be settled in cash, averting a rush for bonds when companies default, under a plan being proposed today by the International Swaps and Derivatives Association. The market for credit derivatives, dominated by credit-default swaps, expanded fivefold in two years to about $12.4 trillion, according to ISDA in New York. Banks sold so many of the contracts that when auto-parts maker Delphi Corp. defaulted in October, there were not enough bonds to settle with, causing prices for the notes to rally. “Lurking in people’s minds is the possibility of a major credit event,” ISDA Chief Executive Robert Pickel said in an interview. “Our plan is to have a series of meetings and get at least the structure of the process done by June 20.”

No one knows just how much debt is insured through credit-default swaps because the contracts are privately arranged and are not listed on any exchange. Federal Reserve Bank of New York President Timothy Geithner and 14 of the largest banks including Goldman Sachs and JPMorgan Chase met to review plans for improving credit derivatives settlement. ISDA, which represents 700 banks and investors in 50 countries, is sending members its cash-settlement proposals and will meet with members March 2 to discuss the details, Pickel said.

Credit derivatives are the fastest growing part of the $270 trillion market for derivatives, financial obligations based on interest rates, the outcome of certain events, or the price of underlying assets such as bonds. Investors use credit-default swaps to protect against non-payment on debt, or trade them as a way of betting on a company’s credit quality. The buyer of the contract pays an annual fee and receives the full amount insured if the borrower defaults. Usually the buyer is obliged to deliver the defaulted loans or bonds as part of the settlement process.

Link here.


While Larry Kudlow and fellow members of the Infinite Wealth Creation Society argue that rising home prices are a cure for everything from stagnant wages to fire ants, sadly there is one group yet to experience the financial nirvana that comes with a bull market in homes. That group is first time home buyers. These are people, who by having the bad luck of being born too late, or having been born with genes too timid, were late to the real estate game. They got in when prices were high and financing was easy. Even if their realtor friends now say their home is worth more than they paid for it, these people have to live somewhere and have no interest in selling. So even though they may be living in a Perpetual Wealth Creating Machine, these late comers still have to make the mortgage.

And that, according to Vanessa Richardson, crack reporter for MSNBC.com, is not always easy, particularly for young adults in an environment of slow wage growth. According to Richardson’s measures, the median home price is up 26% over the past five years while young adults’ incomes have increased less than 10%. That means that it takes a big chunk of a 20-something’s paycheck to keep the mortgage company at bay. Throw in student loans and credit card debt, and things look tighter than Dick Cheney in luge suit. Richardson reports that college graduates now accumulate about $20,000 in student loan debt by the time they toss their mortar boards. After graduation there is credit card debt, which the Fed says has tripled to $12,000 since 1983 for 25-34 year-olds (as of 2001). No wonder it is easier for a young person to crawl out from under a sumo wrestler than wriggle out of a financial bind.

A quick look at the Fed’s Financial Obligation Ratio reveals that it is not just young folks who are stretched. The share of income going to service mortgages generally is at a record high, and that is despite a series of refi booms that enabled homeowners to lower their interest charges. Of course, today’s mortgage burden is not all from traditional mortgage lending – consumers also piled on home equity loans and cash out refinancings. And while some of us may need a good finger wagging for dropping enough money on a barbeque grill to buy a Dodge Neon, according to Elizabeth Warren, we might not be so frivolous after all. Warren is author of the Two Income Trap: Why Middle Class Mothers and Fathers Are Going Broke. She figures that the real squeeze today comes not from lattes and iPods, but from the basic stuff like health insurance, day care and housing.

The “two income trap” comes from Warren’s conclusion that the advent of double incomes drove up housing prices, particularly those in neighborhoods with quality schools, thus driving up the fixed costs of the American family. Warren’s book was published in 2003, when the mortgage finance bubble still had a few years to run. Nonetheless, Warren concludes that while working couples with kids make far more than the typical single-earner family did in the ‘70s, the cost of owning a home has risen faster than family incomes. As a result, the discretionary income of today’s families is a smaller share of the total than their double-knit-wearing predecessors. With fixed costs so high and families so leveraged, Warren concludes that more families today are just one financial emergency away from bankruptcy.

Link here.

Every dog has his day.

We were trying to explain a minor triumph. Our book, Empire of Debt, was named by The Economist as one of the most important financial books of 2005. But when a husband tries to explain his successes to his wife, his arguments are limited. He cannot attribute it to genius, or even to virtue. She knows it is not true. All he can do is bark and roll over. Woof!

When David Brooks writes in the NY Times about what great people NY Times readers are and how the United States is the world’s rising power not China nor India, almost no one laughed … or rolled over. Instead, they perked up their ears and wagged their rear-ends; they liked the sound of it. But every four-legged empire has its day, too.

The latest employment numbers reinforce this idea: just under one in 21 people are without work. True: in America today, more people are working more hours than ever before. False: they are better off for it. We thank our dinner companion last night, financial strategist Simon Hunt, for pointing something out to us. He drew our attention to Elizabeth Warren, writing in Harvard magazine, who shows that the median family had only one wage earner in the early 1970s, who earned $41,670, in today’s money. Out of this, he or she paid the family’s regular, more or less fixed, expenses: taxes, mortgage payments, health insurance, car and gas payments, etc. Typically, these costs rose to 55% of monthly income. This left the family $1,630 to spend on food, clothes, entertainment and so forth. Now, 30 years later – after the Reagan Revolution, the fall of the Berlin Wall, the disappearance of the last vestiges of the gold standard, and the biggest financial boom in history – the median family has two wage earners who, between the two of them, working nearly twice as much as before, earn around $73,770. But fixed costs have risen to 75% of income, leaving only $1,509 in “discretionary” spending. Is there any doubt that U.S. economic progress is a swindle?

The U.S. economy has been good to us. We do not want to be ungrateful. But being grateful does not mean being blind. Nor does it mean forgetting about those other dogs whose day has not come. The people who suffer the swindle are people who are stuck in the middle of it. For example: American couples, both working – with a large mortgage on a small house – toward the short end of the income stick. Those people, in the bottom 10%, have seen their incomes fall by nearly 2% in the last two years. These poor stiffs now work night and day, and earn less money. Their quality of life must have fallen sharply over the last generation, for they not only have less money, but they also have much less free time. They are the people who have been teased and trapped into carrying debt loads that crush them, who make mortgage payments with minimums that are now being reset, and who pay usurious rates on every dime they borrow. We guess that even their health has deteriorated. With no one at home to prepare proper meals and no time to exercise, they eat poorly, get fat, and die young.

Again, we do not mean to appear ungrateful. This weakness in American incomes is not exactly the fault of the U.S. economy itself or its working class lumps. All the world’s developed economies are being hounded by competition from overseas, where GDP growth rates are three times those of the U.S., and where real wages doubled in the last 10 years. India, we read today, has 27 billionaires with a collective net worth of $106 billion. These trends are not likely to come to a halt anytime soon. Americans work harder and longer than any people on Earth, says Brooks. They expect to rule the world. Alas, people do not always get what they expect, or even what they think they deserve. They get what they have got coming.

Every dog has his day, we point out again. But the U.S. Empire’s day was probably yesterday.

Link here.
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